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Types of Compensation: A Guide For HRs

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In today’s fast-paced growth and organizational changes, companies strive to be at the forefront. One ingredient separates the great from the rest: engaged and motivated employees.

But what is the secret to ensuring a loyal workforce in the long run?

Competitive compensation packages are the secret behind long-term employee retention. Astonishingly, 63% of US employees have left their organizations and the culprit? Money!

Moreover, replacing your departing employees costs twice as much as retaining them.

It’s crucial for organizations to gain a complete understanding of the meaning, various types and aspects of compensation. This knowledge empowers business leaders to make a positive impact on their employees’ lives, resonating throughout their brand reputation and profitability.

So, what is compensation?

Employee compensation refers to all forms of pay going to employees and arising from their employment.
– Gary Dessler

In a nutshell, compensation refers to a combination of financial and non-financial rewards provided to employees in recognition of their services to the organization.

Dissecting this further:

Compensation = Wage or Salary + Employee benefits + Non-recurring financial rewards + Non-pecuniary rewards.

Based on the definition discussed above, compensation can be broadly classified under two heads:

  • Direct Compensation
  • Indirect Compensation

Now, let’s discuss these components in more detail.

1. Monetary / Direct Compensation

Direct/Monetary Compensation refers to a form of financial reward given to employees for their services at a regular time interval. It is further divided into the following types:

Basic Wages/Salaries

It is usually the cash component of the wage structure that determines other components. It is usually a fixed amount but can be periodically changed due to increments or performance-based hikes.

Wage refers to the hourly rate of pay, and salary refers to the monthly rate of pay, irrespective of the number of hours invested by the employee. They are subjected to changes due to external factors and vary based on the industry type, nature of the job, and merit.


Allowances are additional financial components of the compensation; they are fixed and help employees meet their daily needs above their base salary. The most common types are:

  • House Rent Allowance: Organizations usually compensate for employees’ housing facilities, differing based on the metro and non-metro cities.
  • Dearness Allowance: This helps employees face the onslaught of inflation of prices of goods and services.
  • Leave Travel Allowance: Employees are given allowances to take vacation time alone or with family and friends.
  • City Compensation Allowance: It is compensation paid to employees to cover the additional cost of living in cities and varies according to location.
  • Special Allowance: They give employees an additional sense of social security and motivation to work. Examples of this allowance include overtime, mobile, travel allowances etc.

Bonuses and Incentives

Incentives are paid to employees beyond their base salary and depend on their productivity, sales, profit, or cost-reduction efforts. They can be paid to an individual employee or a group of employees for their additional efforts.

A bonus is a pre-defined amount paid to employees during festive seasons or company profit. It is made mandatory by the government and usually amounts to one month’s salary to boost their confidence and social security.


Employees receive them during a particular time, which varies according to the sales revenue or company profits. They are mostly paid to sales employees on the achievement of their targets on a monthly or a periodic basis.

Stock Options

In this, employees can purchase the company’s shares at a fixed price lower than the market price, and only employees who worked for a certain period (generally three to five years) are eligible for this type of compensation.


Employee benefits include health insurance, medical coverage, retirement benefits, legal insurance, etc. A Glassdoor survey reveals that 48% of employees consider a good benefits package over a salary while accepting a job offer.

Thus, the monetary aspect of employee compensation helps satisfy their basic needs by guaranteeing social security and economic safety.

But is it enough to satisfy the higher-level needs of employees?

Well, no, your compensation package needs to have indirect benefits, too.

We may ask why, because employees value them more than your financial benefits.

2. Non-monetary / Indirect Compensation

Non-monetary compensation plays a vital role in the lives of today’s workforce. They are crucial to the long-term survival of employees in the organization while impacting the reputation and profitability of the company.

Non-financial reward is a reward focused on the needs most people have, although to a different degree for achievement, recognition, responsibility, influence, and personal growth.
– Armstrong & Murlis

They are of the following types:

Reward and Recognition

Recognizing the employees often boosts their motivation and enhances their productivity. They can be recognized for their efforts, performance, attitude, team spirit, problem-solving ability, etc., with a reward to increase their overall performance.

Recognition can be a small gesture of ‘Well done’ or a public appreciation and be either in a verbal or written form. Small gestures of acknowledgment at regular intervals make the employees more enthusiastic and satisfied in their job role.


Promotions promote a positive attitude among employees by providing opportunities for personal growth, increased responsibilities, and increased social status. It infuses a spirit of healthy competition among the employees, impacting the overall levels of job satisfaction and productivity.

Prolonged spells of delayed or no promotions increase the rate of employee attrition, as the employees feel their growth is stunted and look for opportunities elsewhere. So, a fair promotion system helps organizations retain their talented employees.

Work-life balance initiatives

A flexible work schedule increases the mental, physical, emotional, and social wellness of employees. Introducing work-life balance initiatives like remote work, hybrid work, reduced office hours, etc., helps employees fulfill their commitments to their family and friends.

Flexible schedules are directly proportional to employee morale, which makes it easier to cultivate a healthy work environment. This helps create highly confident, motivated, and stress-free employees who are happier and healthier in their workplaces.

Career Development Opportunities

Employees place continuous growth opportunities and learning new skills above other needs. A proper career progression plan provides employees with social security and helps them develop skills to assist in their future roles.

Investing in the employees’ L&D programs develops employees with the latest skills and helps organizations stay ahead of the competition. With this, organizations can create future leaders for their top positions and reduce the hiring costs for the top positions.

Integrating these non-monetary components in your compensation makes it more comprehensive and attractive for your existing workforce while also attracting the right talent to your organization.

Why is Compensation Important?

A question that truly answers itself, a comprehensive compensation package significantly motivates employees to be more productive.

An HBR survey reveals that increasing the base pay of an employee by 10% shows an increase in their likelihood of staying with the firm by 1.5%!

A comprehensive compensation package is significant for the following reasons:


In the raging talent war, organizations find it challenging to retain their current workforce. 70% of employees quit their jobs owing to lesser pay packages, significantly impacting the firm’s attrition rates. Recently, a survey concluded that with rising inflation and constant salaries, younger employees tend to change jobs at a quicker pace for higher pay. So, it’s crucial for organizations to constantly update their compensation packages.

Job Satisfaction

96% of employees place remuneration at the core of their job satisfaction, states an SHRM report. To increase the levels of job satisfaction, it’s crucial for organizations to focus on non-monetary initiatives like team building and work environment initiatives.

Gathering regular feedback helps organizations measure the impact of their efforts, while allowing employees to present their concerns.


Employee productivity is directly proportional to compensation, as a slight change in wages directly impacts their productivity. Many organizations increase their compensation to attract the right talent when the labor market turns too competitive.


Employees who feel they are underpaid show lower levels of enthusiasm for their work and invest more time in their personal pursuits. Increasing the compensation through performance-based incentives boosts their motivation and enhances their performance. It also promotes desirable organizational behavior where employees are motivated to do their best.

If the employees receive the prize for their hard work and efforts, they feel appreciated, which helps them work better.

Wrapping it Up

Compensation Management is one of the most effective tools businesses use to attract, retain, and inspire their employees. Understanding compensation, its types, and its impact on the workforce is essential for business leaders and managers.

While a few employees focus more on the financial aspect, others focus on the non-financial aspects. Regardless of their personal choices, it’s essential to note that both forms have a significant impact on the lives of employees and having a proper balance between the two helps in sustaining the stability and profitability of business organizations.

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