What is Retro Pay? Meaning, Examples, and How it Works

Sometimes, mistakes in payroll can be expensive, especially if an employee was paid less than they should have been. If not handled properly, it can even lead to legal trouble under US labor laws. So, what do you do when this happens? 

Retro pay is the solution to fix payroll errors. It is simply the extra money an employee gets when there is an error in their paycheck. If you work in HR or accounting, you should know how retroactive pay works. In such cases, your payroll number has its own significance.

Let’s break down retro pay meaning, how to calculate it, how it is different from back pay, and other basic details.

What is Retro Pay?

Retro pay is known as Retroactive payment which is given by an employer to an employee to fix a past payment mistake. This usually happens when there’s an error in the salary or a delay in updating new pay rates.

Let’s understand the retro pay meaning with the help of an example. If someone was supposed to get a raise starting last month but the payroll was not updated on time, the employer would need to pay the extra amount to rectify the mistake. 

In short, it helps make sure employees are fully paid for the work they have already done.

When and Why Do Employees Receive Retro Payment?

Now that you know what is retro payment, let’s look at some common situations when an employer needs to pay the retro bill:

• Missed Overtime Pay: If the system does not correctly calculate overtime hours, the employee might not get paid for the extra work. Retroactive payment is used to fix that.

• Shift Differential Not Included: Some employees earn extra for working night shifts or less desirable hours. If the extra pay is missed in the paycheck, retro pay is added later to make up for it.

• Unpaid Commissions: It can also be used to adjust the commission amount earned during a pay period that was not included in the salary.

• Raises or Bonus Not Included: To cover the gap of raises or bonuses that are approved but not added to the paycheck right away.

• Payroll Mistakes: Errors in data entry or software issues can also lead to wrong payments.

Retro pay ensures employees are fairly paid when something is missed or delayed in their regular paychecks.

How Retro Pay is Calculated?

Retroactive pay should be processed as per the rules of Generally Accepted Accounting Principles (GAAP). It is calculated as the difference between what an employee was paid and what they should have been paid. 

It is calculated based on gross pay and applicable taxes are deducted afterward. Let’s break it down for both hourly and salaried employees using simple examples:

Example 1: 

An employee’s hourly rate increased from $15 to $16.50, but the raise was missed for 2 pay days. He worked 180 hours during that time.

• Pay difference per hour: $1.50
• Total hours worked: 180
• Retro Pay: 180 x $1.50 = $270

Example 2:

An employee worked 48 hours in a week but was paid the regular $15/hour rate for all hours, including 8 hours of overtime.

• Regular pay received: 48 x $15 = $720
• Overtime should have been paid at 1.5x of the rate: $15 x 1.5 x 8 = $180
• Correct total pay: $15 x 40 + $180 = $780
• Retro pay: $780 – $720 = $60

Example 1:

A salaried employee’s pay increased from $58,000 to $61,480 annually. The raise was not reflected in the last biweekly paycheck.

• Old biweekly pay: $58,000/26 = $2,230.77
• New biweekly pay: $61,480/26 = $2364.62
• Difference and retro pay owed for one period: $133.85

Accountants need to identify the payroll number and compensate for the difference amount. It is simply about correcting underpayments, whether for hourly shifts, missed overtime, or delayed salary updates.

Difference Between Retro Pay and Back Pay

• Retro pay and back pay both refer to money an employer owes an employee, but they happen for different reasons.

• Retroactive payment is given when an employee was paid incorrectly, usually due to miscalculation. It covers the difference between what was paid and what should have been paid.

• Back pay, on the other hand, is given when the employee is not paid at all for the work they did. For example, a missed paycheck, unpaid hours, or uncredited bonuses and commissions. It usually involves a larger amount because it covers full unpaid earnings, not just a portion.

• Another key difference is in the calculation. Retro pay often takes more effort to figure out, while back pay is simply the total amount that was never paid.

• In some companies, these terms might be used interchangeably, and ‘retro pay’ can sometimes refer to both situations.

How Does Tax Work with Retro Payment?

Retroactive payment is still considered regular income, so it gets taxed just like your normal paycheck. Employers also pay their share of payroll taxes. Before giving out retro pay, deductions are made for:

• Federal income tax
• Social Security and Medicare (FICA)
• State and local income taxes (if applicable)

If it is paid separately from your regular paycheck, a flat 22% federal tax rate is often used. But if it is added to your next paycheck, taxes are calculated using the usual tax tables.

You don’t need to worry about taxation, payroll software usually takes care of all this automatically. Also, be informed about the Tax year to have in-depth details of tax along with its dates and deadlines. 

Final Words

Retro pay is an important aspect of accounting for any company. Managing and issuing it can be a challenge in a big corporation. Thus, personnel of HR and accounting departments, who handle account payable and account receivable service to maintain your wages should be aware of all the important details.

I tried to provide all the basic details regarding retroactive payments to help you understand the concept easily. If you like it, please share it with your friends and colleagues.

Frequently Asked Questions (FAQs)

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