Bonus: Definition, Different Types, and Tax Treatment

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A bonus is compensation paid to an employee on top of regular salary or hourly wages. It may reward individual or company performance, help recruit or retain staff, or mark an occasion such as the year-end holidays. Unlike base pay, a bonus is not part of the fixed rate an employee earns for each pay period. It is paid separately, often as a lump sum, and it may or may not be guaranteed, depending on how the employer structured it. In the United States, the IRS treats a bonus as taxable income, and employers withhold tax from it as supplemental wages.

How a Bonus Works

Every bonus sits on a spectrum from fully discretionary to fully contractual.

A discretionary bonus is one the employer decides to pay, and decides the amount of, at or near the time of payment, with no prior promise that would lead employees to expect it. A surprise year-end gift of $500 to every staff member is the classic case.

A nondiscretionary bonus is announced in advance, in an employment contract, offer letter or written plan, and tied to criteria: hitting a sales target, meeting a production quota, staying through a merger, or receiving a formula-based share of profits. Once the conditions are met, the employer may be obligated to pay it, with the exact rights depending on the written terms and on state law. In the U.S. the bonus also enters the overtime calculation for nonexempt workers (covered below).

Bonuses can be paid to an individual, a team, a department or an entire company. They can take the form of:

• Cash, paid through payroll in a regular paycheck or a separate check
• Stock, such as restricted stock units that vest over time
• Stock options, which give the right to buy shares at a set price
• Noncash rewards, such as gift cards, extra paid time off or gifts

Noncash rewards are not automatically tax-free. Cash and cash equivalents such as gift cards are taxable wages in the U.S. regardless of the amount.

How a Formula-Based Bonus Is Calculated

Many employers who pay performance bonuses express them as a percentage of salary, known as the target bonus or bonus opportunity. A common structure looks like this:

Bonus = Base salary × Target bonus % × Payout factor

The payout factor reflects how well the individual, team or company performed against goals. It might be 0% if a minimum threshold is missed, 100% at target and higher for exceeding it.

Hypothetical example: An employee earns $80,000 with a 20% target bonus. The company sets the payout factor at 90% because it fell slightly short of its profit goal.

• Target bonus: $80,000 × 20% = $16,000
• Actual bonus: $16,000 × 90% = $14,400

If the same plan paid 120% in a strong year, the bonus would be $19,200. The percentage on the offer letter is a target, not a promise, unless the plan document guarantees a minimum.

Types of Bonuses

Signing Bonus

A signing bonus is a one-time payment offered to a candidate to accept a job, often when the employer is competing with rival firms for the same hire. It frequently comes with a repayment clause: if the employee leaves within a set period, part or all of the bonus must be returned. Because the bonus is taxed when paid, repaying it later can create tax complications.

Referral Bonus

A referral bonus goes to an existing employee who recommends a candidate the company ends up hiring. Some programs pay only after the new hire completes a probation period.

Retention Bonus

A retention bonus encourages key employees to stay through a specific period, such as an acquisition, restructuring or difficult economic stretch. It is usually paid only if the employee remains employed until a stated date, and it does not guarantee long-term job security.

Performance Bonus

Performance bonuses reward results. They are often paid after a project ends or at the close of a fiscal quarter or year, and they come in several forms:

• Annual bonuses tied to yearly individual and company results
• Spot bonuses, smaller awards given on the spot for a specific contribution, sometimes worth only tens of dollars
• Milestone bonuses, which may recognize a project milestone or a service anniversary such as 10 years with the firm

Senior executives generally receive larger bonuses than lower-level staff, both in dollars and as a share of total pay, and a larger portion of their bonuses is often paid in stock.

Profit-Sharing Bonus

Some employers build a profit-sharing arrangement into employment contracts, distributing a portion of the year’s profits among employees by formula. The payout rises and falls with company earnings, so it is closely related to a performance bonus but measured at the company level rather than the individual level. Profit-sharing can also refer to a retirement plan contribution, which is a different arrangement from a cash bonus.

Holiday Bonus

A holiday bonus is paid around the December holidays, either to everyone or to employees who meet conditions such as a minimum length of service. It may be cash, a gift card or a gift. In the U.S., holiday bonuses are generally voluntary.

Legally Required Bonuses

In some countries, a year-end bonus is required by law. Mexico’s aguinaldo, sometimes called the “thirteenth salary,” must be paid by December 20 each year and equals at least 15 days of the employee’s salary. It applies to employees regardless of job title, and employers that fail to pay can face fines of up to 5,000 times the daily minimum wage. Costa Rica and El Salvador also require employers to pay an aguinaldo.

How Bonuses Are Taxed in the U.S.

Bonuses appear on the employee’s Form W-2 together with regular wages and are reported on the annual tax return. The employer must withhold taxes when the bonus is paid. Bonuses paid in stock are generally taxable when the shares are delivered or vest, based on their value at that time.

Withholding Methods

The IRS classifies bonuses as supplemental wages, a category that also includes commissions, overtime pay and severance. An employer can withhold federal income tax on a bonus in one of two ways:

1. Percentage (flat-rate) method: If the bonus is identified separately from regular wages, the employer can withhold a flat 22% for federal income tax. Supplemental wages above $1 million paid to one employee in a calendar year are subject to mandatory withholding at 37%.
2. Aggregate method: The employer adds the bonus to the regular paycheck for that period and withholds as if the combined amount were the employee’s normal pay. Because the withholding tables assume that pay level for the whole year, this method can withhold more than the flat rate would.

Social Security tax (6.2%, up to the annual wage base) and Medicare tax (1.45%) apply to bonuses the same way they apply to salary. An additional 0.9% Medicare tax is withheld on wages above $200,000 in a calendar year. State and local income taxes may apply too, with their own rules for supplemental wages.

Withholding is not the final tax. A bonus is taxed as ordinary income at the employee’s marginal rate, combined with all other income when the return is filed. Only the portion of income above a bracket threshold is taxed at the higher rate, so a bonus does not raise the rate applied to the rest of your income. If too much was withheld, the difference comes back as a refund; if too little, the employee owes the balance. The idea that a bonus is “taxed more” than salary usually comes from seeing the withholding on a single check, not from a higher tax rate.

Worked Example

Hypothetical: An employee receives an $8,000 cash bonus, paid separately from regular wages. The employer uses the flat-rate method. Assume the employee’s year-to-date wages are below the Social Security wage base and the $200,000 Medicare threshold, and ignore state taxes.

If this employee’s marginal federal bracket is 12%, the actual federal income tax on the bonus at filing would be closer to $960, and the extra withholding would reduce tax owed or increase the refund. If the bracket is 24% or higher, the employee would owe more at filing.

Are Bonuses Tax Deductible for Companies?

For the employer, bonuses are generally deductible as compensation, an ordinary and necessary business expense, provided total pay is reasonable for the services performed. Timing rules apply: a company using accrual accounting can generally deduct a bonus in the year it is earned if the bonus is fixed by year-end and paid within two and a half months after the close of that tax year. Employers also pay their matching share of Social Security and Medicare taxes on bonuses.

Bonuses and Overtime Pay

Under the federal Fair Labor Standards Act (FLSA), nonexempt employees must receive overtime at 1.5 times their regular rate for hours over 40 in a workweek. Nondiscretionary bonuses must be included in that regular rate. Discretionary bonuses, gifts and certain other payments are excluded.

Hypothetical example: An hourly worker earns $20 per hour, works 45 hours in a week and earns a $50 production bonus for that week.

• Straight-time pay: 45 × $20 = $900
• Regular rate: ($900 + $50) ÷ 45 = $21.11 per hour
• Overtime premium: 0.5 × $21.11 × 5 overtime hours = $52.78
• Total weekly pay: $900 + $50 + $52.78 = $1,002.78

Without including the bonus, the overtime premium would be $50 (0.5 × $20 × 5), so the bonus adds $2.78 to overtime pay that week. When a bonus covers a longer period, such as a quarter, the employer has to allocate it back across the weeks it was earned and pay any additional overtime owed. Salaried exempt employees are not entitled to overtime, so this rule does not apply to them.

How a Bonus Differs From Similar Pay

Bonus vs. salary. Salary is a fixed amount paid each period for doing the job; a bonus sits on top of it. “Total compensation” usually includes bonuses, which is why a job offer quoting total compensation can look larger than the base salary.

Bonus vs. raise. A raise permanently increases base pay, and every future paycheck, as well as any benefits calculated from salary, builds on it. A bonus is a one-time payment; next year’s bonus starts over. Over a career, a raise compounds because future percentage increases apply to the higher base.

Bonus vs. commission. A commission is pay calculated directly from sales, usually a percentage of each sale, and for some roles it is the main form of compensation. A bonus is typically tied to broader goals or periods. Both are supplemental wages for tax purposes.

Bonus vs. benefits. Health insurance, retirement contributions and paid leave are benefits, not bonuses. Their tax treatment differs: employer-paid health coverage, for example, is generally excluded from taxable wages, while a cash bonus is fully taxable.

Bonus Shares and Dividends

A dividend is a distribution of company profits to shareholders, usually in cash. Instead, a company may make a bonus issue, giving existing shareholders additional free shares in proportion to their holdings, which lets a company short on cash reward investors. Shareholders can keep or sell the new shares. Because the issue adds shares without adding assets, the price per share typically adjusts downward and proportional ownership stays the same.

Limitations and Drawbacks of Bonuses

Bonuses in place of raises. Some employers keep wage increases small and rely on bonuses to close pay gaps. This lowers the company’s fixed costs: a bonus can be reduced or skipped in a slow year or recession, while cutting salaries is much harder. For the employee, it means a larger share of income is uncertain. A discretionary bonus carries no obligation to be paid again, even if it was paid in prior years.

Across-the-board payouts. When companies pay bonuses to everyone to avoid resentment, the bonus can lose its link to performance. Measuring performance fairly is also difficult. An employee who misses a quota may have been held back by production delays or an economic downturn outside their control, while another may hit targets because of favorable conditions.

Clawbacks. Executive bonuses may be subject to clawback policies, under which pay can be recovered if financial results are later restated.

Size is highly variable. There is no standard bonus amount in the U.S. Bonuses range from a few hundred dollars to several thousand or more, depending on industry, company size, job title and performance.

The Bottom Line

Employees weighing a job offer or expecting a year-end payout should read the plan terms, since a target percentage or discretionary award carries no guarantee unless the document says so. In the U.S., the withholding on a bonus check is an estimate, and the actual tax is settled at filing at the employee's marginal rate. Workers who rely heavily on bonuses in place of raises carry more income uncertainty from year to year.