Pay Compression: Causes, Consequences, and Solutions

What is pay compression?

Pay compression, also known as salary compression or wage compression, happens when there is a small difference in pay between employees, regardless of their experience, skills, or years with the company.

This usually occurs when new hires receive pay that is close to or even higher than that of current employees or long-standing employees. It creates a gap where more experienced or tenured employees do not see their value reflected in their pay compared to less experienced employees or new hires.

Pay compression vs. Salary compression vs. Wage compression

While the terms "pay compression," "salary compression," and "wage compression" sound similar, they have slightly different meanings:

• Pay compression is a general term that refers to a small difference in pay among employees with varying levels of experience or job roles.

• Salary compression often refers specifically to salaried employees where starting salary differences between new and existing employees are minimal.

• Wage compression usually focuses on hourly employees and occurs when wage differences between new hires and current employees become too small due to minimum wage laws or changes in the labor market.

For example, consider a company where new hires are offered a starting salary close to what a long-standing employee earns. This can create dissatisfaction among experienced employees, especially if they see no fair pay increase over time.

Causes of pay compression

Pay compression occurs for several reasons, and understanding these causes helps in addressing pay compression effectively.

Minimum wage increases

Minimum wage increases can create pay compression when companies raise the base salary for low-level employees to meet new minimum wage laws.

This often leaves less room between the pay of new employees and more experienced employees, resulting in a small difference in pay that feels unfair to long-term employees.

Market rate changes

Changes in the job market, especially in a tight labor market or competitive labor market, force companies to offer higher salaries to attract talent.

When market rates increase quickly, new hires often get salaries close to those of experienced employees, causing pay compression.

Inconsistent pay practices

Inconsistent pay practices, like giving higher starting salaries to new hires while not adjusting the pay of current employees, create pay compression.

If a company does not regularly review its salary ranges or make fair pay adjustments, existing employees may feel undervalued, leading to lower employee morale.

Lack of regular salary audits

Without regular salary audits, companies may fail to notice when pay compression occurs. Audits help identify pay differences and ensure that pay structures reflect the current job market, market rate, and employee contributions.

Lack of audits can result in pay inequities and even lead to legal challenges if pay compression becomes severe.

Pay increases focused on new talent

When companies focus too much on attracting new talent, they may offer higher salaries to new hires but neglect the compensation strategy for current employees.

This approach can create pay compression, making long-standing employees feel unappreciated and unfairly compensated compared to new employees.

Examples of pay compression

Pay compression can occur in many ways and affect different levels within a company. Here are some common examples to help you understand how this issue might be affecting your organization:

1. Retail chain example:

A retail chain raises the minimum wage for new employees to comply with updated minimum wage laws. New hires are now paid $15 per hour, while employees who have been with the company for three years are only earning $16 per hour.

The small difference in pay between new employees and long-standing employees leads to frustration among experienced workers who feel their tenure and loyalty are not valued.

2. Healthcare organization case:

A healthcare organization recruits new registered nurses at $80,000 per year due to a high demand in the labor market. Existing employees, who have been with the organization for several years, are earning $82,000.

With only a $2,000 difference in pay, experienced employees feel their skills and commitment are not recognized, which can negatively impact job satisfaction and morale.

3. Manufacturing company situation:

In a manufacturing company, a senior technician hired five years ago is earning a base salary of $60,000. Due to market changes and a tight labor market, new technicians with less experience are now starting at $58,000.

The small difference in pay between the senior and new technicians creates a sense of unfairness and affects the overall workplace environment.

How does pay compression impact your organization?

Pay compression can have far-reaching effects on your organization, impacting everything from morale to competitiveness in the job market. Let’s explore some of these impacts:

Employee morale and retention

When employees see little difference between their pay and the pay of new hires, especially if they are more experienced or tenured employees, it can harm their morale and job satisfaction.

They may feel their loyalty and hard work are not adequately recognized, which can lead to higher turnover rates. Retaining high-performing employees becomes harder if they feel undervalued.

Pay equity and legal challenges

Pay compression can create issues with pay equity, which could lead to discrimination lawsuits and other legal challenges.

If employees see a pattern of unfair pay practices, they might view wage compression as a form of discrimination. In some cases, this may be seen as illegal pay compression, creating grounds for costly legal battles and damage to the company’s reputation.

Job market competitiveness

In a competitive labor market, organizations need to attract talent with competitive salaries. However, if pay compression occurs, it can make it difficult to offer competitive compensation without upsetting current employees.

Companies may find it challenging to bring in new talent while keeping existing employees satisfied with their pay.

Impact on performance and motivation

When there is little difference in pay between less experienced employees and long-term employees, motivation and performance can suffer.

High-performing employees may feel their extra efforts and contributions are not valued, leading to reduced productivity and engagement. Addressing pay compression is crucial to maintaining a motivated and effective workforce.

Identify pay compression in your organization before it’s too late!

Spotting pay compression early is crucial to maintaining fair employee pay and a positive work environment. Here are a few ways to identify if pay compression is happening in your organization:

• Review salary ranges regularly: Look closely at the salary ranges within your organization. If you see that new hires or less experienced employees are earning nearly the same as tenured employees, pay compression might be an issue.

• Analyze compensation data: Use salary data to compare the pay of similar roles and experience levels. Look for any small differences in pay between new hires, long-term employees, and employees with similar responsibilities or job roles.

• Check employee pay during market adjustments: When the job market changes, compare your pay rates to current market rates. If you find that new employees are hired at higher salaries, but there is no similar adjustment for existing staff, pay compression may be occurring.

• Monitor employee feedback: Pay attention to employee feedback and complaints related to compensation. If employees feel their pay is not fair or they see pay transparency issues, it might signal pay compression.

Solutions to address pay compression

Once you identify pay compression, you need to take steps to address it and ensure fair pay for all employees. Here are some effective solutions:

• Conduct regular salary audits: Regularly check salary data across all roles and levels. This helps you spot and address pay compression early and keep your pay structure fair.

• Provide pay raises based on performance: Make sure pay increases reflect an employee's performance and contributions, not just market rates. This approach helps keep direct reports motivated and valued.

• Compare salaries with current market rates: Regularly review compensation data and compare it with the market rate. This helps you maintain competitive pay ranges and avoid wage compression.

• Identify and fix pay issues early: Look for any pay anomalies or gaps and address them as soon as possible. This proactive approach prevents pay inequities from becoming a bigger problem.

• Frequently update and review pay policies: Keep your pay policies up-to-date with market trends and company needs. Regularly reviewing these policies ensures that your compensation strategy remains fair and competitive.

Best practices for preventing pay compression

Preventing pay compression starts with having a clear and fair pay structure. Make sure to conduct regular salary audits to identify any gaps or inconsistencies in employee pay. Use compensation data to set pay ranges that reflect the market rate and adjust for experience and performance. Encourage pay transparency so employees understand how their pay is determined.

Provide performance-based pay raises to reward high performers and recognize their contributions. Regularly update your compensation policies to align with changes in the job market and avoid wage compression. By following these best practices, you create a more equitable work environment where employees feel valued and motivated.

Employee scheduling and Time-tracking software!

• Easy Employee scheduling
• Clear time-tracking
• Simple absence management

Try for free Request a demo

Conclusion

Pay compression can harm morale and create pay inequities in your organization. By identifying it early and using proactive solutions, like regular audits and clear pay structures, you can maintain fair pay for all employees. These steps help keep your workforce engaged, motivated, and committed to your company’s success.