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4 Min. Read

3 Different Types of Compensation

3 Different Types of Compensation

As a business owner, it’s essential to understand the different types of compensation.

Every business is legally responsible for compensating its employees for their labor. Not only that, but you’re also responsible for explaining the different types of compensation available. 

Compensation can take many forms. So it’s vital that your workers understand how they are being compensated. They should also know the different types of compensation available to them and the value of their compensation package. 

But what are the different types of compensation? We’ll take a look at the definition of compensation and the different types available. 

Here’s What We’ll Cover:

What Is Compensation?

The 3 Different Types of Compensation

Direct Compensation

Indirect Compensation

Non-Financial Compensation

Key Takeaways

What Is Compensation?

Compensation is most commonly defined as the payment received by an employee from an employer. This will be after their work has been tracked and delivered.  

But it’s important to note that compensation doesn’t purely refer to wages and employee benefits. It’s also possible to be given compensation for something that has been lost or damaged. This is referred to as “workers’ compensation” for unemployed or injured workers. 

Compensation can also refer to a payout as a result of a lawsuit.

So a more appropriate definition of compensation in a business and legal context would be anything of value given to make up for a loss. Whether that loss is a loss of time, i.e. labor, or a loss of income due to injury or unemployment. 

So now we have a better understanding of what compensation is, let’s have a look at the 3 different types most commonly available. 

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The 3 Different Types of Compensation

While there are a number of ways to compensate somebody, each method tends to fall under the umbrella of three different types. These types are direct, indirect and non-financial. 

So let’s break these three types down and give some examples:

Direct Compensation

Direct compensation tends to be one of the most common forms of compensation.

It includes money paid to employees as cash, salaries, bonuses and commission. Both hourly rates and salaried work will fall under this category. 

Within direct compensation, there are two subcategories of base pay and variable pay. Wages or an annual salary tend to fall under the category of base pay. This is because they are reasonably consistent. Whereas bonuses and commission fall under variable pay. 

Indirect Compensation

Indirect compensation is a type of compensation that still has a monetary value, but it is not a direct payment in the form of cash. 

Different organizations tend to differ in what is considered indirect compensation. But it tends to be defined by the benefits or fringe benefits that come with employment. 

An example of indirect compensation would be any employer-sponsored health insurance. Or it could be an employer’s contribution to an employee’s retirement plan. 

Receiving stock options or profit sharing is also a form of indirect compensation. You could also consider a company-paid gym membership or a travel allowance as indirect compensation. 

It’s essentially anything with a specific monetary value that isn’t paid directly to you in extra cash or as a part of your base salary. 

Non-Financial Compensation

Compensation doesn’t have to have a monetary value. You can be offered various perks that offer no financial gain but are still valuable. 

Things such as time off, flexible working hours, recognition and awards cannot be given a monetary value. However, they are still considered compensation.

Non-financial compensation is often used by employers as a morale-boosting venture. They can also be used to entice an employee to join the workforce. It’s a good way to value your employees and raise the attraction of the job opportunity. 

There is some dispute over the difference between indirect compensation and non-financial compensation. Some companies will attempt to pass off indirect compensation as a form of non-financial compensation or vice versa. 

Key Takeaways

Compensation is a vital element of any business.

Not properly compensating your employees for their efforts and their time is bound to have negative effects. They will either have poor morale and performance or will more likely just end up leaving the organization. 

Therefore it’s essential that you understand what compensation is, and how to implement it. This can help to create a more conducive work environment and a happier and more profitable business. 

Are you looking for more business advice on everything from starting a new business to new business practices? 


Then check out the FreshBooks resource hub.


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