Everyone should receive the pay they deserve. But what if the wages you can afford to offer don’t reflect employee skills? The reason may actually be wage compression.
Wage or pay compression can affect any role in any business and often happens when inflation rates are on the up. Another common cause is when skill levels rise faster than wages, making pay rates look unappetizing compared to competitors.
The result? Top, essential employees soon drift away, and hiring replacements gets harder.
When wage compression is the problem, understanding and preventing it is the only solution. We’re here to clarify the concept and teach you how to perfectly harmonize wages and talent.
TL;DR — Key Takeaways
Pay compression happens when internal company wages become too similar or stagnant. Compression reduces the gap between pay for new hires, middle managers, and even veteran leaders.
Causes of pay compression include inflation and labor market tightening. Companies may increase entry-level wages in line with minimum wage increases, for example, without increasing pay for existing employees.
Pay compression damages morale. Recruiting efforts struggle when management salaries dip below market rates. Staff turnover rises, and skills gaps emerge.
You can reduce the risk of wage compression by tracking market pay rates and regularly auditing pay policies. HR professionals can focus on urgent skill gaps. They can also compensate for lower pay with suitable non-financial benefits.
Pay compression is a critical aspect of talent retention. Combine wage compression solutions with vibrant company culture, rewards for career development, and anti-discrimination measures. It’s also important to ensure a good candidate experience to score the brightest talent.
What is salary, wage, or pay compression?
HR experts often talk about wage, pay, or salary compression. These are synonyms for the same idea, so there’s no need for confusion. However you define it, wage compression levels pay between employees, where wages in affected organizations become relatively similar regardless of seniority, performance, or skills.
Compression usually happens when companies pay new employees too much compared with senior colleagues or when they limit pay raises as employees scale the ladder. It’s also (unfortunately) not rare, with over 56% of US companies reporting wage compression problems.
Just because it’s common doesn’t mean it’s acceptable, though. We hope it goes without saying that employee pay should increase as workers gain skills and responsibilities.
Frequent, reasonable salary increases encourage individuals to develop their abilities and improve their performance. Employees who anticipate steady increases in their wages are also more likely to stay, which helps reduce turnover and strengthen morale.
What causes wage compression?
Companies often stumble into pay compression situations because they don’t understand its roots.
This is understandable in a sense. When employees mysteriously start to leave and hiring becomes tough, the causes aren’t always obvious. Factors could be internal (policies or management), external (inflation or competition), or a mixture of both.
Diagnosing the cause makes addressing pay compression easier. Factors to consider include…
Changes to minimum wage laws
Sometimes, pay compression occurs when minimum wage increases drive up your wage floor.
68% of companies raise their wages above statutory minimum wage levels when regulations change. This brings entry-level pay closer to current employees. Increases also often occur quickly, catching unaware or unprepared companies off guard.
How can you anticipate minimum wage changes? No one has a crystal ball, but staying informed about political changes and policy initiatives should usually help to give a heads-up!
Tight labor markets
Pay compression issues can happen when labor demand increases relative to supply. In this scenario, companies facing a tight labor market may need to offer higher entry-level salaries to attract hires.
We saw this after the pandemic when non-remote workers were at a premium. Many companies in the tightest labor markets needed to pay higher entry-level wages for essential jobs, from hospitals to supermarkets.
Left unchecked, this can close the gap with more experienced employees, eroding rewards for performance or upskilling. Tracking labor market trends is helpful in preventing this, but staying competitive isn’t always possible.
Inconsistent pay practices
Chaotic pay policies can also cause wage compression. Without regular monitoring, some salaries stagnate while others rise, even for the same job. When salaries go up during short-term hiring booms, the pay of a long-term employee is less valuable.
Only a structured compensation strategy can track the salary range across the organization. A robust strategy includes gathering employee compensation data and applying best practices, such as defining salary levels on job descriptions.
Periods of rapid inflation
Finally, pay compression can happen due to general inflation. When you hire new employees, starting wages reflect current living costs. When inflation spikes, it’s sometimes essential to offer a higher salary.
But here’s the problem: If you don’t adjust everyone else’s pay, this will inevitably cause pay compression. However, in either case, your salary expenses as a business will also rise, exposing you to financial risks when an economic downturn hits.
Top tip:
Follow economic trends. Inflation could be long-lasting or a brief market adjustment. Awareness of market shifts helps you make informed pay decisions.
Why is salary compression so important to monitor?
Some causes of wage compression are controllable, while others stem from external sources and require planning and adaptation. Whatever the root cause, pay compression is something you definitely want to avoid.
This may not seem urgent right now. After all, everyone seems happy. Productivity is good, wages are paid on time, and hiring is going smoothly.
But pay compression often develops under the radar, and the consequences include:
Decreased morale: Healthy workplaces provide opportunities to rise and build careers. When role responsibilities don’t match pay rates, employees feel undervalued. A workforce of undervalued people is likely to become dysfunctional.
Employee turnover: Wage compression makes mid- and higher-level positions less appealing than similar roles at competitors. When employees discover that their salaries don’t reflect current market rates, they will quickly look elsewhere.
Skill gaps: The skills and qualities that people take with them also matter. Pay compression tends to affect highly skilled (and in-demand) workers more than others. Skilled staff need to feel valued. If they don’t, plenty of other employers will step in.
Inefficient hiring: If your pay structure lags, wage offers to job applicants won’t reflect market rates. Promising hires may head elsewhere if wages are even slightly out of date.
Alongside those negatives, dealing with wage compression has positive effects. Clarity about pay rates and promotion routes contributes to a competitive working environment. Every individual knows their worth to the organization. They know what they need to do to succeed and grow their pay packet.
A well-managed pay structure is not only fairer but also much more sustainable. If wages properly reflect seniority and skill levels, nobody should feel underpaid or discriminated against.
These factors make it essential to monitor pay compression, which is where we’ll head next.
How to prevent or combat pay compression
Adjusting wages every time you hire is not sustainable. You’ll need a plan to permanently address wage compression. Monitoring requires a systematic approach. Fortunately, there are plenty of easily achievable solutions. The tips below will help you avoid a nasty salary crunch.
Monitor market rates
First off, remember that pay compression is relative. Employees look at wages across the economy (or within national or international sectors). You need to know trends in pay rates for every role.
Companies implementing robust salary benchmarking practices are 63% more likely to attract and retain top talent in today’s fiercely competitive job market.
UKG
Salary benchmarking is the only solution.
Start by classifying roles by job families. A job family is a group of positions with similar functions. Function refers to what employees in those roles contribute to your organization.
Secondly, assess seniority. Determine whether roles apply to junior staff, senior leaders, or tenured employees.
Add a data field to show how established the individual is. This data indicates how long they have been in post.
For each role, decide whether the individual manages people or processes (the job track).
If relevant, add location details to the matrix as well. Pay rates may vary for different countries or states.
This process creates a database of roles linked to their occupants. This information lets you compare salaries across your sector. Without it, wage comparisons will be much less precise.
After creating the pay compression database, there are two ways to populate it with salary data.
Third-party benchmarking firms like Hays or Mercer are efficient but don’t come cheap. PayScale provides less in-depth services but may be more affordable.
Manually researching salaries at competitors is the next-best option. If you choose this route, expect a time-consuming process. You will also need to revisit salaries annually to ensure good data. On the other hand, going solo suits smaller companies with relatively few competitors and can be cheaper.
You’ll need to make a judgment call on this one. Whatever method you choose, monitor salaries regularly and feed wage data into the hiring process. Pay increases should stay comfortably within industry norms.
Conduct pay equity reviews
Pay equity reviews assess salaries to determine whether pay rates sufficiently reward employees. Reviews ensure similar roles receive the same compensation and align pay with market rates.
Over 60% of US companies claim to carry out pay equity reviews, but most treat reviews as period exercises or crisis responses.
Don’t be like those firms. Regularly schedule equity reviews to identify mismatches between salaries and roles.
The core purpose of reviews is to assess roles of equal value to your organization. To achieve this, you need to research comparable roles, and to do that, you’ll need to collect a lot of data. Classify roles, taking into account:
Starting and current salaries
Years of experience
Seniority and job title
Qualifications
Management responsibilities
Previous promotions
Performance data (such as annual ratings)
Part-time or full-time status
Location
Collect this data centrally. If you followed our tips for comparing market rates (see above), the jobs matrix is a good starting point.
Use the data to connect roles and fair pay rates. If discrepancies appear, analyze why they exist. You may need to eradicate discrimination or simply correct pay lags.
Companies sometimes like to share the findings of pay equity reviews with employees. Disclosure can promote internal morale and establish a useful transparency baseline as you try to stamp out wage compression.
Top tip:
Schedule annual pay equity reviews, whether you share findings or not. A regular rhythm of data collection and analysis should be the heart of your pay compression strategy.
Prioritize urgent pay gaps
After assessing market rates and reviewing pay equity, it’s time for action. Your research may well uncover glaring pay compression issues for existing employees. Don’t wait for upcoming pay reviews.
Meet with affected individuals before sharing pay equity findings to arrange a fresh compensation package. Prompt action could determine whether you retain an inspirational leader or require a grueling recruitment process.
Consider a non-financial compensation strategy
Financial pay is not the only aspect of wage compression we need to discuss. Many organizations combine pay with bonuses or benefits. Non-financial measures can compensate for lower pay, potentially solving the pay compression issue — at least for a while.
If you cannot offer higher salaries at the moment, consider alternatives like:
Health insurance. Or other health-related perks like gym membership.
Professional development opportunities. Training, overseas secondments, or participation in industry events all make roles more appealing.
Flexible working. Some employees value remote work or flexible hours — often more than small salary increases.
Employee recognition. Staffers receive reward points for outstanding performance, which they can redeem financially or via company partners.
Regardless of which you choose, know that benefits enhance employee morale and job satisfaction. If you can benchmark employee pay, do so. But if you can’t, the alternatives above are a good starting point.
Top tip:
Non-financial rewards can also become misaligned with industry norms, resulting in similar issues. Audit your compensation strategy annually to ensure benefits measure up.
How to handle wage compression as a small business
The strategy above applies across the board, but some recommendations may challenge the resources of smaller businesses. With that in mind, let’s explore strategies for firms outside the corporate elite.
A small business pay compression might look something like this.👇
Offer every new employee a competitive starting salary
Offering new hires a competitive wage is an easy win. “Competitive” doesn’t mean going overboard. Instead, use the pay range of your closest competitors as a reference point.
You probably can’t afford to buy cutting-edge salary data, but open-source data is almost as good. Check out Glassdoor and open job advertisements, or ask around employee networks. Word gets around in specialized sectors, so you should be able to find the right ballpark figure.
Review salaries regularly and identify discrepancies
Disgruntled employees will quickly find a higher-paying job in a competitive labor market. Small businesses cannot afford to lose pivotal staff — especially by fumbling pay inequities.
Schedule annual salary reviews to gauge whether pay meets employee expectations. Compare the pay of existing employees with the market rate. If you already keep pace with competitors, that’s great. If not, you need to make a decision.
Determine a target salary for each role based on market data. If you currently pay less than this rate, don’t hide it. Employees likely know already. Take action to raise pay or benefits to compensate.
Listen to employees about pay concerns
Small businesses can’t always spend time and money researching pay rates. Sometimes, research is not even necessary. Employees often tell managers directly or indirectly about salary issues, even if not all companies listen.
Take a proactive listening approach to understand pay. Meet with staffers to discuss their pay and benefits — including career prospects and living costs.
Listen for chatter about job ads or external training. Employees looking elsewhere may be recoverable if you take their pay worries seriously.
Top tip:
Listening applies to job applicants, too. Candidates may choose other employers based on salary concerns. Ask for feedback from everyone in the applicant pipeline and use this information to decide on the final compensation package. This is another good reason to optimize the candidate experience, as happy candidates are more likely to provide helpful information
Communicate transparently with colleagues
The fallout from pay compression isn’t usually just about pay discrepancies. Employee reactions are often worse in workplaces characterized by poor communication and distant management styles.
Be transparent about your salary range and pay policies. Ask managers to provide direct reports about salary compression and how the company addresses the issue. Never leave employees in the dark, unsure of where they stand.
Top tip:
Write a pay policy outlining how you determine salaries and avoid pay compression. Detail how and when you schedule salary upgrades. Make this policy available to all hires, and carry out annual policy audits.
Offer small business benefits instead of higher wages
Finally, small businesses should think creatively about how to compensate when wages lag market norms. Small business benefits play a critical role here.
Think about benefits employees value that won’t exhaust your budget. Flexible working and remote work allowances could help. Staff events build morale, while funding for training promotes a positive atmosphere.
A final word about pay transparency
Before we finish, it’s important to stress how important pay transparency is when you address pay compression. Transparency matters for a couple of reasons.
Firstly, transparency informs workers about relative earnings. Workers know their entitlements and are well-prepared to negotiate better terms when compensation lags.
On the flip side, transparency helps employers keep track of rising wages. Managers can refuse excessive wage demands, pointing to the need to raise wages for all employees. Transparency makes refusals more credible.
Transparency also suits today’s workforce. 40% of Gen Z and millennial workers share salary information with co-workers. Workers also tend to value transparency, as it limits the scope for bias and discrimination.
We know all about this at Toggl. Every job description we publish includes accurate salary data, and we never hide employee pay ranges.
Openness works for us. It promotes fairness and allows us to make honest salary decisions. It will most likely work for you, too. Even so, only around 20% of US companies have adopted pay transparency. If you want to join them, keep these best practices in mind:
Avoid demotivation by linking salaries to professional development. Create pathways to higher pay for every employee.
Combine personal development with standardized pay structures.
Stay aware of potential conflicts. Transparency exposes pay differences for current employees, which can lead to internal friction.
Audit pay before rolling out pay transparency. Check for discrimination, as pay inequities could lead to compliance problems. For instance, audits may uncover a yawning gender pay gap.
Be honest about market rates. If you can’t match competitors, explain why. Document how non-financial benefits compensate for lower pay.
Define your compensation philosophy. Write a short document outlining how performance, seniority, responsibilities, and skills feed into employee pay.
Use external expertise to research market rates. If possible, leverage compensation data to back up your pay rates. Don’t rely on back-of-the-envelope calculations.
Listen to employee feedback. Create a dedicated email address for pay issues and respond to every message. Use feedback to address pay inequities.
Other ways to attract, engage & retain great employees
Hopefully, you’re now tuned in to the dangers of pay compression and potential solutions. We recommend action whenever pay compression occurs.
But don’t stop there. When we zoom out a little, retaining talent demands more than robust pay structures and compensation audits. Solving pay compression is one part of a wider talent retention strategy, and there are many ways to improve talent retention.
Enabling career development, rewarding employee achievements, and ensuring fairness at work all contribute. Generous benefits and a positive company culture encourage new employees to stay and thrive.
Smart companies also engage talent from day one. Everything starts with a smooth candidate experience during the hiring process, and we can help you with that.
Our ATS and skills testing solutions make life easy for candidates and your hiring manager. User-friendly tests deliver razor-sharp insights about critical skills. Feedback helps candidates, while tests feed seamlessly into a simple candidate management system.
Create a free Toggl Hire account and streamline your hiring process. Combining efficient recruitment and transparent pay policies will keep employee turnover rates low. Even in challenging market conditions, you’ll never lack essential skills and talent.
Elizabeth is an experienced entrepreneur, writer, and content marketer. She has nine years of experience helping grow businesses, including two of her own, and shares Toggl's mission of challenging traditional beliefs about what building a successful business looks like.
