What is retro pay, and when should you use it?

Payroll is one of those things you really want to get right the first time. But between salary changes, shifting schedules, and the occasional administrative oversight, even a well-run team can miss something. Maybe an employee's recent raise didn't make it into the latest payroll run or someone worked more hours than their paycheck reflects.

When mistakes like these happen, you’ll need to make up the difference. That's where retroactive pay, or retro pay, comes in. It’s a way to correct an underpayment and get employees the compensation that they've already earned.

In this guide, we'll walk through how retro pay works, when you might need it, and how to calculate and process it accurately.

Retroactive pay, commonly called retro pay, is the additional compensation that an employer owes an employee for work they've already completed. It typically comes into play when an employee receives less than they should have during a pay period, whether because of a payroll error, a delayed raise, an incorrect pay rate, or something else.

Say you give an employee a $5,000 annual raise effective October 1, but their October 15 paycheck still reflects their previous salary. Rather than changing the effective date of their raise, you can use retro pay to cover the difference between what they earned and what they received.

Some of the most common situations where you’ll need to use retro pay include these:

• Delayed raises or promotions: For example, say a manager approved a salary increase effective at the beginning of the month, but payroll continued using the employee's previous rate.
• Incorrect pay rates: This is when an employee's paycheck reflects the wrong hourly wage or salary, leaving them with less compensation than they should have received.
• Missed hours or overtime: This could happen when your payroll records don't account for all the hours an employee worked, or if you calculate their overtime using an incorrect rate.
• Delayed bonuses or commissions: This could occur when an employee earns additional compensation under an existing agreement, but payroll didn’t include the correct amount when it's due.

Retro pay and back pay both address compensation shortfalls, but they typically apply to different situations:

• Retro pay covers the difference between what an employee received and what they should have earned, such as when payroll mistakenly continues using an old hourly rate after a raise.
• Back pay generally refers to wages that an employee never received. This is often in connection with wage disputes, wrongful termination, or unpaid work.

To calculate retro pay, start with a simple question: How much should the employee have earned, and how much did you actually pay them? The difference is what you owe (also called the gross retroactive payment).

The specific formula that you’ll need to follow will depend on whether the employee earns an hourly wage or a salary, as well as any additional compensation you need to account for.

How to calculate retro pay for hourly employees

For hourly employees, multiply the difference between the correct and original hourly rates by the number of hours the employee worked during the affected period. You can use this formula:

Retro pay = (Correct hourly rate − Original hourly rate) × Hours worked

Example

Say an employee received a raise from $25 to $28 per hour, but payroll continued using their old rate for 80 regular hours. This is how you’d calculate the employee’s retro pay:

• Hourly difference: $28 − $25 = $3
• Total retro pay: $3 × 80 = $240

You'd owe the employee $240 in gross retro pay, before taxes and deductions.

How to calculate retro pay for salaried employees

For salaried employees, divide the difference between their previous and updated annual salaries by the number of pay periods in the year. You can use this formula:

Retro pay per pay period = (New annual salary − Previous annual salary) ÷ Number of annual pay periods

Example

Say you increase an employee's annual salary from $70,000 to $76,000, but their raise doesn't appear in two consecutive biweekly paychecks. This is how you’d calculate the employee’s retro pay:

• Annual salary difference: $76,000 − $70,000 = $6,000
• Difference per pay period: $6,000 ÷ 26 = $230.77
• Total retro pay owed: $230.77 × 2 = $461.54

If the raise took effect partway through a pay period, you'd also need to prorate the adjustment based on the applicable days or hours.

How do overtime, bonuses, and commissions affect retro pay?

Not every retro pay calculation is as straightforward as correcting an hourly rate or salary. If the employee earned overtime, bonuses, or commissions during the affected period, you may need to make additional adjustments.

For example, a retroactive hourly raise can also increase the overtime wages you owe for that period. Certain bonuses and commissions may affect an employee's regular rate of pay under the Fair Labor Standards Act (FLSA), which can change how you need to calculate overtime.

Review each compensation component separately and check whether it affects the employee's regular rate of pay. That way, you can correct the full shortfall, rather than just the difference in their base wages.

Once you've calculated how much retroactive pay you owe an employee, the next step is to process the adjustment through your payroll system. Most payroll platforms let you add retro pay as a separate earnings item, making it easier to track the correction and apply the appropriate taxes and deductions.

Here's how to approach it:

1. Verify the original underpayment. Review the employee's pay records, compensation agreement, and relevant timesheets to confirm when the discrepancy occurred and how much you owe.
2. Calculate the full adjustment. Determine the gross retro pay amount, including any additional overtime, commissions, or other compensation that the error affected.
3. Enter the adjustment in payroll. Use your payroll provider's retro pay or earnings adjustment feature to record the amount. Depending on the circumstances and applicable wage laws, you may need to issue an off-cycle payment, rather than waiting until the next scheduled payday.
4. Apply the appropriate taxes and deductions. Make sure your payroll system accounts for required withholdings and any applicable benefit or retirement contributions.
5. Review the payment and notify the employee. Double-check the adjustment before processing it, then explain the correction so the employee understands what changed and what to expect on their pay statement.

If you manage payroll manually or you're still building out your processes, our guide to how to do payroll for a small business walks through the fundamentals.

Retro pay counts as taxable wages, just like an employee's regular earnings. That means you'll need to account for federal income tax withholding, Social Security and Medicare taxes, and any applicable state and local taxes when processing the adjustment.

The amount you withhold may depend on how you issue the payment. For example, if you include retro pay in an employee's regular paycheck, your payroll system may calculate withholding based on their combined earnings for that pay period. If you issue it as a separate payment, the IRS's supplemental wage withholding rules may apply.

Under those rules, employers can generally use a flat 22% federal income tax withholding rate for qualifying supplemental wages, subject to certain conditions and thresholds. However, the correct method will depend on how you process the payment and the employee's circumstances.

Keep in mind that the gross retro pay amount doesn't change based on taxes. If you owe an employee $240 in retro pay, that remains their gross adjustment, even though they'll receive less after applicable withholdings.

For a closer look at how these calculations work, check out our guide to payroll taxes and our article on how to calculate payroll tax deductions.

Federal and state wage laws establish requirements for how much you need to pay employees and when they should receive their wages.

Under the FLSA, employers must meet federal minimum wage and overtime requirements for covered employees. If a payroll error causes you to fall short of those obligations, you'll need to correct the underpayment, including any additional overtime compensation you owe. The U.S. Department of Labor provides guidance on recovering unpaid wages under federal law.

State laws may impose additional requirements, including stricter payment deadlines, higher minimum wages, and penalties for late or unpaid wages. Depending on the local laws where your employees work, you may need to issue a correction before your next regular payroll run.

For good measure, keep records of the original error, your calculations, the corrected payment, and any related employee communications. The FLSA generally requires employers to retain payroll records for at least three years, although other federal and state rules may require longer retention periods.

Although you probably can't eliminate every payroll error, a few good habits can help you catch discrepancies before they affect an employee's paycheck: Start by keeping compensation records up to date (including salary changes, promotions, and effective dates), and making sure whoever manages payroll has access to that information.

It's also worth building a quick review into every payroll cycle to check hours, pay rates, and any recent compensation changes before approving payments. As your team grows, payroll software can help you automate calculations, track adjustments, and reduce the sort of manual work that often leads to mistakes.

For a broader look at building a reliable process, check out our guide on how payroll works.

Payroll mistakes happen, and how you handle them matters. When you identify an underpayment, having a clear process for calculating the difference, correcting the payment, and documenting the adjustment helps you meet your obligations and maintain employee trust.

Using the right tools can also make payroll easier to manage as your business grows. Mercury integrates with payroll and HR platforms, like Gusto, Deel, and Rippling, helping you connect payroll with your broader financial operations. You can also fund supported payroll providers directly from your Mercury checking account, making it easier to manage the cash that keeps payday running smoothly. Plus, Mercury Payroll lets you pay your team right from the account you already bank with.