Employee benefits encompass a broad range of benefits—other than salary—that companies provide to their employees. Some of these benefits, such as workers' compensation, social security, and unemployment insurance, are required by law. The majority of benefits offered to employees, however, are bestowed at the discretion of the business owner. Such benefits, which are commonly called "fringe" benefits, range from such major expenditures as paid holidays, health insurance, paid vacations, employee stock ownership plans (ESOPs), and profit sharing to more modest "extras" like bestowing performance awards and prizes, providing an employee lunchroom, or paying for a company picnic.

Employee benefits are an indirect means of compensating workers, but they can be quite important in fostering economic security and stability within the work force. Insurance coverage, for instance, is often terribly expensive, so the company that offers medical and/or life insurance to employees as part of its benefits package is bestowing significant savings on those employees and their families. Companies, however, must be careful when putting together a compensation package for their work forces, and prudence is especially important for the small business owner. As Irving Burstiner remarked in 1989 in The Small Business Handbook, "all the 'extras' that firms have added to the basic compensation of their employees over the years amount to a sizable cost factor today." Noting that financial 'fringe benefits' can often add up to a startling amount of money, Burstiner added that "small firms are cautioned against adopting these fringe benefits too quickly and too freely. Some are almost mandatory if an organization is to compete effectively for personnel against other firms in the industry. Other fringe benefits, while perhaps desirable, should be postponed until the company is in a strong, healthy position."

Employee benefits are any kind of compensation provided in a form other than direct wages and paid for in whole or in part by an employer, even when they are provided by a third party such as the government, which disburses social security benefits that have been paid for by employers. Employee benefits can be most easily divided into two categories: mandatory and optional.

Mandatory Benefits. Mandatory benefits are required by law. They serve to provide economic security for employees (and their dependents) who have ceased working because of retirement, unemployment, disability, poor health, or other factors. Notable mandatory benefits include: Medicaid; basic Medicare; Public Assistance; Social Security retirement; Social Security disability; Supplemental Security income; unemployment insurance; and workers compensation.

Optional Benefits. Optional benefits are those that an employer has the option of providing. These optional, or supplementary, benefits include such major compensation areas as insurance and tax-qualified plans of deferred compensation. Such compensation programs are designed for the exclusive benefit of employees and their beneficiaries and are subject to specific Internal Revenue Service (IRS) regulations. Primary deferred compensation plans include: 1) Pension plans—established and maintained by employers and paid out to employees over a period of years after retirement; 2) Annuity plans—paid out of annuity or insurance contracts; 3) Stock bonus plans—arrangement wherein employees are given stock in the company and receive money from appreciation in the value of shares and/or the dividends or income from that stock; 4) Profit-sharing programs—plan in which business profits earned by the employer are shared with employees; 5) 401(k) Plans—option that allows employees to deduct a portion of their pre-tax salary and invest it in a profit-sharing, fixed contribution, or stock bonus plan.

Optional benefits are handled in a variety of ways under the tax code. Some are fully taxable, but others are tax-preferred, tax-exempt, or tax-deferred, meaning that taxes are not incurred on the benefit until it is used. Optional benefits serve many of the same basic functions as mandatory benefits, but also include perquisites—known as "perks"—only tangentially related to actual business. These perks can range from country club membership to use of a company car.

Fully taxable optional benefits include cash bonuses and awards; non-qualifying stock bonuses; nonqualifying stock ownership and profit-sharing programs; and severance pay. Tax-preferred benefits include life insurance; long-term disability insurance; and sickness and accident insurance.

Tax-deferred benefits include 401(k) retirement plans; deferred profit-sharing plans; employee stock ownership plans (ESOPs); most types of qualified pension plans; stock bonus plans; and thrift savings plans.

Finally, tax-exempt benefits that companies may offer include cafeteria facilities and meals; dental and vision insurance; dependent care; flexible spending accounts; free or discount club memberships; health insurance for employees and retirees; legal assistance; free parking or parking subsidies; supplementary Medicare premiums; tuition reimbursement; and use of company car.

In addition, most companies offer time-oriented compensation packages that encompass paid vacations and holidays; paid sick days; flexible shifts; maternity and paternity leave; bereavement leave; jury duty; overtime; paid lunch; and sabbaticals. These time-oriented benefits, while optional, are among the most popular and widely used of the various non-salary compensation options.

A comprehensive benefits package, while expensive, can be an important and useful asset for a company. Indeed, while salary considerations remain paramount for many workers, an attractive benefits package can be a major factor when a prospective employee is weighing his or her options. A parent with two small children, for example, might well be willing to choose a lower-paying position with a company that offers a superior family health insurance package over a significantly higher paying one that does not provide good health insurance benefits for its employees and their dependents.

One option that some companies have turned to is known as the "cafeteria plan" or "flexible benefit program." Under this type of arrangement, employees are given a certain number of "credits" which they can use to choose, from a menu of possible benefits, the benefits that they most desire for themselves and their families. Each worker thus puts together his or her own individualized package of employee benefits.


Indeed, a chief role of employee benefits is to provide various types of income protection to groups of workers. Five principal types of income protection delivered by benefits are: disability income replacement; medical expense reimbursement; retirement income replacement; involuntary unemployment income replacement; and replacement income for survivors. Different mandatory and voluntary elements of each of these categories are typically combined to deliver a benefits package to a group of workers that complements the resources and goals of the organization supplying the benefits.

Disability Benefits . Benefits that provide disability income replacement include programs such as Social Security and worker compensation. The bulk of these benefits are mandatory, although numerous supplementary plans, most of which are tax-favored, exist. Most organizations seek to assemble a disability package that will provide an adequate safety net, yet not act as a disincentive to return to work. A common objective is long-term income reimbursement of 60 percent of pay, which is preceded by higher levels of reimbursement, usually as much as 100 percent during the first six months of disability. Long-term disability pay typically ends at retirement age (when pension payments begin), or when the worker recovers or finds another job.

Another disability-related benefit incentive is sick pay, although companies handle this category in a variety of ways. Some organizations have instituted policies that provide cash awards for unused sick days at the end of the year. Others opt to combine separate leave policies for vacation, illness, and "personal time" into a single policy for paid time off. (Such a policy provides employees with an allotment of days off each year that can be used at the employee's discretion.) Employers may vary the quality of their disability package with different co-payment options, limits on payments for voluntary coverage, and extended coverage for health insurance, life insurance, and medical benefits related to the disability.

Medical Benefits . Medical expense reimbursements are typically one of the most expensive and important elements of a company's compensation package. The two primary types of voluntary medical coverage options are fee-for-service plans and prepaid plans. In addition to voluntary plans, government-backed health care plans, such as Medicare and Medicaid, serve as safety nets to furnish medical coverage to select groups of society and to those least able to afford other types of health insurance.

Under traditional fee-for-service plans, the insurer pays the insured directly for any hospital or physician costs for which the insured is covered. Under a prepaid plan, insurance companies arrange to pay health care providers for any service for which an enrollee has coverage. The insurer effectively agrees to provide the insured with health care services, rather than reimbursement dollars. Typical features of prepaid plans are reduced administrative expenses and a greater emphasis on cost control. The most common type of prepaid plan is the health maintenance organization (HMO).

Most plans cover basic costs related to: hospitalization, including room and board, drugs, and emergency room care; professional care, such as physician visits; and surgery, including any procedures performed by surgeons, radiologists, or other specialists. More comprehensive plans provide higher dollar limits for coverage or cover miscellaneous services not encompassed in some basic plans, such as medical appliances and psychiatric care. The most inclusive plans eliminate deductible and coinsurance requirements and may even cover dental, vision, or hearing care.

Companies have many options that they can pursue in shaping their medical benefits packages. Indeed, a dizzying array of co-insurance, co-payment, and coverage limit options are available today. Some companies pick comprehensive medical benefits packages that handle all health care costs incurred by employees and their dependents, while others select less expensive plans that call for employee co-payment of insurance coverage and/or high deductibles (the deductible is a set amount that an individual must pay before insurance coverage begins). The plan that a company ultimately selects is predicated on any number of factors, from its own financial well-being to the benefits packages offered by its industry competitors.

Retirement Benefit. Companies provide retirement-related employee benefits through three avenues: Social Security, pension plans, and individual savings. The Social Security system is a federal government program paid for by a tax on earnings; this tax is shared equally by both employee and employer. The system, which is administered primarily through the Social Security Administration, provides payments to qualified individuals; it is designed to defray income lost by people as a result of old age, unemployment, or sickness.

Pension plans are primarily financed by employers. Unlike the financially troubled U.S. Social Security system, pension plans, which are created by private employers, are subject to strict government controls designed to ensure their long-term existence. The two major categories of pension funds are defined benefit and defined contribution. Under the former arrangement, workers are assured a specified level of regular payments (given expected Social Security disbursements) upon retirement, and the company is responsible for managing the account. In contrast, defined contribution plans utilize such savings techniques as money purchase plans, stock ownership plans, and profit sharing. Companies make regular contributions to workers' accounts through those different instruments, and may also integrate employee contributions. The beneficiary simply receives the value of the contributions, with interest, at retirement. The latter methodology is preferred by some because of its comparative flexibility and the fact that taxes on earnings are deferred.

The third type of retirement benefit offered by many employers is the supplementary individual savings plan. These plans include various tax-favored savings and investment options. Employers may also provide retirement benefits such as retirement counseling, credit unions, investment counseling, and sponsorship of retiree clubs and organizations.

Unemployment Benefits . Many employers offer some form of protection against termination as a benefit to employees. This is due in part to the fact that termination benefits are required under various circumstances by collective bargaining agreements and state and federal laws. A common unemployment benefit is severance pay. Under this arrangement, a worker whose employment is terminated may be compensated financially with a lump sum or a series of payments. Length of employment is generally an important factor in determining severance pay. It is important to note, however, that an employee who is discharged because of legitimate misconduct is not entitled to receive unemployment benefits. "The unemployment office will note the precise language you used when they determine if an ex-employee is entitled to receive unemployment insurance benefits," noted Mark A. Peterson in The Complete Entrepreneur. "If your employee quit without good cause, he cannot receive any benefits. If you fire him for mis-conduct connected with work, he cannot receive any benefits. If he fails to accept other suitable work that you may have offered him, he cannot receive any benefits." Peterson and other small business consultants thus encourage small business owners to contest unemployment claims that have been unfairly lodged against them, for they can ultimately result in higher premium payments for the business.

Some industries provide supplemental unemployment pay plans. These are employer-funded accounts designed to ensure adequate and regular payments to workers, usually members of labor unions, during periods of inactivity. Other companies, meanwhile, provide placement assistance to workers who have been laid off.

Survivor Benefits . Like disability compensation, benefits for the survivors of deceased employees are comprised primarily of mandatory Social Security and workers compensation benefits. Eligibility for these benefits is determined by such factors as age, marital status, and parental responsibilities. In addition, a plethora of different privately financed benefit packages are available; many of these enjoy favored tax status. Most plans are set up to make payments to a beneficiary designated by the employee. Payment levels are usually contingent on the cause of death. For example, a worker killed while on the job would likely receive much more than an employee who died at home or on vacation. A common survivorship benefit is some form of term life insurance that takes advantage of tax preferences and exemptions. Those plans often allow employees to make financial contributions as well.


The entrepreneur who is launching a new business faces a daunting array of options when the time arrives to design a compensation package for his or her employees. As Michael Armstrong observed in A Handbook of Human Resource Management, benefits "are no longer merely the icing on the cake of cash remuneration, but a considerable part of it." But before making any decisions as to the character and scope of an employee benefits package, the new small business owner needs to gain a familiarity with the various laws and regulations that apply to employee benefits. "There are numerous federal and state laws which regulate the administration of wages and benefits," wrote Jill A. Rossiter in Human Resources: Mastering Your Small Business. "For example, the Federal Fair Labor Standards Act stipulates the minimum wage and regulated overtime pay." In addition to withholding various federal, state, and local taxes from payroll checks, employers also are responsible for adhering to "other laws [that] specifically regulate the administration of retirement programs, withholdings for child care, etc. Finally, there are tax laws regarding what payments are and are not deductible as normal business expenses and what benefits might be taxable to the employees." Given these myriad factors, small business consultants commonly recommend that the owner(s) of a fledgling small business enterprise utilize the services of legal and accounting professionals when putting together their company's benefits packages.

The small business owner should work to put together a fair and equitable package, but he or she should also remain mindful of business realities and the ultimate need to be a profitable enterprise. The intelligent entrepreneur will research typical compensation packages both in the geographic region and in the industry in which they will be operating. Newspapers, associations, libraries, and various municipal and state agencies all can be helpful sources of information in this regard. Successful entrepreneurs also need to gauge their own expenses and business expectations (in terms of profitability, growth, debt, etc.) when pondering the character of the benefits package they will offer. Employee benefits can be a significant business cost, and if your profit margin is slim—or if you expect to operate in the red for your first few years of operation—then you need to be cautious. Some fringe benefits—vacation days, for example—are practically mandatory in today's business environment. But others, such as health insurance or pensions, can create an unacceptable burden on a new company. In addition, there are also some industries whose membership simply does not offer much in the way of fringe benefits for its workers, either because of narrow profit margins or the laws of supply and demand within the labor market.

In the final analysis, the benefits package that a new or growing company puts together should be predicated on a few very important factors: company size and financial health, regional standards, industry standards, employee benefits offered by competitors, and work force needs.


Briggs, Virginia L., Michael G. Kushner and Michael J. Schinabeck. Employee Benefits Dictionary . The Bureau of National Affairs, Inc., 1992.

Burstiner, Irving. The Small Business Handbook. Prentice Hall, 1989.

"Easier Done than Said." Employee Benefit News. December 1,2000.

Fundamentals of Employee Benefit Programs. Employee Benefit Research Institute, 1990.

Jenks, James M. and Brian L.P. Zevnik. Employee Benefits Plain and Simple . Collier Books, 1993.

Michael, Andy. "Playing a Pivotal Role." Employee Benefits. December 2000.

Peterson, Mark A. The Complete Entrepreneur. Barron's Educational Series, 1996.

Rossiter, Jill A. Mastering Your Small Business Human Resources. Upstart Publishing, 1996.

Simmons, John G. "Flexible Benefits for Small Employers." Journal of Accountancy. March 2001.

SEE ALSO: Employee Reward Systems ; Sick Leave and Personal Days

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