How do bonuses work and what are the different types?

Updated 1 June 2023

Many employers offer bonuses to employees as an extra form of compensation for their hard work, so it's important to understand what a bonus is when weighing up a job offer. Employers award bonuses in many ways, with some types of bonuses carrying more value than others. Bonuses can relate to individual performance or employers can award them at a flat rate to all employees. In this article, we explore what bonuses are, how bonuses work and what types of bonuses a company may offer you.

How do bonuses work?

When you secure a new job, your new employer gives you the details of both the salary they're offering you and any bonuses your new company pays out. Bonuses aren't a guarantee, but some companies may decide on whether to pay out bonuses at particular times of the year or during the employment period. These might include:

when you sign your contract as an extra incentive
after your annual performance review
at the end of the tax year, after a company performance evaluation
at Christmas or other holidays
at the end of any big project
if you refer a friend to your company who they then hire

Some of these bonuses, such as bonuses at the end of projects or those paid out annually, are more likely to relate to performance than others. When bonuses relate to performance, there are two different approaches that a company can take when allocating bonuses and deciding how big each employee's bonus is.

Discretionary bonuses

Your employer awards discretionary bonuses at their own discretion, so they don't guarantee them no matter how well you perform at work. They might mention discretionary bonuses when you're hired, but it ought to be clear that they do not guarantee these at certain points throughout the year. Your employer can decide themselves how to allocate discretionary bonuses based on performance or effort, when to pay them and how much to payout.

Non-discretionary bonuses

These are bonuses that incentivise hard work. They usually describe them in your contract, where they set out the criteria for earning your bonus. For example, your contract might state that you earn a bonus of a certain percentage of your salary if you meet certain performance criteria, such as volume of sales. Non-discretionary bonuses always payout provided you reach the targets in your contract.

What is a bonus?

A bonus is a form of financial compensation that is not guaranteed, which means it's not connected to your annual salary. They often pay bonuses after some kind of event, for example after the completion of a big project or at the end of the financial year. Bonuses can be cash, but they can also take the form of non-cash awards such as company shares, extra time off work, gifts and vouchers.

Bonuses are usually performance-based, though they could depend on the performance of an individual, an entire team or the company. This usually means that the better a company performs, the bigger the bonus that's paid out to employees. Sometimes, they calculate a bonus to be a percentage of an employee's salary, while other employers calculate them on a completely individual basis, depending upon a company's profits and performance that year. It's important that employees understand that, no matter how appealing potential bonuses are, they aren't a guarantee.

Why do companies give out bonuses?

Companies award bonuses for a huge number of reasons, but primarily because bonuses are another way to motivate and reward employees for hard work. Awarding bonuses is a way that employers and managers can foster a positive working environment, making employees feel appreciated and fairly rewarded for their hard work. Employers use different bonuses for different reasons. For example, sign-on bonuses attract top talent to a company, while annual bonuses offer compensation to existing employees to boost productivity and employee satisfaction. The reasons an employer might include bonuses as part of their compensation package include:

motivating employees to work harder and hit targets to earn a performance-based bonus
rewarding employees for hard work and ensuring that employees feel their employer recognises their efforts
attracting talented employees with competitive bonus packages and sign-on bonuses
supplementing salary compensation with bonuses to offer financial rewards that are most cost effective for the company

If you're negotiating a new contract with your employer, you may negotiate a bonus, even if they refuse to offer you a higher salary. Bonuses, particularly performance-based bonuses, are an effective way for employers to increase the financial rewards they offer to employees in a way that is cost effective and economical.

Types of bonuses

There are many types of bonuses your employer might offer you. Some bonuses are tangible rewards, while others might be perks, such as extra holiday time or even parking perks. Below are some of the most common types of bonuses that employers offer to incentivise hard work among employees.

Annual bonuses

Employers payout these bonuses annually to employees, often based on performance over the past 12 months. An employer might allocate an annual bonus because of either an individual's performance or the entire company's performance. A company may give out annual bonuses every year or may choose to only award annual bonuses after more successful years.

Profit-sharing

Some companies employ profit-sharing plans to incentivise employees to work hard. Under this structure, a company shares a certain percentage of the company's annual profits among its employees, which means that better company performance means bigger bonuses for everyone. Profit-sharing not only motivates employees to work hard but also ensures that employees feel invested in the company they work for.

Spot bonuses

Managers can usually award spot bonuses at their own discretion, often to employees who have demonstrated hard work during a recent project. Spot bonuses are usually small, ranging from £50 to £100, and could be cash bonuses, gift vouchers or other perks. An example of a spot bonus might be if an employee earns a £50 gift voucher for working until late on multiple evenings for a busy project.

Sign-on bonuses

A sign-on bonus is a bonus that employer and employee agree upon during the hiring process as a guaranteed part of a new employee's compensation package. This non-discretionary type of bonus can attract highly qualified new staff, and it offers a more attractive reward package without increasing salary. Sign-on bonuses can be financial and employers can either pay them in a single lump sum or via instalments over the coming year or more.

Milestone bonuses

Milestone bonuses are another kind of bonus that is directly tied to work performance. Companies might offer milestone bonuses after a team reaches certain milestones, for example, after selling a particular amount or after completing a certain project. Milestone bonuses may pay out for milestones that a team meets or for milestones reached by the individual.

Christmas bonus

Many companies offer a Christmas bonus to all of their employees, which is usually paid out just before the Christmas holidays. This Christmas bonus is a reward for all the hard work completed over the past year and it's a gesture of goodwill towards staff and colleagues at Christmas. Christmas bonuses may payout in relation to performance, though they often pay them at a flat rate to all employees.

Commission

Commission pay is a particular bonus pay that relates to performance. They usually offer a commission to employees working in sales and it means that employees receive a certain amount of commission payment for every sale they make. In commission-based roles, employees usually understand that their total compensation for the year depends heavily on how well they perform at work and that the difference between a good commission slip and a poor one can make a vast difference to your final salary.

What's better, a raise or a bonus?

Now that you know the answer to the question, 'how do bonuses work?', you can accurately weigh up your options at work when offered a bonus as part of your financial compensation. If you're choosing between a bonus and a raise, it's important to consider both of your options. While a raise offers a long-term increase to your salary, a bonus is a one-off payment and, in many cases, is not a guarantee. It may be tempting to take a larger bonus over a small raise, particularly if you can use the cash now.

How do bonuses work and what are the different types?