California Court Upholds Percentage Bonus, Without Recalculating Overtime Regular Rate

Similar to the federal Fair Labor Standards Act (FLSA), California law requires an employer to pay overtime based on an employee’s “regular rate of pay.” That rate may not be just an employee’s hourly wage, or straight time, rate.

Non-discretionary bonuses and certain other amounts also must be included in the regular rate, resulting in a higher overtime rate of pay. As a result, employers often must recalculate an employee’s regular rate — and sometimes make a further “true up” payment of additional overtime later when paying a bonus that covered a longer period.

Under the federal FLSA, the US Department of Labor’s regulations long have recognized an exception to the recalculation obligation for a “percentage bonus.” There, when an employer pays a bonus based on the same percentage of an employee’s total non-overtime and overtime wages, an employer can avoid having to recalculate the overtime regular rate to include the percentage bonus. In its recent decision in Lemm v. Ecolab Inc., the California Court of Appeal held that California employers lawfully may use this same approach under the state’s law. This development makes clear that California employers may use this helpful approach – as long as they do so correctly.

A Percentage Bonus Based on Total Compensation

Ecolab involved an overtime non-exempt route sales manager, who worked overtime. Under its annual incentive compensation plan, the employer paid him an hourly wage and a nondiscretionary monthly bonus. The company paid straight time and overtime wages every two weeks. The monthly bonus was nondiscretionary because, as the court described it, “the employee is entitled to it under his or her compensation package whenever the employee meets target metrics.” The incentive had two components. If the employee met his goals under one portion, he earned a bonus of at least 22.5% of his gross wages for the month. If he met his goals under the second component, the employee earned another bonus of an additional 5% of his monthly gross wages. The company paid these bonuses as a percentage of all straight time and overtime wages, which also included overtime hours paid as double time.

The employee sued for civil penalties under the Labor Code Private Attorneys General Act (PAGA). He alleged that the company failed to pay him and other route sales managers overtime at the proper rate, considering the nondiscretionary percentage bonuses.

The employer argued that it properly followed the FLSA’s “percentage bonus” method. It contended that it paid the employee all overtime due on the bonus that way, having paid the same percentage bonus on all straight time and overtime paid. The employee, however, insisted that California law required the employer to have recalculated the regular rate to include the percentage bonuses, and then base overtime pay on the resulting higher amount. The trial court agreed with the employer: “Simply put, a requirement for an employer to pay overtime on a percentage bonus that already includes overtime pay makes the employer pay ‘overtime on overtime.’ This is not a requirement under the law. By paying a bonus based on a percentage of gross earnings that includes overtime payments the employer automatically pays overtime simultaneously on the bonus amount.” It thus dismissed the employee’s overtime claim.

No “Overtime on Overtime” Required

The Court of Appeal affirmed the trial court’s decision. It recognized an employee’s regular rate may vary between different periods, depending on whether additional compensation must be included. The court set forth the FLSA regulations for the general rule that, when a bonus amount is not known until later, an employer must apportion the bonus amount back over the period during which it may be said to have been earned. Ordinarily, based on the new higher regular rate including the bonus, an employee then must receive additional pay for any overtime that he or she worked during the bonus period.

The FLSA’s percentage bonus regulation, however, provides that payment of such a bonus equally on straight time and overtime paid satisfies the regular rate requirement, and does not require recomputing the regular rate for the bonus. It recognizes that, in some instances, a contract or plan “may also provide for the simultaneous payment of overtime compensation due on the bonus. For example, a contract made prior to the performance of services may provide for the payment of additional compensation in the way of a bonus at the rate of 10% of the employee’s straight-time earnings, and 10% of his overtime earnings. In such instances, of course, payments according to the contract will satisfy in full the overtime provisions of the [FLSA] and no recomputation will be required.” 29 CFR. § 778.210.

Based on this regulation, several federal courts have upheld percentage bonuses as complying with the FLSA, with no computation required. As a leading case recognized, a percentage bonus is permissible because it “increases both straight time and overtime wages by the same percentage . . . .” Brock v. Two R Drilling Co. Inc., 789 F.2d 1177, 1180 (5th Cir. 1986).

The Court of Appeal in Ecolab concluded that the employer’s percentage bonus complied with the federal FLSA’s overtime requirements, because the plan provided “for the simultaneous payment of overtime compensation due on the monthly bonus by way of a percentage increase to his straight time and overtime earnings.” It also agreed with federal courts that held such percentage bonuses also comply with California law.

The Court of Appeal rejected the employee’s proposed calculation as representing “a double counting of ‘overtime on overtime.’” His calculation “failed to take into account that the bonus he received already included overtime on the bonus.” It concluded that the employee’s formulation, “without taking into account that bonus attributable to the workweek already includes overtime on overtime,” would contravene Labor Code section 510 and the wage orders. They require an employer to pay overtime at 1.5 times, or double, the regular rate of pay, “not some greater amount.” By paying overtime at the required rates, including with the percentage bonus, the Court of Appeal held that the employer’s percentage bonus complied with the law.

Finally, the Court of Appeal rejected the employee’s argument that the California Supreme Court’s decision in Alvarado v. Dart Container Corp. of California, 4 Cal.5th 542 (2018), required recalculation of the regular rate. Alvarado did not involve a percentage bonus. Rather, it concerned the issue of how an employer should determine the regular rate on a flat sum bonus. There, the California Supreme Court held that employers must divide a flat sum bonus only by non-overtime hours and not by all hours worked under California law, unlike the federal FLSA. (Our alert on Alvarado is available here.)

Even if, as a general matter, California courts adopt an interpretation of California wage and hour rules favoring employees, the Ecolab court rejected the notion that the regular rate had to be recalculated with a percentage bonus. Regardless of that rule, the court explained that “[w]e do not understand this policy to obligate courts to interpret state law to give an employee ‘overtime on overtime’ when such an interpretation would be inconsistent with the fundamental [principle] of overtime” at certain rates. It concluded that “we see nothing in California law that favors giving an employee a windfall” by applying the usual rule requiring recalculation of the regular rate when it does not apply under the concept of a percentage bonus.

Employer Takeaways

Ecolab is a significant decision. For a long time, under the FLSA, federal courts allowed employers to pay a percentage bonus without having to recalculate the overtime regular rate. Ecolab is the first published decision by a California court approving the use of a percentage bonus under California law in the same manner. It makes clear that California employers may incentivize and reward employees with a percentage bonus — without the burden of then having to recalculate the regular rate. The decision also correctly recognizes that having to recalculate the regular rate to include a percentage bonus, which already accounted for overtime by paying the same percentage on overtime as well as straight time – illogically would result in an employer having to pay “overtime on overtime.”

Employers who have wanted to offer bonuses, but also did not want to have to recalculate the overtime regular rate to include a bonus, should consider the percentage bonus option. Nonetheless, employers should be careful when implementing and paying a percentage bonus. Among other things, they must ensure that they pay all overtime correctly in the first instance, as well as apply the same bonus percentage to all straight time and overtime in the bonus period. Other amounts paid also may be subject to the percentage bonus. As with any bonus, employers are strongly encouraged to consult employment law counsel.