Total compensation has three components: (1) base compensation, the fixed pay received on a regular basis; (2) pay incentives, programs designed to reward good performance; and (3) benefits or indirect compensation, including health insurance, vacations, and perquisites.

An effective compensation plan enables the firm to achieve its strategic objectives and is suited to the firm’s unique characteristics as well as to its environment. The pay options managers need to consider in designing a compensation system are (1) internal versus external equity, (2) fixed versus variable pay, (3) performance versus membership, (4) job versus individual pay, (5) egalitarianism versus elitism, (6) below-market versus above-market compensation, (7) monetary versus nonmonetary rewards, (8) open versus secret pay, and (9) centralization versus decentralization of pay decisions. In all situations, the best choices depend on how well they “fit” with business objectives and the individual organization.

There are two broad categories of compensation tools: job-based approaches and skill-based approaches. The typical job-based compensation plan has three components: (1) To achieve internal equity, firms use job evaluation to assess the relative value of jobs throughout the firm. (2) To achieve external equity, they use salary data on benchmark or key jobs obtained from market surveys to set a pay policy. (3) To achieve individual equity, they use a combination of experience, seniority, and performance to establish an individual’s position within the pay range for his or her job.

Skill-based compensation systems are more costly and more limited in use. Skill-based pay rewards employees for acquiring depth skills (learning more about a specialized area), horizontal or breadth skills (learning about more areas), and vertical skills (self-management).

The major federal laws governing compensation practices are the Fair Labor Standards Act (which governs minimum wage and overtime payments and provides guidelines for classifying employees as exempt or nonexempt), the Equal Pay Act (which prohibits pay discrimination based on gender), and the Internal Revenue Code (which specifies how various forms of employee pay are subject to taxation). Some countries and municipalities have comparable worth legislation, which calls for comparable pay for jobs that require comparable skills, effort, and responsibility and have comparable working conditions, even if the job content is different.