Underpaying Employees: Why This Is Risky and How to Fix It

Underpaying employees, whether unintentionally or deliberately, is a serious offense that can lead to severe consequences. As it’s a form of wage theft, it can result in penalties with interest, costly legal battles, damaged business reputation, and more.

In this article, we’ll explore the different forms of underpaying employees, the common causes of this practice, and the various legal and financial consequences that result from it. We’ll also provide guidance on how to prevent underpaying employees and rectify any underpayment that may occur. Let’s get started!

Key Takeaways

• Underpaying employees is the act of compensating workers below minimum wage or less than they have earned for a given pay period.
• It stems from payroll miscalculations, unpaid overtime, misclassification, withholding portions of wages or tips, improper time tracking, and more.
• Consequences of underpaying employees range from back pay and fines to lawsuits, class actions, and reputational damage.
• To prevent or correct underpayment, verify your calculations promptly and provide back pay as soon as you notice a mistake, regularly audit your payroll system, and stay informed about the latest wage laws and regulations.

What Is Considered Underpaying Employees?

Underpaying employees is the act of compensating them below what is legally required or less than their actual earnings.

Let’s learn what types of wage underpayment there are:

#1. Below Minimum Wage

Paying employees below minimum wage is a direct violation of the Fair Labor Standards Act (FLSA). The FLSA is a federal law that mandates workers be paid at a rate of at least $7.25 per hour.

It’s important to note that some states and even cities have different minimum wage laws with higher rates. Employers are required to pay their employees the highest minimum wage applicable.

The exception can be tipped employees; the federal law allows them to be paid less as long as the tips they receive bring their hourly earnings above the minimum wage. However, if their tips don’t add up to a minimum wage, the employers are required to make up the difference.

#2. Unpaid Overtime

Unpaid overtime is another form of FLSA violation. The law mandates that all non-exempt employees be paid at a higher rate for each hour worked in a week beyond the standard 40 hours. The overtime rate must be at least one and a half times the regular rate, though the rate can be higher in some states.

Unpaid overtime violations are common and can happen due to various oversights and miscalculations. Some employers fail to calculate the hours correctly, while others don’t pay for overtime hours at all. Even paying the employee their regular hourly rate for hours worked beyond 40 is still a violation of FLSA and is a form of underpayment.

#3. Misclassifying Employees as Contractors

Misclassifying an employee as an independent contractor leaves them without FLSA-mandated protections, leading to underpayment. Employees are entitled to a minimum wage and overtime pay, while independent contractors typically aren’t.

Moreover, employers withhold and pay portions of taxes on behalf of their employees, whereas independent contractors are usually responsible for their own taxes. As a result, misclassified employees may lose out on a lot more than just their take-home pay.

That’s why there are clear IRS contractor vs. employee guidelines to help businesses make a proper distinction. If a business has sufficient financial and behavioral control over the worker, they are likely in an employer-employee relationship.

Following the IRS’s employee classification rules helps businesses avoid making these costly mistakes, which can result in back payments, penalties, legal disputes, and other consequences.

#4. Withholding Wages or Tips

Withholding wages or tips from employees is a form of direct underpayment. Employers aren’t allowed to make arbitrary deductions from their employees’ paychecks; the FLSA places limits on what types of deductions can be made.

For instance, an employer can’t deduct the funds for uniforms, tools, or software required for the job if that would reduce the employee’s earnings below the minimum wage. They also can’t take any portion of their employees’ tips unless they have a specific tip-pooling arrangement.

Another form of underpaying employees includes withholding their final paycheck or not paying them for all of their hours worked upon their departure from the company.

#5. Unrecorded hours (off-the-clock work)

Employees must be compensated for all hours worked. This includes not just the hours during their regular shifts, but also any work that they must do before or after that, during their breaks, or at home.

Asking employees or allowing them to work outside their scheduled shifts (off the clock) and not compensating them for it is a serious violation of the FLSA. Some of the most common examples of this include businesses requiring workers to come in early to set up or to stay late to clean up after closing.

Even requiring employees to respond to work-related emails and messages from home outside their shifts is a form of underpayment unless compensated. This practice denies workers their regular and overtime wages and can lead to significant issues and legal consequences.

6 Common Causes of Underpaying Employees

Now that we know the different types of underpayment, let’s explore the most common causes for companies underpaying employees.

#1. Payroll Miscalculations

Payroll errors and miscalculations can stem from simple clerical mistakes and can result in significant issues down the road. Entering the wrong pay rate, miscalculating overtime, or withholding the incorrect amount of tax can result in paying the worker less than they are owed.

These calculations are often unintentional and come as a consequence of human error. When manually entering the information, it’s easy to misinput the rates or hours worked, resulting in wrong calculations. Payroll software can also be misconfigured or set up with outdated data.

For instance, if employees get a raise but the payroll system isn’t updated with those details, they will continue to receive their salary at the old, lower rates, resulting in underpaid workers.

#2. Misclassifying Workers

Misclassifying workers is a common and costly mistake that many businesses make both accidentally and deliberately. Making a clear distinction between a W-2 worker and a 1099 contractor can be challenging, which is why it’s essential to follow the guidelines provided by the IRS.

The main factors used to determine worker classification revolve around the degree of control the business has over its workers. If you control when and how someone does their job, and if you provide the necessary tools and resources, you’re likely employing a W-2 worker.

Misclassifying them as independent contractors means denying them access to various benefits, such as minimum wage, overtime pay, and other legal protections typically associated with employment. All of these elements can add up, resulting in severely underpaying wages.

#3. Not Understanding Overtime Rules

Overtime rules feature some nuances that can lead to misunderstandings and mistakes on the employer’s end. One common mistake a business can make is to classify an employee as “exempt,” even though they don’t meet the necessary criteria for it. However, the main consequence of being an exempt employee is not being eligible for overtime pay.

That’s why it’s essential to conduct overtime tests provided by the Department of Labor. For example, merely giving an employee a salary doesn’t automatically make them exempt if they don’t pass other tests.

Another common unpaid overtime violation occurs when employers fail to include all types of compensation, such as non-discretionary bonuses and commissions. Calculating these earnings at a regular rate when they are supposed to be multiplied by an overtime rate results in underpayment.

#4. Failure to Track Hours Properly

Failing to track hours properly is a direct cause of having underpaid employees. This is particularly important for non-exempt, hourly employees, as they are paid for all hours worked.

Failure to account for activities such as arriving early for pre-shift meetings and preparation, or staying after hours to clean up, can accumulate and result in significant underpayments.

This problem can be worsened further when an employer tracks hours manually. Manual timesheets can be easily falsified or incorrectly filled in due to human error. Additionally, requiring employees to do “off-the-clock” work and then not counting that toward their salary is illegal and will lead to severe legal and financial consequences.

#5. Using Outdated Wage Rates

Wage rates are subject to change at the federal, state, and even local levels. Since these changes typically don’t happen frequently, they can catch employers off guard and have them use outdated rates that are lower than the legal minimum.

That’s why it’s essential for employers to keep an eye out for the latest changes in laws and regulations and to update their payroll systems accordingly. Failing to do so can result in underpaying employees, as they may receive less than the minimum wage for their work.

Another common mistake businesses make is failing to update a pay rate after giving an employee a promotion. If an employee progresses in their job and reaches a higher seniority level, while their pay rate hasn’t been updated, they’ll be underpaid until the problem is rectified.

#6. Not Including Bonuses or Commissions in the Wage Base

Bonuses and commissions are often an integral part of an employee’s wage, and not including them when calculating an employee’s salary will result in underpayment. This is especially important with non-discretionary bonuses that have to be calculated with appropriate rates.

For instance, if a non-exempt employee earns a commission during their overtime hours, an overtime rate needs to be used when calculating the earnings from the commission. Using a regular rate will reduce the employee’s salary, ignoring the fact that they worked overtime, leading to underpayment.

Legal and Financial Consequences of Underpaying Employees

Underpaying employees is illegal, and the consequences vary depending on the degree of the violation. Let’s explore the most prominent payroll mistakes small businesses run into.

#1. Back Pay

One of the most direct consequences of underpaying employees is having to pay back all owed wages. This can include liquidated damages on top of the difference between what was paid and what should have been paid. Since liquidated damages are equal to the amount of back wages, they essentially double the amount the employer has to pay.

#2. Fines

Apart from back pay, businesses can be fined by the Department of Labor for each violation of minimum wage, overtime, and other laws. Deliberate and repeated offenses can lead to civil money penalties and result in up to $1,000 for each violation.

Exceptionally egregious and willful violations can result in criminal prosecution, which can significantly increase the amount of fines and even lead to imprisonment.

#3. Lawsuits or class actions

Underpaid employees can file lawsuits to recover their lost wages. If they win their cases, the employers will have to pay not just lost wages, but also attorney fees and court costs. This can ramp up to be exceptionally costly while also taking a lot of time.

Moreover, if multiple underpaid employees join together, they can file a class-action lawsuit. These can last even longer, encompass several years of back pay, and be financially devastating for the business.

#4. Reputational Damage

Apart from the immediate legal and financial consequences, businesses that underpay their employees often suffer from long-term reputational damage. News of wage theft can spread quickly among professionals in the same field, and even lead to broader public outrage and boycotts.

This negative perception can be challenging to overcome and may lead to a loss of customers and business partners, ultimately impacting revenue and profitability.

#5. Higher Turnover Rate

Poor compensation and being overworked are some of the leading causes of high turnover rates, both of which are directly related to being underpaid. On the other hand, high turnover rates are expensive for businesses, as they require more resources to be spent on finding, hiring, and training new staff.

How to Fix Underpayments in 4 Steps

Now that you know the most common causes and consequences of underpayment, let’s see how you can fix them and ensure payroll compliance in four easy steps:

• Calculate the total amount of underpayment. This involves carefully reviewing your payroll records to determine the exact pay period for which the underpayment occurred and the corresponding amount.

• Communicate honestly with your employee. Scheduling a meeting with them to explain the mistake and how it occurred helps maintain transparency and restore their trust in your business and payroll management.

• Issue the back payment as soon as possible. Once you’ve determined the exact amount to be repaid to the employee, settle it as soon as possible. You can add it to their next paycheck or even as a separate payment before that.

• Identify and fix the root cause. You should discover why the mistake happened in the first place and correct it to ensure it doesn’t happen again.

How to Avoid Underpaying Employees

Here are the proactive steps you can take to avoid running into underpayment issues in the first place:

• Regularly audit your payroll system. You should do this at least once a year or whenever you experience significant structural changes to make sure that everything is running smoothly.

• Automate the payroll process. Leveraging specialized payroll software to automate complex calculations (e.g., overtime, deductions, and taxes) significantly reduces the chances of mistakes due to human error.

• Stay informed and seek expert advice. Laws and regulations are prone to change, so you should follow the latest developments to avoid mistakes. When in doubt, contact a relevant tax or legal expert; that way, you can clarify things and avoid running into problems in the future.

Why Pay Stubs Matter: Avoiding Underpayment Claims

Pay stubs are important in avoiding underpayment claims, as they help employers maintain transparency and legal compliance. They contain detailed information about every employee’s hours worked, rates, earnings, deductions, gross and net pay, and other relevant details.

Providing your employees with pay stubs that detail their salaries offers them a clear breakdown of their compensation, reducing the likelihood of misunderstandings. Pay stubs facilitate transparency, allowing employees to verify if they’ve been paid properly for their work.

Paystub requirements vary by state. Employers are typically required to provide them outright, issue them at the employee’s request, or grant employees access to them via a digital platform.

If you want to create professional and accurate pay stubs quickly and effortlessly, you can use our pay stub generator. We developed specialized software with ready-made templates and built-in calculators to help you create these documents in minutes, ensure payroll compliance, and prevent underpayment.

Why Independent Contractors Also Need Clear Records

Independent contractors (while not eligible for the same FLSA protections as W-2 employees) still need clear and accurate payment records. They can help you during audits from agencies like the IRS or DOL to prove your relationships with clients and show that you haven’t been misclassified.

For each individual payment you receive from your clients, you should send a detailed invoice that describes the goods sold or services rendered. You can use our invoice generator to create and send these documents effortlessly.

Following that, you need to collect Forms 1099 at the end of the year from each client that you’ve received $600 or more. Alternatively, if you’re running a business that hires independent contractors, you need to issue these forms and file copies with the IRS. You can use our Form 1099 generator to help with that.

Final Thoughts

Underpaying employees, both deliberately and accidentally, is a critical mistake any business can make. The penalties can range from modest fines to legal battles and even criminal charges. Furthermore, if you keep repeating these offenses, your business will likely see a high turnover rate and suffer reputational damage, which can be detrimental.

That’s why it’s essential to correct any underpayments as soon as you spot them. Additionally, you should regularly audit your payroll system to make sure that everything is in place and working as intended.

Don’t forget to automate the processes as much as possible to avoid instances of human error. To help with that, you can use our software, like the pay stub generator and Form 1099 generator.

Underpaying Employees FAQ

#1. I am being underpaid. What do I do?

If you’re being underpaid at work, start by gathering the documentation that proves it, like pay stubs. Then, contact your employer or the HR department to discuss the problem. If that doesn’t resolve it, you can file a complaint with the Department of Labor’s Wage and Hour Division.

#2. Can I fix an underpayment without getting fined?

Yes, you can fix an underpayment without getting fined if it was an honest mistake and you acted quickly and proactively. You should calculate the amount you owe and pay it back to the employee. This includes benefits and tax contributions, as well.

#3. What if I forgot to pay overtime?

If you forget to pay overtime, you must calculate the amount owed and repay it as soon as possible. The rate for overtime pay is at least one and a half times the regular rate, and all adjustments must also be reflected in the payroll and tax documentation.

#4. Do I need to issue a new pay stub after correcting a wage error?

Yes, you need to issue a new pay stub after correcting a wage error. That way, you ensure that both you and your employee have an accurate record of the issued salary. This is critical for record-keeping purposes, especially during the tax season or an audit.