What Is Retro Pay? Definition and Examples

Retro pay, or retroactive pay, is compensation provided to an employee to correct an underpayment from a past pay period. This payment addresses situations where an individual received less than the amount they were rightfully owed for work already performed. It ensures employees receive the full, accurate compensation for their labor, rectifying discrepancies from prior payroll cycles. This payment mechanism is distinct from regular wages as it addresses a historical shortfall rather than ongoing earnings.

What Retro Pay Is

Retro pay is a payment to correct a previous underpayment for work already performed. It covers the difference between what an employee was actually paid and what they should have been paid for a specific past period.

Common reasons for retro pay include delayed implementation of pay raises, where an increase was approved but not reflected in paychecks immediately. Clerical or payroll processing errors, such as incorrect data entry or miscalculations of hours worked, can also lead to underpayments. Other scenarios involve changes in pay rates, miscalculated overtime, or adjustments to commissions that were not correctly applied at the time.

How Retro Pay is Calculated

Calculating retro pay involves a direct comparison of what was paid versus what should have been paid over a specific period. The first step is to identify the exact timeframe during which the underpayment occurred. This period typically spans from the effective date of a pay change or error to when the correction is implemented in the payroll system.

Once the affected period is determined, the difference between the correct pay rate and the rate actually paid is calculated. This difference is then multiplied by the number of hours, days, or pay periods involved. For instance, if an employee was underpaid by $2 per hour for 80 hours over two weeks, the retro pay would be $160 ($2 x 80 hours). Accurate record-keeping, including timesheets, pay stubs, and documentation related to pay rate changes, is essential to ensure the correct calculation.

Tax Implications of Retro Pay

Retro pay is considered taxable income and is subject to various payroll taxes, similar to regular wages. Employers must withhold federal income tax, state income tax (if applicable), Social Security (FICA), and Medicare taxes from retro payments. These withholdings ensure the employee’s tax obligations are met for the additional income received.

For federal income tax purposes, the Internal Revenue Service (IRS) often treats retro pay as supplemental wages. Employers can either withhold federal income tax at a flat rate, commonly 22%, or combine the retro payment with regular wages and withhold taxes based on the employee’s Form W-4 and applicable withholding tables. Social Security tax is applied up to an annual wage base limit, which is $176,100 for 2025, while Medicare tax is applied to all eligible compensation without a wage base limit, at a rate of 1.45%. The timing of when the retro payment is received determines the tax year in which it is reported.

Illustrative Retro Pay Situations

Retro pay addresses various scenarios where an employee was underpaid for past work. One common situation involves a delayed raise. For example, if an employee’s annual salary increase was effective January 1st but not processed until the March 1st payroll, they would receive retro pay for the difference in salary for January and February. This payment corrects the two months they were paid at the old, lower rate.

Clerical errors frequently necessitate retro pay. An employee might have their hours incorrectly recorded, or a wrong pay rate could be entered into the payroll system, leading to an underpayment. The retro pay in this case would cover the cumulative difference between the correct amount and the amount actually paid due to the administrative mistake. Similarly, a retroactive promotion can result in retro pay; if an employee is promoted on April 1st but the higher salary is made effective March 1st, they are owed the difference for March.

Miscalculated overtime is another frequent cause for retro pay. If an employee worked hours that qualified for overtime pay but was mistakenly paid at their regular hourly rate, retro pay would cover the additional half-time rate for those hours. Commission adjustments may also lead to retro pay if an error in calculating sales commissions resulted in an underpayment. The retro pay would then account for the additional commission earned but not initially paid out.