Skip to content

Building a strong compensation strategy: Is location-based pay best?

location-based pay

Is your business expanding into new states? Or are you hiring remote workers from across the U.S.?

Either way, you’ll want to build a strong compensation strategy. You may be considering location-based pay – also known as a geographic pay differential. This means that you pay employees differently based on their location.

In some cases, this refers to additional compensation given to employees to account for higher costs of labor or cost of living in the areas where they reside and work. Here’s everything you need to know, including answers to the most common questions on location-based pay.

How employee pay ranges are determined in any given market

Standard pay ranges for employees occupying similar jobs vary across markets, because the cost of labor and the cost of living aren’t consistent everywhere.

Cost of labor

Cost of labor is the metric that the vast majority of companies use to set employee pay. The term cost of labor refers to what the average employer is willing to pay a worker in that area to perform a certain job. It’s usually industry specific. This information is often available from salary reporting surveys. In each market, cost of labor is influenced by:

  • Supply of labor
  • Demand for labor

Cost of living

Cost of living refers to the price of goods and services, such as food, gas, housing and transportation, in a specific market. Although cost of living may very much be a concern to employees when it comes to negotiating their salary, it hasn’t traditionally been something that many companies have considered in salary budget planning.

However, because of record-high inflation, a growing number of companies are starting to consider cost of living when establishing employee pay. This is because the labor market is extremely competitive and they want to win the talent war. At the same time, this is driving significant wage growth.

This information is available via the Consumer Price Index (CPI), the economic indicator released monthly by the U.S. Bureau of Labor Statistics.

Note: The cost of labor and cost of living don’t always align – in fact, they rarely do. Right now, both the cost of labor and cost of living are high due to the unique market dynamics that we’re facing.

Employer approaches for location-based pay

Now that we know how general pay ranges are set in various markets, what do you, as an employer, do with this information to build a competitive compensation strategy? How do you determine your compensation structure?

Here are four options:

1. Pay each employee according to their individual location

Remote work is now widely accepted by employers, a shift that has enabled recruiters to procure talent from any location across the country. While this expands the talent pool and exposes employers to the best talent anywhere, thereby elevating the quality of new hires, it can also leave HR departments with a dilemma: How should they pay all these employees spread out in various locations?

Location-based pay may be the ideal approach for employees, but it can quickly become a logistical nightmare for employers. The more employees that a company has, the greater the administrative burden. No one wants to keep up with a complex patchwork of custom geographic pay differentials, but you do have to consider the competition for talent in those markets

2. Set employees’ pay according to market rates for the area where your company headquarters is located.

This approach solves the problem of managing too many geographic pay differentials. It’s simple and straightforward for employers. However, if your headquarters is located in an area with a lower or mid-tier cost of labor or living, this approach can frustrate employees in areas with higher costs of labor or living who feel they’re not getting paid as much as they should. This can hurt your ability to recruit talent in certain areas.

3. Set employees’ pay based on market rates for the nearest regional office to where they reside

This approach may stave off resentment from employees in areas with higher costs of labor or living, but now companies are back to dealing with several geographic pay differentials and the logistical headaches that come with it. Of course, it’s also possible that the nearest regional office doesn’t entirely align with local conditions where an employee is – your company could end up over-paying or under-paying an employee.

4. Set a national pay standard and adjust upward for a few key zones

The standard that many companies are moving toward is having a set national pay range for each specific job and then adjusting upward by a certain percentage for only a few key zones with higher costs of labor or living. The zones for which companies most commonly adjust pay upward are the East Coast (New York City) and West Coast (Bay Area).

This approach as a compensation strategy is favored because:

  • It’s a streamlined approach that’s less problematic from both a logistical and legal standpoint
  • It satisfies employees who live in more expensive areas by giving them premium pay while enabling your company to avoid paying extremely high market rates.
  • It allows employees more flexibility and the ability to move and live where they choose

The pros of location-based pay

So, why would your company want to even consider this option in the first place? Let’s sum up what we’ve covered so far.

With geographic pay differentials as part of your compensation strategy, your company can:

  • Avoid significantly under-paying or over-paying employees in different markets
  • Exert greater influence over where your talent comes from:
    • Save money by recruiting talent in lower-cost-of-labor areas
    • Save money on talent in anomalous, super-high-cost areas
    • Add a salary premium to geographic areas where talent that your company is eager to recruit tends to concentrate
  • Resolve administrative hassles and simplify operations with fewer salary structures
  • Demonstrate fairness toward employees

Risks to watch out for

Geographic pay differentials aren’t without issues that you need to watch out for.

  • You don’t want to run afoul of pay-equity laws, both at the federal level (The Equal Pay Act of 1963) or at the state level. Pay equity means that your company must pay employees who perform similar work equally, regardless of protected status, such as gender, race or disability. However, companies can allow for pay variances within their compensation structure owed to “bona fide factors,“ such as educational level, training and experience.

In some cases, geographic location is not considered a “bona fide factor.” Therefore, your company needs to be careful about not making geographic location the sole reason for a pay differential. Thoroughly document all the reasons for pay differentials within your compensation philosophy.

  • Pay compression is becoming a more significant issue because of the competitiveness of the job market. Companies feel the pressure to ratchet up salaries to prevent job candidates from going elsewhere – and then brand-new hires are paid the same or more than highly experienced or senior-level employees. You’ll want to guard against this as you create your compensation structure and set geographic pay differentials.
  • In general, maintain awareness of relevant legal requirements in all the states your company operates in. Certainly, there are variances in state law.

How to get started

1. Consider your budget

The first and primary consideration is what your company can afford to pay employees in each job category. You can’t disregard your financial bottom line – especially as a potential economic downturn looms.

2. Put it in writing

Any time your company implements a policy or practice, it’s important to document it. This establishes consistency, promotes transparency and prevents accusations from employees of unfair treatment.

Within your written compensation philosophy, create language about geographic pay differentials. Explain how it will work and what compensation structures are based on. Address general, likely scenarios that may arise, such as what happens when an employee moves to a new location or acts as a “digital nomad,” traveling between locations and working there for prolonged periods.

Keep the policy as simple as possible.

3. Include salary ranges with job postings

Certain states, such as California, New York and Colorado, require companies to disclose salary ranges in job descriptions – and trends indicate that more states will follow suit in the future. This is intended to promote pay equity and transparency, and it will likely lead to standard salary ranges for specific jobs at the national level.

If you operate in one of these states where posting salary ranges is currently a requirement, or you want to be able to recruit from everywhere, you’ll have to comply.

Provide wide enough salary ranges to account for “bona fide factors” and geographic differentials. Be clear in explaining that actual pay may vary based on these factors.

4. Review and update your pay practices regularly

Conditions surrounding the workplace are continually in flux. To make sure your pay practices aren’t outdated and that your company is aligned with what competitors and industry peers are doing, you’ll want to review your pay practices at a regular cadence – such as once or twice per year – and update as needed.

Summing it all up

Compensation by location, or geographic pay differentials, is an important consideration for companies with multiple offices or that recruit from non-local areas. The many benefits of this pay practice include saving money, eliminating administrative burdens and complexity in salary structure, and demonstrating fairness toward employees. Remember to stick to your budget, put the parameters around this pay practice in writing, adhere to all applicable federal and state laws and review your practices regularly.

To learn more about recruiting and retaining talent successfully with a carefully thought-out, compliant compensation program, download our free e-book: 7 most frequent HR mistakes and how to avoid them.