What Is Retro Pay? A Complete Guide for Employers

Paying employees on time is one thing, but what about when you realize you’ve shorted them? Retro pay is something many small business owners don’t immediately think about, but it’s an important situation to be prepared for.

Whether it’s because of a missed salary increase, incorrect overtime rate, or another common pay error, retro pay makes sure your employees are paid fairly for their completed work. Handling retro pay properly—and quickly!—doesn’t just lower turnover and keep morale high, it also helps you keep your company on the right side of labor laws. 

So how does retro pay work? Is retro pay taxed higher? What about the difference between backpay and retro pay? Let’s get into exactly what counts as retro pay in payroll, retroactive pay law, and how to calculate retro pay with examples for hourly and salaried workers. 

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What is retro pay?

Retro pay (short for retroactive pay) is when extra pay is added to an employee’s paycheck to make up for an error on a previous paycheck. 

To calculate retro pay in your payroll systems, subtract the amount of wages received from the amount that should have been received according to the employee's pay rate. The remaining difference becomes retro pay.

What's the difference between retro pay and back pay?

If you owe an employee retro pay, it means you paid them an incorrect amount. Back pay, on the other hand, means that you owe the employee unpaid wages because they were never paid at all (gulp). 

In short, one refers to incorrect salary, while the other refers to missing salary.

Be careful of back pay. If left unchecked, too many missed payments may lead to legal disputes. After all, paying your employee accurately, and on time, is a legal obligation.

Instances where back pay is owed could include:

• when an employee wasn’t compensated at all for working overtime.
• when a commission or bonus wasn’t paid.
• when your company couldn't pay or had problems with the payment system.

Back payments are usually higher than retro payments and are often easier to figure out, with fewer manual calculations. That's because with back pay, the employee didn’t receive their pay at all, while retro pay is a mistake in the employee’s pay. 

When do employers need to pay retro pay?

Common payroll-related mistakes leading to retro pay include:

• Miscalculated overtime: Your employee worked overtime, but you accidentally paid them their regular rate rather than their overtime rate.

• Late salary increases: Your employee received a raise, but didn’t get that in their pay. Or, you added a raise to their paycheck, but you didn’t add the right amount. Nip these payroll errors in the bud with payroll automation.

• Miscalculated shift differentials: Your employee should have been paid more for hours worked outside of their normal shift (like Christmas Day or a night shift), but they were accidentally paid their regular rate.

• Missed commissions or bonuses: Your employee was owed a commission, but the funds were delayed due to late customer payment. (This is considered retro pay in some accounting systems.)

• Payroll processing errors: There was incorrect data entry or some other problem with the payroll process, leading to further payroll errors down the line.

How to calculate retro pay

1. Figure out what they should’ve been paid

If the retro pay is due to a raise:

• Start by finding out when the raise was supposed to kick in.
• Count how many pay periods they were paid at the old rate.
• Then, calculate the difference between the new rate and the old one.
• Multiply that by the number of missed pay periods—that’s the retro pay you owe.

If it’s about missed overtime or shift differentials:

• Go back and look at timecards or shift schedules.
• Tally up the number of hours that were underpaid.
• Figure out the difference between what they should have earned and what they did earn.
• Multiply that by the number of hours. That’s what you owe them in retro pay.

2. Don’t forget taxes and deductions

• Once you’ve got the gross retro pay amount, it’s time to withhold taxes just like you would for a regular paycheck.

• Apply federal, state, and local taxes. When you withhold federal income tax from retroactive pay, you can use either the flat rate of 22% or the aggregate method.

• Deduct any benefits like health insurance or retirement contributions, if they normally apply

Retro pay is still considered taxable income, so make sure you run it through your payroll system correctly to avoid surprises—for you or your employee.C

3. Pay your employee

Now that you've done the math, go ahead and add the retro pay amount to the employee’s next pay period.

Retro pay example for an hourly employee

Mia earns $15 per hour as an hourly worker. In the last week, Mia worked a total of 50 hours (10 hours of overtime). However, because of a payroll mistake, you accidentally paid her $12 per hour for overtime wages instead of time-and-a-half. 

Start by asking, what gross wages were incorrectly paid to Mia without giving her time-and-a-half for overtime? 

They were: $12 x 50 hours = $600. Then look at how much you should have paid her. 

Mia should have made: $12 x 40 hours = $480 for her regular hours, plus $18 (time-and-a-half) x 10 hours = $180 for her overtime hours. Add $480 for her regular hours to $180 for her overtime hours. Her correct rate should have been $660.

You can see that you now owe Mia $60 in gross retro pay.

Retro pay example for a salaried employee

Jamil earns an annual salary of $50,000, and since he is paid biweekly—26 times a year—his gross pay for each pay period is $1,923 ($50,000 ÷ 26).

Jamil is getting a $3,000 raise for his performance. This means his gross pay for each pay period is increasing to $2,038 ($53,000 ÷ 26).

However, during the first pay period after receiving this raise, you forgot to include his raise when calculating his gross wages. As a result, Jamil’s gross pay was still $1,923 instead of the $2,038 it should’ve been.

You can see that you now owe Jamil his normal gross pay ($2,038) as well as $115 in retro pay ($2,038 - $1,923) for a total of $2,153 ($115 + $2,038).

How is retro pay taxed?

Although it’s a correction to a past paycheck, retro pay is still payroll, which means retroactive payment is taxable. As a small business owner, you’ve got two main ways to handle the tax withholding.

• Percentage Method (Flat Rate)

This one’s simple. The IRS sets a flat percentage rate (currently 22% for federal income tax), and you apply that rate to the retro pay.

It’s most commonly used when retro pay is issued as a separate, lump-sum payment. Straightforward, easy to apply, and done.

• Aggregate Method

This method rolls retro pay into the employee’s regular paycheck, and the total amount is taxed based on their normal W-4 withholdings—just like you’d handle any other paycheck.

That means you’re also withholding for:

• Federal, state, and local income taxes
• Social Security and Medicare
• Any other usual deductions (like retirement or insurance)

This option takes a little more legwork, but it may be more accurate if you want the taxes to match the employee’s normal pay structure.

How employers should process retro pay and avoid payroll mistakes

Let’s be real: Payroll mistakes happen. Maybe someone got a raise that wasn’t entered on time. Maybe the wrong shift rate was applied. Whatever the cause, retro pay helps you make it right.

But doing it right matters—not just for compliance, but to maintain trust with your team. Here’s how to handle it the smart way (and reduce the chances you’ll need to do it again).

Identify payroll errors and calculate retro pay correctly.

First, spot the mistake—whether it’s a missed raise, forgotten overtime, or the wrong shift differential.

Then, run the math carefully to figure out what the employee was underpaid and exactly how much you owe. Get it right the first time, so you’re not scrambling to fix it later.

Ensure compliance with labor laws and deadlines.

According to the Fair Labor Standards Act (FLSA), you’re required to issue retro pay no later than 12 days after the pay period ends.

If you can’t include it in their next regular paycheck without missing that window? You’ll need to issue it as a separate payment.

Messing this up can lead to penalties, fines, and legal headaches—so make sure you stay on top of deadlines.

Choose the correct tax withholding method.

Retro pay is taxable, so you’ve got to withhold the right amount of taxes. Choose the method that works best for how you’re issuing the payment:

• Percentage Method: 22% flat federal rate
• Aggregate Method: Taxed with regular pay based on the employee’s W-4

Adjust payroll records and issue retro pay properly.

Be sure to update your payroll records accurately. Then, issue retro pay the right way, so your employees aren’t left in the dark about the adjustment.

Communicate with employees about retro pay.

Let your employee know: What the retro pay is for, how much they’re getting, and when they’ll see it hit their paycheck.

Nobody likes surprises when it comes to money. Keeping your team in the loop builds trust and shows you’ve got their back.

Avoid common payroll processing mistakes.

If you aren’t using dedicated HR or payroll software, paycheck errors and retro payments are going to crop up. But avoiding payroll mistakes and shrinking your retro payments becomes so much easier when you’re using payroll software like Homebase. 

Homebase helps make your payroll process easier, faster, and more accurate. By keeping all your data in one place:

• Hours worked are instantly calculated
• Breaks and overtime are tracked.
• It’s all synced to payroll, so mistakes are easily avoided. 
• Taxes and deductions are handled for you

So if your business is constantly playing catch-up with payroll corrections (like retro pay), Homebase’s suite of time tracking, timesheet, and payroll tools gives you everything you need to run easier, more accurate payroll.

Get started with Homebase today—and get back to moving your business forward.

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FAQs about retro pay

How does retro pay work?

Retro pay is money owed to an employee for hours they already worked—but weren’t paid correctly for.

Maybe a raise didn’t kick in when it should have. Maybe the wrong pay rate was applied to a shift. Whatever the reason, retro pay covers the difference between what was paid and what should’ve been paid.

You calculate the gap, then pay it out—either as a lump sum or added to their next paycheck.

Is retro pay taxed higher?

Retro pay is subject to the same payroll taxes as regular pay, according to the employee’s contract. If you adjust the employee’s pay for federal income tax, state income tax, local income tax, Social Security payments, and Medicare/Medicaid through their payroll, then you should make the same adjustments to the retro pay.

Is retro pay legally required?

Yes. If you underpaid an employee—even by accident—you’re legally required to make it right.

Missed raises, unpaid overtime, shift differentials that weren’t applied—all of it qualifies for retro pay.

Skipping retro pay can lead to wage theft claims, labor law violations, and costly penalties. Bottom line: if you owe it, you need to pay it.

How long does an employer have to pay retro pay?

According to the Fair Labor Standards Act (FLSA), retro pay should be issued no later than 12 days after the end of the pay period where the error happened.

If adding it to the next regular paycheck means missing that 12-day window, you’ll need to issue it as a separate paycheck to stay compliant.

Do employees have to pay taxes on retro pay?

Yep—retro pay is considered taxable income.

Employees will see the usual deductions—income tax, Social Security, Medicare, and any other standard withholdings—just like with any other paycheck.