A sneak preview of proposed modifications to the rules governing overtime was provided last year, but a change has been coming for two years. On May 18, the Department of Labor (DOL) came out with its new final rules, which take effect on December 1, 2016. The rules will significantly raise the salary level used to determine whether employees are eligible for overtime and will affect more than 4 million salaried employees, according to the DOL.

The goal of Obama administration was to reset the income threshold to the point it would have reached, with period inflation adjustments, had it not been frozen more than a decade ago. Under the new rule, the wage threshold test is more than doubling from today’s $23,660 ($455 per week) to $47,476 ($913 per week). The limit will be adjusted every three years beginning January 1, 2020. Employees earning less than $47,476 are deemed non-exempt, and therefore entitled to overtime pay, regardless of their job responsibilities.

Exempt or Non-exempt?

Unless specifically exempted, employees covered by the Fair Labor Standards Act must receive pay for hours worked in excess of 40 in a workweek at a rate of not less than one and one-half of their regular rates of pay. Not only will employers have to pay the overtime, they’ll also be liable for payroll taxes on it.

Two tests determine whether employees should be treated as “exempt,” and thus not entitled to overtime pay:

1. A pay threshold test, and
2. A duties test, under which employees who “primarily perform executive, administrative, or professional duties,” are deemed exempt. Regulations spell out those criteria in greater detail.

Highly Compensated Threshold

The pay threshold for “highly compensated” also went up — from $100,000 to $134,004. Employees earning above that higher amount, regardless of whether their jobs would be classified as non-exempt under the “duties” test, can still be treated as exempt, and thus not entitled to overtime pay.

This means, beginning in December, whether employees whose pay falls between $47,476 and $134,004 are to be eligible for overtime pay as non-exempt workers will be determined by the same duties test that has been in place for years.

Note: Employees’ pay for purposes of determining their exempt/non-exempt status includes nondiscretionary bonuses, incentive pay and commissions, as long as those payments occur at least on a quarterly basis and don’t exceed 10% of the employee’s compensation.

Salaried employees who, thanks to the soon-to-be higher income threshold will be entitled to overtime pay, don’t need to be switched to being paid an hourly wage or to punch a time clock. However, for salaried non-exempt employees below the threshold, it’s important to track time worked to ensure that the hours:

1. Don’t exceed 40 hours a week, or
2. That employees are awarded the overtime pay they have earned.

Determining overtime pay will be based on calculating what the employee’s salary translates to on an hourly basis for a 40-hour workweek.

Impact Assessment

In response to the new rules, here are some immediate steps to consider. Start by answering these questions:

• How many of your employees will be newly classified as non-exempt?
• How many of them routinely work more than 40 hours a week?
• What would it cost you if they continue to work more than 40 hours per workweek and are eligible for overtime?
• What systems do you need to put in place to monitor employees’ hours carefully after the new rules go into effect? The DOL says employers “may use any method they choose for tracking and recording hours” as long as it’s complete and accurate.

You’ll encounter more questions once you get a basic handle on this information. Suppose, for example, that you don’t implement any changes and your payroll costs go up by more than you can manage. You would then need to address questions like these:

• What if we hire some part-time people to keep newly non-exempt employees from having to exceed 40 hours a week?
• Can we reduce or eliminate overtime hours?
• Will it be more economical to give raises to employees who are currently earning somewhat less than $47,476, to get them to the exempt level and avoid having to track their hours and pay them overtime?
• Can we lower the salaries or wages of employees who will become entitled to overtime pay so that, when they earn overtime pay, they will wind up earning the same amount as they did before?
• Can we make adjustments to our employee benefits program to offset the rise in payroll cost?

Each possible response raises its own issues and there are no easy answers. For example, if you’re currently paying for all or a portion of employee benefits such as group life and long-term care insurance, you could shift those over to “voluntary” (employee-paid) status. But doing so would certainly be a takeaway, and many employees would resent it, although perhaps not as much as an actual wage reduction.

No Free Lunch

Another way you could dampen the impact of cutting pay or benefits is to increase non-exempt employees’ vacation benefits. However, be aware that there’s no “free lunch.” Doing this may increase the total hours that non-vacationing employees would need to work to cover for their vacationing colleagues, thereby driving up overtime pay.

Any such adjustments would need to be considered in light of your total compensation package, and the overall competitiveness of your labor market. Although other employers in your area will probably be facing the same pressures, losing valued employees might cost you more than having to pay some overtime.

Suppose you raise the pay of employees who are near the threshold and routinely work more than 40 hours a week, to keep them in the exempt category. That solves the overtime problem but could have negative ripple effects. For example, one issue is “pay compression,” or the narrowing of the spread in pay between high and average performers, veteran employees and new hires, or employees and their supervisors. Some resentment is inevitable.

In turn, that could put pressure on you to give raises to employees already above the exempt threshold. That might be necessary as a way to restore the original spread and make things “fair” in the eyes of the higher paid workers. While that’s not often the case, this assumes they will become aware of pay changes occurring among their colleagues, and it’s a safe bet that many will figure it out.

“Can We Talk?”

Be ready to answer questions from your employees, as it’s a safe bet that your employees will have heard about the impending rule change and want to know the effects. For most employers it’s probably wise to begin engaging employees on the topic, even if you haven’t mapped out the details of how you will respond. An honest “we’re figuring this out” answer can be better than silence.

If you would like further more information on the final rules, consult with your tax adviser or payroll.