Compliance and entrepreneurship are not often words that hang well together.

And when you're focusing on growing your business, assessing the full cost of your employees' working arrangements can slip off the priority list.

But labour costs form a large part of your expenditure and some of the mechanisms used by entrepreneurial businesses to incentivise their people can result in hidden expense.
Several large, high profile businesses have hit headlines after systemic issues were identified with their leave calculations. But the working arrangements giving rise to these issues are also commonly found in start-ups and smaller businesses.

Annual leave is calculated by looking at what the employee is paid for an ordinary working week, compared with the average he or she earned in the previous 12 months. The higher amount is paid to the employee.
Where an employee is entitled to an annual bonus or a commission arrangement, in most cases that payment will be incorporated into the annual average. So these employees are likely to earn more when they go on holiday than they do in an average week.


If the employer cannot calculate an employee's ordinary weekly pay - for example, because the employee works flexibly - then the employer needs to take a four-week average, then measure this against the annual average. For employees who are regularly paid by an incentive or productivity bonus, taking annual leave in the four weeks after that payment can mean a significant pay increase.

Take John, as an example. John works as a salesperson at an online travel company. In addition to his $50,000 salary, he is eligible for an annual 5 per cent bonus based on the company's EBITDA. He also receives a monthly commission based on his individual sales.

John has been doing well and generally gets around $5000 a month in commission. During a normal working week, he would receive $961.54 in salary. However, if he goes on a week-long holiday shortly after receiving his annual bonus and monthly commission, he would receive $2291.66 - more than double his salary.

Many businesses are failing to factor these additional leave payments into their labour costings. Where employers are required to recalculate the payments for all current and former employees over a six-year period, the impact can be significant.

What happens if the bonuses are "discretionary"?

Truly discretionary bonuses do not need to be factored into the averaging calculations when employees take annual leave. But the meaning of "discretionary" is narrowly defined. Any bonus creating a contractual commitment to pay the employee is likely to be considered non-discretionary.

It does not matter whether the bonus is included in the employment agreement, or in another document. It does not matter if the payment is conditional on the employee achieving certain KPIs or targets. And it does not matter whether the amount of the payment is at the employer's discretion. As long as there is a commitment to make some form of payment in exchange for a certain level of achievement by the employee, the bonus must be accounted for.

More broadly, employers need to weigh the benefits of providing an incentive with certain parameters as part of the overall employee value proposition, against the cost of including incentive amounts in annual leave costings.
What about overtime? Where employees regularly work paid overtime, then those amounts also need to be factored into the annual leave calculations. Again, where an employee has worked a large amount of overtime and then takes a well-deserved break, this can be reflected in an inflated annual leave payment. In addition, overtime can impact on sick, bereavement, public holiday and alternative day calculations. When an employee is away for these reasons, the employer is required to look at what the employee would have earned on the day concerned.


If the employer cannot calculate this amount with certainty - for example, due to unpredictable overtime or daily commission entitlements - he or she needs to average the employee's gross earnings in the previous 12 months against the number of days the employee worked during that period.

Again, where overtime or commission forms a large part of the employee's remuneration, the difference can be significant.
What about casuals and contractors?

If an employee works so irregularly or intermittently that he or she cannot be given four weeks' annual leave, an employer can include payment for that leave in their normal pay as an 8 per cent loading, if it is appropriately documented and identified. Engaging independent contractors, who are responsible for managing their own leave, is even simpler.

However, businesses need to ensure day-to-day working arrangements truly reflect the "casual" or "contractor" label. Miscategorising a casual employee can mean the employer is liable for providing four weeks' leave, despite already having paid the 8 per cent loading. Miscategorising a contractor can lead to tax and employment law difficulties, in addition to a four-week leave entitlement.

So what's the answer? Invest in a good payroll system and good advice. Resource your payroll appropriately, depending on your size and complexity.

But don't rely blindly on your payroll system. Make sure your payroll provider gives you a payroll configuration document, describing exactly how your system calculates leave for your different employee groups. Make sure you understand how those calculations correspond with your Holidays Act obligations.

It goes without saying that your payroll system is only as good as the data being entered. Don't set and forget. Review your working arrangements regularly and ensure they still meet the assumptions in your payroll configuration document. Ensure any changes in working arrangements are worked through to assess the payroll implications. Build annual, sick and public holiday leave calculations into any decisions around incentive arrangements and overtime approvals.

Take advantage of the increasing awareness of these issues and the increasing amount of guidance available. Young businesses have the opportunity to get these calculations right from the start to avoid costly and time consuming recalculation processes further down the track.

Christie Hall is Employment, Health & Safety and Privacy Law Leader at EY Law