Will DOL’s Final Overtime Rule Result in Pay Increases for 4.2 Million Americans?

Reprinted with permission from the June 23, 2016 issue of the New Jersey Law Journal. © 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

On May 18, the United States Department of Labor (DOL) released its long-anticipated changes to the Fair Labor Standards Act’s (FLSA) overtime exemption rules (the “Final Rule”). The Final Rule marks the first major revision to the overtime rules since 2004. The Final Rule is anticipated to extend overtime pay eligibility to an estimated 4.2 million workers who are currently classified as exempt. However, despite the DOL’s desired impact, employers are certain to utilize creative strategies to comply with the Final Rule in an effort to keep escalating labor costs in check. This article examines the scope of the Final Rule, the effect it may have on wages, and strategies employers may use to comply with the new law.

The FLSA and the Scope of the Final Rule

Distilled to its essence, the FLSA provides that unless an individual is subject to an exemption, employees must be paid overtime for all hours worked over 40 hours in a workweek. See 29 U.S.C. §207. There are, however, numerous exemptions to the FLSA’s overtime requirements including, but not limited to, the executive, administrative and professional exemptions—the “White Collar Exemptions.” See 29 U.S.C. §213. The rules have always set three requirements for application of the White Collar Exemptions: (1) the employee must earn a salary (or fee) “that is not subject to reduction because of variations in the quality or quantity of work performed” (the “salary basis test”); (2) the salary or fee must be in the requisite minimum amount (the “salary level test”); and (3) the employee’s job duties must involve executive, administrative or professional duties as defined by the applicable regulations (the “duties test”). See 29 C.F.R. §541.0 et seq. The current salary level of $23,660 per year ($455/week) was last adjusted in 2004. See 29 C.F.R. §541.600. The rules also currently set a relaxed duties test for employees earning at least $100,000 per year (“highly compensated employees”). See 29 C.F.R. §541.601.

The Final Rule, which goes into effect on Dec. 1, is designed to address the effect of the 2004 changes to the FLSA, which exempted lower paid workers from overtime pay despite their performance of few of the requisite duties. The Final Rule changes the salary level test for the White Collar Exemption; however, the salary basis and the duties tests remain unchanged. The Final Rule increases the minimum salary required from $23,660 to $47,476 annually ($913/week). This sets the standard salary level at the 40th percentile of earnings of full-time salaried workers in the lowest-wage census region (currently the South). The Final Rule also increases the annual salary for highly compensated employees from $100,000 to $134,004. Significantly, the Rule also provides for automatic updates to the salary and compensation levels every three years beginning Jan. 1, 2020, to account for inflation. In addition, the Final Rule permits employers to include nondiscretionary bonuses, incentive payments and commissions to satisfy up to 10 percent of the salary level provided the payments are made at least quarterly.

The Effect of the Final Rule on Wages

Will employers actually raise salaries or devise new strategies for compliance?

The DOL estimates that the Final Rule “will transfer income from employers to employees in the form of higher earnings” either in the form of overtime pay or raises to meet the new exemption, and “[a]verage transfers are estimated to be approximately $1.2 billion per year over the first ten years.” https://www.dol.gov/whd/overtime/final2016/faq.htm. Despite this estimate, however, it would be naive to assume the Final Rule will result in across-the-board pay increases or overtime pay for the millions of workers affected by the government’s mandate. Rather, because the law does not require employers to pay employees at any particular rate, employers may utilize creative strategies to keep costs in check.

Generally speaking, employers have two options in confronting the Final Rule: either raise salaries to meet the new salary level or reclassify affected employees as non-exempt and employ a variety of payment strategies to cope with the potential for increased labor costs. The former would prove beneficial for employees who are currently near the threshold salary, and who work a lot of overtime, as increasing their salary to keep them exempt not only boosts morale, but also alleviates the need to compensate them for overtime. Conversely, it could be exponentially expensive for employers to universally raise salaries of workers not currently near the threshold. Moreover, if employers raise salaries to satisfy the new salary level test, pay compression could inadvertently result whereby lower level white collar employees may have salaries commensurate with those of more highly skilled and educated white collar employees, which, without adjustments, could create morale issues and internal discord.

It is safe to assume that in lieu of increasing salaries to meet the new salary level, many employers will look to reclassify the affected employees to non-exempt status and avail themselves of different compensation scenarios. One option employers may embrace to avoid higher wages and overtime is to reclassify affected employees as non-exempt, and limit salaried non-exempt employees to working 40 hours per week. Under this scenario, extra work could be assigned to either exempt employees whose workload can be increased without fear of having to pay overtime, or given to part-time workers hired specifically to compensate for this need. From an economic stand-point, this option may be viewed positively by employees close to the 2004 threshold of $23,660, as it may result in those employees earning the same amounts while working substantially less hours. On the negative side, however, employees may view their reclassification to non-exempt status as a demotion, which could affect morale, and lead to a less invested workforce. Entitlement to benefits could also be altered by such a change in status. Additionally, the morale of remaining exempt employees may also be negatively affected as they may be absorbing additional hours and responsibilities with no additional compensation. Finally, employers will have the added cost of additional part-time workers.

A second option available to employers is to reclassify affected employees to non-exempt status, and pay them overtime at the rate of 1.5 times their regular hourly rate for all hours worked over 40 hours per week. This option will surely lead to higher employee morale, as it will result in significantly higher wages. Conversely, it may be costly for employers to pay overtime to this category of employees. By way of example, one source has estimated that the impact of the Final Rule on an employee who earns $40,000 per year and puts in only one hour of overtime per week for the entire year will result in an increased labor cost of $1,500 per year for each affected employee. See www.paycor.com/dol-overtime-changes.

A third option is reclassifying the employees to non-exempt status, and modifying their rate of pay. Here, employers would essentially “reverse engineer” an employee’s salary so that even when the non-exempt employee is paid overtime, he/she is making the same salary as when he/she was exempt. Such a scheme, while attractive to employers, will certainly result in employee morale issues as employees will work significantly more hours to earn the same compensation.

The FLSA also allows for other compensation models that would allow employers to pay a “half-time” rate in certain situations and thus limit cost increases. One such possibility is to reclassify employees as non-exempt and pay them a fixed salary for more than 40 hours per week of work, which arrangement must be in writing. See 29 C.F.R. §778.113. By way of example, an employer and an employee can agree the employee will be compensated $750 for a 50 hour workweek ($15/hour). Pursuant to the overtime regulations, the employee would then be entitled to receive overtime pay of .5 times his/her regular rate of pay ($7.50/hour) for any time between 40 and 50 hours. In this example, the employee would be entitled to 10 hours at the half-time rate. Then, for any hours worked over 50 hours, the employee would be entitled to overtime at the rate of 1.5 times his/her regular rate of pay.

Yet a related fifth option available to employers is to reclassify employees to non-exempt status and pay them under a “fluctuating workweek” model. See 29 C.F.R. §778.114. To utilize this option, the amount of time an employee works must actually fluctuate from week to week, and the employer and employee must have a written understanding that the employee’s salary is for all hours worked. Because the hours will fluctuate from week to week while the salary stays constant, the hourly rate will thus effectively decrease as the number of hours increases. This method, however, is difficult to administer because the employee’s regular rate of pay varies from week to week. It should be noted that the compensation under this model must always remain equal to at least minimum wage. This option is likely to be negatively received because the more hours an employee works, the lower the half-time rate that will be paid. In addition, it should be noted that if the employee works less than 40 hours, he must still be paid his weekly salary.

While it remains to be seen whether the Final Rule will actually transfer income, it is certain to cost employers money, if only in training and implementation. Employees too will lose in other areas, such as bonuses, benefits, training and the flexibility that comes with not having to “punch a clock.”

Given the availability of the described strategies, the effect on compensation, workplace relations and potential litigation cannot yet be quantified. One thing, however, is certain: employers must carefully analyze all affected employees’ pay and hours to determine the best way to meet these new obligations, maintain a happy workforce and keep the business profitable—a delicate balance, to be sure.

As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.

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