How to avoid pitfalls in vacation policies and practices

Three weeks’ vacation at 6%. Sounds easy doesn’t it. However, vacation policies are complex and unless you pay careful attention, it’s easy to stumble. Here’s how to avoid the major pitfalls.

Employers often promise employees so many weeks of paid vacation per year. Such employers often track employee vacation entitlements in hours and when employees take vacation time, regular hours, as shown on the pay stub, are shifted to vacation time taken, paid at the same hourly rate. This practice has several advantages. First, it provides a handy record should employees ever question how much vacation pay has been received. Paying the same amount as their regular pay, while employees are on vacation, can also avoid the requirement to track vacationable earnings and accrue vacation pay as a liability, based on those earnings.

However, there are potential pitfalls with this practice, if employers aren’t careful.

The most serious pitfall can be the failure to limit the paid vacation entitlement based on active service. For example, a common clause in a letter of offer might be: “You will earn 3 weeks of paid vacation time for each completed year of service”. Without further qualification, this overlooks the distinction between active and inactive service. When an employee is away on a maternity or parental leave, they’re still employees, they’re still in service. This distinction doesn’t matter when employers accrue vacation pay based on vacationable earnings. An employee on parental leave typically wouldn’t have much in the way of vacationable earnings, so no vacation pay would typically attach to the period of leave. But if the employer promise is paid vacation time, for each year of employment, an employee could rightfully be away on an extended leave and, on return, request to be given the applicable weeks of paid vacation stated in their letter of offer.

The solution to this problem is to restrict the promise of paid vacation time to active service. The clause above then becomes: “You will earn 3 weeks of paid vacation time for each year of active service”.

The other pitfall with paid vacation time (as opposed to paying accrued vacation pay) is that this may not meet the employment standards minimums in the jurisdiction concerned.

This problem may occur when employees receive earnings other than regular salary or wages. In most jurisdictions, any form of payment for time worked, including overtime, is vacationable, as well as most forms of incentive payments, such as sales commissions, piece work or bonuses.

By default, bonuses paid to employees are vacationable. To be exempt from vacation pay calculations a bonus must meet both the following conditions:

  1. The bonus can’t be an enforceable right under the terms and conditions of employment. If a senior manager’s letter of offer spells out the payment of bonuses based on meeting key performance indicators in the person’s area of responsibility, those bonuses are vacationable. To be excluded from vacation pay calculations a bonus must be completely at the employer’s discretion; and
  2. The bonus calculations can’t be based on some measurable attribute of employee duties. A common definition of bonuses that are vacationable are those that “relate to hours of work, production or efficiency”. For example, if a business analyst is given a bonus for designing a more efficient method of collecting employee time, that bonus is vacationable, even if it’s made entirely at the employer’s discretion.

One common way to avoid this pitfall is to pay vacation pay on vacationable earnings, other than regular wages or salary, at the time these other earnings are paid. For example, if an employee is owed vacation pay at 6% and is being paid a $5,000 bonus, gross pay should be increased by the $300 in vacation pay owing on that bonus. Alternatively, the vacation pay owing could be carved out of the bonus itself. Divide $5,000 by 1.06 and you get $4,716.98. Show that as the bonus and the balance owing as the vacation pay, $283.02, and you have met the requirement for 6% vacation pay.

Other pitfalls relate to the definition and treatment of the vacation year itself. Although we commonly use the term, “vacation year”, there may in fact be 2 distinct vacation years:

  • The year in which employees earn the right to vacation time and pay; and
  • The year in which employees take vacation time, and are given vacation pay, previously earned.

The first pitfall related to vacation year relates to employees who earn greater vacation entitlements, after completing so many years of service. For example, a common vacation policy might be to give employees:

  • 2 weeks of vacation time and vacation pay at 4%, after completing the 1st year of employment;
  • 3 weeks of vacation time and vacation pay at 6%, between the 2nd and 6th years of employment; and
  • 4 weeks of vacation time and vacation pay at 8%, after completing 6 years of employment.

The pitfall here is that the “years” for determining entitlement to vacation time and pay aren’t the same:

Elanor’s hire date was June 15, 2010. As of June 16, 2016, by the above rules, she’s entitled to 4 weeks of vacation time. And she’s entitled to vacation pay at 6%, as of the same date. However, by default this 6% applies to Elanor’s vacationable earnings in the 6th year, i.e. from June 15, 2015, to June 14, 2016.

There are at least 3 different ways of dealing with this pitfall.

One, the employer could start accruing vacation pay at 6% on any earnings paid after June 15, 2015. The difficulty with this approach is that the 6% won’t truly be owing if Elanor leaves her employment prior to completing the 6th year, i.e. before June 14, 2016, and someone might forget to adjust the accrual back to 4%.

Two, the employer could adjust the accrual from 4% to 6%, on any vacationable earnings paid between June 15, 2015 and the same date in 2016, after the 6th year has been completed. This at least avoids the possibility of an overpayment, but, on the downside, requires an extra step, which itself might be overlooked.

Three, so long as the percentages used exceed that owing under the applicable employment standards, the entitlement years for vacation time and vacation pay could be made the same. For example, the terms and conditions of employment could be reworded as follows:

  • 3 weeks of vacation time, between the 2nd and 6th years of employment, and vacation pay at 6% on vacationable earnings paid during those same years; and
  • 4 weeks of vacation time, after completing 6 years of employment, and vacation pay at 8% on vacationable earnings paid after the start of the 7th year of employment.

Another pitfall related to vacation year concerns those employers who let employees take vacation time and vacation pay, in the same year as it’s earned. The normal employment standards requirement is that employees first complete a year of service and then are entitled to vacation time and pay for that completed year. Taking vacation time and pay in the same year as earned may allow employers to avoid carrying a vacation pay liability in their financial statements, particularly when the vacation promise is paid vacation time and the vacation entitlement year matches the fiscal year used in financial reporting.

However, the pitfall in this situation relates to employees who take vacation time and pay early in the year, before it’s been earned, and then leave the employer. In this situation, unless the employer has been careful, it may not be possible to recover the vacation pay that has been paid, but not earned.

For example, in Ontario, employees must agree to such a recovery in writing and the agreement must either give the specific dollar amount to be recovered or give a formula, based on which the amount owing can be determined. Unless these conditions are met, an Ontario employer would have little recourse against an employee to whom vacation pay has been overpaid, other than to pursue the person in small claims court.

The way to avoid this pitfall is to include something like the following language in the terms and conditions of employment: “We allow you to take vacation time and pay in the same year as these are earned, rather than in the year following. Should you leave our employ during a vacation year and the balance for vacation time or pay is negative, for that year, you agree we have the right to cover any negative balance owing, by deduction on your final pay. The amount to be deduced will be the difference between the vacation pay shown as paid on your pay stubs in the current year and the vacation pay owing at the applicable percentage on your earnings in that year.”

Alan McEwen is a Vancouver Island-based HRIS/Payroll consultant and freelance writer with over 25 years’ experience in all aspects of payroll. He can be reached at armcewen@shaw.ca or (250) 228-5280. If you like these articles, please sign up to my email list to be notified of future postings.

About Alan R. McEwen

HRIS/Payroll consultant and freelance writer
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