A 5-Step Process for Effective Pay Cuts

An effective pay cut follows a 5-step process: determine how much to cut through scenario modeling, arrive at a tiered pay cut policy by salary band, choose the cost reduction instrument (permanent cut, salary deferment, or temporary cut), communicate with employees early and transparently, and execute the policy in payroll without disturbing statutory deductions.

Quick Summary

• Step 1: Model scenarios from optimistic to worst case until you have a precise number, like 'reduce 20% of salary costs'.
• Step 2: Build a tiered policy by salary band so lower-income groups carry less burden than the highest earners.
• Step 3: Pick the instrument: permanent pay cut (long-haul impact), salary deferment (temporary cash-flow gap), or temporary cut.
• Step 4: Communicate early, keep employees posted, and use a standard policy because it's easier and more transparent to explain.
• Step 5: Execute in payroll while protecting PF and ESI, avoiding excess income tax deduction, and tracking cuts for later reversal.
• Bonus: a purpose-built tool turns salary revision planning from hours in Excel into minutes with live employee data.

The economy is in doldrums, and businesses are reeling from it. To stay afloat, most businesses have initiated cash conservation measures. Salary costs are a significant component of company expenditure. Sooner than later, companies get down to salary cuts or deferments to manage their payables.

Here's a simple 5-step process guide that can help you navigate the choppy waters of pay cuts.

1. How Do You Determine How Much To Cut?

Model various scenarios from the optimistic to the worst case to understand what cost-cutting balances your cash flows. The exercise should end with a precise number in mind, such as 'I need to reduce 20% of my salary costs'.

It's heartening to see the big consulting firms sharing advice and best practices with their Covid19 Resource Centers. The Covid-19 Matrix by Sequoia is quite helpful in scenario planning, at least for funded companies.

To begin, you need to model various scenarios from the optimistic to the worst case. Doing this will help you understand what cost-cutting measures are needed to balance your cash-flows. After this exercise, you have a precise number in mind: "I need to reduce 20% of my salary costs".

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2. How Do You Arrive At The Pay Cut Policy?

A uniform across-the-board cut is simplest but not fair. Most companies build a tiered plan by salary band where the lower-income group is less impacted and the highest income group carries the most burden, sized so the bands together hit the overall target.

If you know how much salary costs to prune, the most straightforward policy is to do an across the board, uniform cut. If your target is a 20% reduction, do a salary cut of 20% for every employee.

However, this is not a fair policy. Most companies come up with a tiered plan where the lower-income group is less impacted, and the highest income group carries the most burden.

In this step, you want to decide on the various salary bands and how much burden you will place on each group to attain the overall target reduction.

For example, if your overall salary cost is two crores and you want to implement a 20% salary cut, you may end up with a policy like this:

A common protective threshold: exempt employees below a certain salary, say Rs 25,000 a month, from cuts entirely, and grade the percentages upward through the bands so senior leadership absorbs the deepest reduction.

For example, if your overall salary cost is two crores and you want to implement a 20% salary cut, you may end up with a policy like this:

3. How Do You Choose The Cost Reduction Instrument?

There are three instruments, chosen by how fast you expect recovery: a permanent pay cut for long-term impact, a salary deferment when temporary cash-flow issues will reverse, and a temporary cut when lost revenue won't be recouped even after conditions improve.

There are at least three ways in which you can implement the salary expense reduction. It depends on your scenario planning and your estimate about how fast the situation will recover. Will it improve in 2 to 5 months, or will it be for the long haul?

• Permanent Pay Cut: If you predict a long-term impact on business and receivables, it's better to implement a permanent pay cut. You will consider salary revision only when the situation improves for the business.
• Salary Deferment: If you have temporary cash-flow issues and hope to recover your receivables, you can go for a salary deferment. You will pay back employees once your account receivables improve.
• Temporary Cut: If there is no hope of recouping revenue losses even after the situation improves, this is the right way of balancing your cash flows.

4. How Should You Communicate With Your Employees?

Keep employees informed no matter how difficult the news: announce pay cuts well in advance, keep them posted as decisions land, and cut on a standard policy rather than ad-hoc individual arrangements, which carry overheads and reduce transparency.

Taking care of your employees and extensively communicating with them is critical at this time. Keep employees informed, no matter how difficult or unpleasant the news might be. They will appreciate it and empathize with these decisions.

It's equally important to inform the employees about the pay cuts well in advance and then keep them posted when a decision is taken.

It's best to do the salary cuts based on a standard policy since it is easy to communicate. If you choose to do ad-hoc salary cuts customized to each employee, you will need to deliver the information individually. This method not only has significant overheads but is less transparent as well.

5. How Do You Execute The Policy In Payroll?

Translate the policy into a per-employee deduction list, then change payroll carefully: avoid disturbing statutory deductions like PF and ESI for temporary cuts, watch for excess income tax when deducting from gross, and track every deduction so it can be reversed later.

Based on the pay-cut policy arrived at in step 2, you need to determine the quantum of salary deduction for each employee.

Once you have a list of employees and the amount of salary to be cut for each of them, you need to make changes to the payroll. There are a few different ways in which you can make the salary deduction. There are a few concerns to keep in mind:

• If this is a temporary cut or deferment, you may want to avoid impacting statutory deductions like PF & ESI. If you touch these, it may lead to hassles.
• When you deduct the amount from the gross salary, you may be deducting excess income tax. During these times, you want more money in the hands of employees after salary cuts.
• You may wish to keep track of the deductions so that you can reverse them at a later date.

On the mechanics: adjust the Special Allowance component rather than Basic or DA so the PF, gratuity, and ESI bases stay untouched, and confirm post-cut salaries never fall below applicable minimum wages.

Bonus Tip: Why Use The Right Tool?

A purpose-built application beats Excel: salary revision planning with the latest employee data takes minutes instead of hours, the payroll implementation gets simpler, and the changes communicate cleanly through payslips or the Employee Portal.

While Excel spreadsheets are commonly used, a purpose-built application makes life easier. Salary revision planning with the latest employee data can get done in minutes instead of hours. With payroll software, it's also simpler to implement your salary plan and process the payroll. Besides, it's a lot easier to communicate the changes to the employees through the payslips or the Employee Portal.

greytHR's Revision Planner does exactly this inside the full-suite HRMS: set the goal percentage, define bands, run what-if scenarios, and compare plans before touching a single salary.

More work on the way up

The salary cuts are in response to the slowdown and help you manage cash-flows. When the situation starts improving, you will need to reverse some of these decisions. While the process is almost the same as above, the specifics will vary a little. There is more work on the way up.

See how greytHR brings payroll, leave, attendance, and compliance together in one place. Explore greytHR, the full-suite HRMS, or start a free trial to run your entire people operations on a single platform.

greytHR is India's leading HR and payroll platform, offering 50+ Hire-to-Retire tools that automate recruiting, onboarding, payroll, attendance, leave, and compliance. Trusted by 34,000+ businesses, it manages over 3.2 million employees across 25+ countries.

Frequently Asked Questions

What are the 5 steps for an effective pay cut?

Determine how much to cut via scenario modeling, arrive at a tiered pay cut policy, choose the instrument (permanent, deferment, or temporary), communicate with employees, and execute in payroll.

Should pay cuts be uniform across all employees?

A uniform cut is simplest but not fair; most companies tier the burden by salary band so lower earners are protected and top earners carry the most.

What is the difference between a pay cut and a salary deferment?

A cut reduces pay with no repayment; a deferment delays part of the salary and pays it back once receivables recover.

Which components should a pay cut avoid touching?

Statutory bases like PF and ESI, especially for temporary cuts, since disturbing them creates compliance hassles and hurts retirement funds.

Why track pay cut deductions?

So they can be reversed accurately when the business recovers; reversal is essentially the same process with more work on the way up.