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Systemic flaws in a company’s pay practices can create significant liabilities, even if possible violations are unknown and unintentional. Vulnerabilities remain relatively common because of the nuanced and constantly changing federal and state regulatory schemes, as well as an active and increasingly sophisticated plaintiffs’ bar in this field. Class and collective action lawsuits under the Fair Labor Standards Act (FLSA) and state wage laws are some of the largest sources of exposure in employment law. A wage-and-hour audit can help any corporate counsel to identify and reduce this exposure. 

In addition, an audit can help establish good faith compliance with the law. Under the FLSA, an employer’s good faith compliance can be a complete defense to liability in some scenarios or a defense against liquidated damages in others. Similarly, an audit might help show that any violations were not willful, which could shorten the FLSA’s statute of limitations from three years to two years. 

This article outlines 10 key considerations for wage-and-hour audits, including substantive issues and practical takeaways, but is not intended to be a comprehensive checklist. 

1.    Misclassification of Exempt Employees 

One frequently litigated issue is misclassification of exempt employees. Most exempt employees must satisfy both a salary basis test and a duties test. An audit should review both for compliance. 

To evaluate the salary basis test, the first step is relatively straightforward. Review a sample of pay records and confirm exempt employees receive a weekly salary that meets the applicable salary threshold. The current FLSA threshold for the white-collar exemptions ($684 per week) is usually not a problem, but higher thresholds in certain states can be a blind spot for some companies. 

The audit should search for instances where exempt employees do not receive their full weekly salary. In most scenarios, they must receive their full salary for any week in which they perform work, regardless of the number of hours or days worked. Any deductions must be permitted by the applicable regulations. Further, if exempt employees receive additional pay beyond their salary, the audit should evaluate whether the extra pay might violate the salary basis test. 

Compliance with the duties tests often involves “gray area” analyses. As a result, these tests are a common source of litigation and liability, and companies should scrutinize the duties tests in the audit. A good starting place is to compile a list of exempt positions, the basis for their exemption, current salary levels, and their job descriptions. Risky classifications can often be identified based on this information. Special attention should also be paid to exempt positions that cover large groups of employees and may be susceptible to class litigation. To evaluate compliance for risky classifications and large groups, the audit should not rely solely on job titles and job descriptions. Interviews should be conducted with appropriate supervisors and employees to assess the reality of their day-to-day duties, which is what will determine whether they meet the applicable test. 

2.    Misclassification of Independent Contractors

Companies, both in the “gig economy” and more traditional businesses, are outsourcing functions to achieve efficiencies. This has led to aggressive actions by government agencies and high-stakes lawsuits challenging companies’ business models. Further, the rules governing whether workers are employees or independent contractors continue to change at both the federal and state level. These crosswinds can lead to serious wage, tax, benefits, and other liabilities. 

An audit should explore whether there are any groups of contractors who might be misclassified, and special attention should be paid to individuals who have been reclassified from employee to contractor. Although the exact criteria may vary by state, the audit will usually examine relevant contractual agreements; other documentation showing the nature of the relationship; the degree of control exerted by the company; who pays for the supplies, expenses, and insurance; whether the workers also work for other businesses; the degree of permanency of the relationship; whether the work is an independent trade or part of the company’s core business functions; how integrated the contractors are into operations; and other factors. In some scenarios, simple adjustments to the working relationship can be made to mitigate risk. In others, there must be high-level conversations regarding risk and restructuring. 

3.    Off-the-Clock Work

An audit should evaluate the timekeeping system and practices to ensure non-exempt employees are recording and being paid for all hours of work. There is a wide variety of off-the-clock claims that give rise to litigation. Common off-the-clock claims involve pre- and post-shift activities (such as security screenings, donning and doffing, waiting time, preparation time, computer and software loading time, and so on), as well as travel time, on-call time, remote work (such as phone calls, emails, and other work from home), and lax timekeeping and enforcement (such as time records showing employees who record scheduled hours rather than actual hours). The proliferating litigation over meal and rest breaks can also involve allegations of off-the-clock work, as well as non-compliance with state law mandates. 

Identification of risks may involve review of samples of time records, interviewing key players, and on-site inspections in some cases. It is worthwhile to focus on claims common to the particular industry or workforce and large groups of employees who may engage in similar practices.

4.    Calculation of Regular and Overtime Rates

This can often be the hardest area of wage and hour law to comply with. The FLSA generally requires employers to pay non-exempt employees overtime pay at one-and-one-half times their “regular rate” for overtime hours. The regular rate is not just the employee’s normal hourly rate. It must be calculated by dividing all compensation received by the number of hours worked, subject to regulatory exclusions. Some employers (or their payroll processers) unknowingly make technical errors in calculating the “regular rate” and overtime rate for non-exempt employees. The most frequent error is failure to factor in compensation beyond the employee’s normal hourly rate, such as non-discretionary bonuses, commissions, lump-sum payments, and certain expense reimbursements. Errors may also occur if employees receive different hourly rates for different types of work; usually, a weighted average must be used to calculate the overtime rate. These types of errors, which are often systemic and unknown, can be identified by reviewing samples of payroll records. 

5.    Rounding Practices

Rounding of time, i.e., to the nearest 0.1 or 0.25 hours, is permissible under the FLSA. However, the rounding policy must permit both upward and downward rounding. Further, the rounding policy must be neutral in practice (i.e., it must not benefit the employer more often than the employee). In some cases, a facially neutral rounding policy may violate the FLSA if attendance and disciplinary policies result in employees regularly clocking in and out during particular timeframes such that rounding favors the employer over the long term. Rounding problems can be spotted by analyzing samples of timekeeping records and determining whether there is a net neutral result on average. 

6.    Minimum Wage 

An audit should confirm that all employees are receiving the required minimum wage. For large employers, the main issue is complying with the growing patchwork of state and local laws with higher minimum rates. Further, an audit should explore whether employees with relatively low hourly rates are paying for any work-related expenses (either out-of-pocket or through payroll deductions) that might push their rates below the minimum. 

7.    Unusual Pay Arrangements

Special pay arrangements should get special attention in the audit. Examples include day rates, piece rates, fee basis, fluctuating workweek method for overtime pay, commissions, bonuses, comp time, and tip credits. Such practices are frequent targets in litigation and can easily run afoul of federal and state regulations. Likewise, use of unpaid interns and volunteers should be examined carefully. 

8.    Policies, Mandatory Notices, and Recordkeeping

The audit should involve review of written policies on pay and timekeeping for legal compliance and best practices. One example of best practices is a “safe harbor” provision for reporting improper salary deductions. Such a provision can effectively rescue exempt status from improper deductions – if drafted properly and enforced. It also may be helpful to review wage payment notices required under state law, mandatory workplace posters, and, if applicable, contracts and plans governing commissions and bonuses. An audit should also verify that time and pay records include sufficient detail and are being kept for the necessary amount of time under federal and state law.

9.    Privilege

Measures should be taken to protect attorney-client privilege during the audit. Otherwise, any adverse findings may be discoverable in later litigation. Counsel should have a central role in directing and conducting the audit, as opposed to human resources or non-legal consultants. An initial memorandum can summarize the anticipated audit process and make clear that it is being conducted to provide legal advice or in anticipation of litigation. The underlying payroll, timekeeping, and other records are not privileged and do not become so because of the audit. However, communications and analysis of such records should all be marked as privileged and kept confidential among need-to-know company contacts. 

If a lawsuit is eventually filed regarding the pay practices reviewed in the privileged audit, the company and its counsel must decide (a) whether to assert a good faith defense, which an employee may argue results in waiver of privilege over the audit, and (b) whether to preemptively waive privilege over the audit and use it to establish the good faith defenses. The answer to these questions will likely depend on the analysis provided during the audit or in a final audit report and whether the company took any remedial measures as a result of the audit. 

10.    Tailor the Audit

There is no one-size-fits-all audit. An audit of a technology company with operations in California and New York should look quite different from an audit of a manufacturer with operations in Texas. The audit should be tailored to address state law issues where employees are located; wage-and-hour claims common to the industry or to certain job positions with large groups of employees; and any prior complaints, audits, or litigation regarding the company’s pay practices. 

Region: United States
The information in any resource collected in this virtual library should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or ACC. These resources are not intended as a definitive statement on the subject addressed. Rather, they are intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers.