Big Question Under CEO Pay Ratio Rule: Who Is Your Median Employee?


For the first time, public companies are comparing the boss’s compensation to that of the “median employee” as required under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act

The new requirement sounds simple enough. Companies identify a median worker, do the math to show how much the CEO makes in comparison to that person, and disclose the ratio in proxy statements and Forms 10-K covering fiscal years that began on or after Jan. 1, 2017.

But that raises an obvious question: Who is the worker at the midpoint of the employee population in terms of compensation? Rules and guidance from the Securities and Exchange Commission allow some flexibility with this determination. As a result, companies aren’t just answering one big question when identifying that special median somebody, but instead addressing a number of smaller questions along the way.

Who’s In and Who’s Out?

Finding an individual in the middle of the pack first requires a determination of who belongs in the pack. The SEC’s definition of employee encompasses full-time personnel and certain other types of workers, including:

  • part-time employees, 
  • seasonal employees,
  • temporary employees,
  • furloughed employees, and
  • independent contractors who are treated as employees for tax law purposes. 

Companies can also exclude certain employees from their median employee calculation. For example, companies can leave out personnel who were added through acquisitions during the fiscal year. 

Foreign employees can be excluded for a couple of reasons.  If their jurisdiction has extensive data privacy laws, some information that is vital to the calculation may be protected, allowing companies to omit those employees. Companies may also exclude workers in countries with relatively few employees (less than 5 percent of the company total). See related article, "There's No Love for Hard-Won Exemption to Pay Ratio Rule."

In addition, the CEO is always excluded from the calculation.

Which Day Was It Again?

Companies must choose a measuring date for their pay ratio calculations. It can be any day within the last three months of their fiscal year.

Seasonal and temporary employees may bloat the workforce of some companies on a short-term basis, but having a three-month window allows companies to find a calculation date that best reflects their workforce throughout the majority of the year.

How Do Companies Pick the One?

There is no specified method for identifying the median employee. Companies are free to select a methodology that is appropriate for them. They may take into account variables such as company size, structure, and compensation scheme. 

Under the SEC rules, any reasonable strategy can be utilized to select the median employee. Tactics may include a full analysis of all employees, statistical sampling, or estimating.

What Counts As Compensation?

The pay ratio regulations require companies to apply a consistent measure of compensation in picking the median employee and calculating that individual’s compensation. This may include information derived from tax and payroll records.

One option is to use “total compensation” as defined by SEC Item 402(c)(2)(x), which includes salary, bonus, stock awards, option awards, non-equity incentive plan compensation, change in pension value and nonqualified deferred compensation earnings, and all other compensation.  

Because there is no prescribed procedure, companies must thoroughly explain their calculation methodology. Any material assumptions, adjustments, and estimates used to determine the median employee’s compensation must be included in the pay ratio disclosure. Also, companies must use the same method to determine both the median employee’s compensation and the CEO’s compensation. 

What Else Do Companies Consider?

There are several additional factors in the SEC rules that affect the median employee calculation.

  • Companies only have to go through the steps of selecting someone as their median employee once every three years if they keep using the same person the whole time and their pay structure remains relatively stable. However, they may wish to switch to someone else in years two or three if the median employee’s compensation changes dramatically.
  • Companies may annualize the compensation of a permanent employee who did not work for the whole year, but may not do so for temporary or seasonal employees.
  • There is no cost of living adjustment allowed for foreign employees included in the calculation.
  • After performing the median employee calculation, a company may choose not to use the individual they identified if the employee exhibits anomalous characteristics that significantly affect the company’s pay ratio. In such a case, the company may replace the one identified with another worker that has substantially similar compensation.
  • Companies may choose to supplement their pay ratio disclosure with additional information, including additional ratios, as long as the added information isn’t displayed more prominently than the required disclosure. Companies may incorporate median employee data into such information if they want.

Are We There Yet?

While the destination is a simple ratio of the CEO’s compensation to the median employee’s pay, the rules allow companies to take any number of routes in getting there. In the end, companies must report not only the pay ratio, but also the options and methods they utilized in fulfilling the disclosure requirement. 

Failure to provide such a disclosure or the inclusion of improper or intentionally misleading statements therein will subject companies to the same potential liabilities as with other SEC filings, including liability under Exchange Act Section 18.  

As with many other things, the devil’s in the details. But at least the SEC gave companies some flexibility in deciding how they would handle the pay ratio disclosures. Beyond the guidance provided in the final rule, the SEC has also supplied interpretive guidance to assist companies in their compliance efforts. 

Gain a deeper understanding of the legal complexities of employee benefits and executive compensation with a free trial to Bloomberg Law:  Benefits and Executive Compensation .