HR Management & Compliance

How to Conduct an Internal Wage and Hour Audit

Employers often ask when their company should do an internal wage and hour audit. The best answer is usually, “Yesterday.”

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Last year saw a record increase in the number of wage and hour claims filed against employers. In fact, the Wage and Hour Division (WHD) of the U.S. Department of Labor (DOL) recovered a record $304 million in wages from employers for wage and hour law violations. Claims involving employee pay and wage and hour laws continue to be one of the largest uninsured risks for employers.

With wage and hour claims on the rise, the new year provides you with an opportunity to manage the risk by conducting an internal audit on employee pay. An internal audit (1) can uncover major sources of risk for correction and (2) if properly completed with legal counsel, can provide a complete or partial “good-faith” defense to wage and hour claims. Below is an overview of how to conduct an internal wage and hour audit and a checklist for identifying key risks.

So, What Are We Auditing?

The federal Fair Labor Standards Act (FLSA)—one of the oldest employment law statutes on the books—governs employee pay. Although the Act has changed and evolved over time, two core principles remain: (1) All covered employees must be paid at least minimum wage for all hours worked (currently $7.25 at the federal level), and (2) all covered employees must receive time and one-half of their regular pay rate for all hours worked over 40 in a week. North Dakota also follows and incorporates the FLSA into its state wage and hour laws.

While those principles seem simple enough, the FLSA is a constant source of litigation and confusion because wage and hour law also encompasses hundreds of DOL regulations interpreting the Act and its overtime requirements, and those regulations contain a number of traps for the unwary.

Conducting an internal audit is a key risk management tool that you can use to spot a potential wage and hour issue and resolve any problem with employee pay before it turns into a wage claim.

Conducting the Audit: a Checklist

Wage and hour audits can take several forms. Generally, the audit process involves working with legal counsel to review documentation relating to employee pay, such as job descriptions, payroll records, and leave policies. An audit also should involve interviews with HR personnel and higher-level management to gain a clearer understanding of employee pay systems and employee classifications. The primary goal of the audit should be to complete a comprehensive review of employee pay and payroll policies to screen for any possible wage and hour exposure.

Beyond a review of written policies, there are certain wage and hour matters that should always be reviewed as a part of an internal audit.

(1) Review exempt employee classifications. The default rule under the FLSA is that covered employees are “nonexempt” from its minimum hourly wage and overtime requirements. However, it provides a complete exemption from minimum wage and overtime pay for certain employees who meet exemptions under the Act. Often the employees hold administrative, executive, professional, computer professional, and outside sales positions. Certain highly compensated employees are also exempt if salary standards are met. Many employers, however, wrongly assume that an employee paid on a salary basis is automatically exempt from overtime requirements.

To be properly classified as exempt, the employee must first meet the salary requirement of earning at least $23,660 per year or $455 per week (but look for this to increase in 2019 by direction of the DOL). In addition, she must primarily perform the specific job duties under the applicable exemption. This is often where employers get it wrong because the application of the duties test isn’t always intuitive and often involves a careful review of the wage and hour regulations. If a salaried employee doesn’t meet the applicable duties test, she isn’t exempt from overtime.

An internal audit of exempt employee classifications should include a careful examination of all exempt employees and their job duties. Specifically, the audit should look beyond a job description and analyze what primary tasks and responsibilities exempt employees are actually performing on a day-to-day basis. Each exempt employee should be reviewed carefully to ensure compliance with the FLSA.

(2) Review overtime and regular rate of pay calculations. Paying an employee time and one-half for all overtime hours worked in a week seems simple enough on its face. But what if she works in two different positions at two different rates? Or what if she was awarded an incentive bonus? Employers often make mistakes in calculating the regular pay rate and overtime by excluding certain payments, such as a nondiscretionary bonus, which must be treated as wages.

The regular hourly pay rate for an employee is determined by dividing the total remuneration for employment (except statutory exclusions) in any workweek by the total number of hours actually worked. The calculation is more complicated if you have different pay rates or if she is paid on a piece-rate basis. However, the key component of an internal audit is checking the math—you want to be sure the regular pay rate and overtime are being calculated correctly according to the DOL regulations. Consulting with your legal counsel will help you navigate these regulations.

(3) Review timekeeping records and policies. A large number of wage and hour claims involve an employee claiming to have worked far more hours than he recorded on his time sheet.

As a part of the audit process, you should review your timekeeping policies and procedures. Best practices include having all employees sign off and verify their time sheets each week so they are attesting to the accuracy of the work time.

Reviewing leave and time-off policies also should be a part of an internal audit on employee pay. Ensuring that they are properly tracking meal periods and time off from work is important to minimize wage and hour risk. Employees often fail to properly document noncompensable work time in their time records, which increases your risk of making pay errors.

(4) Review independent contractor classifications. Another classification error that employers often make is improperly classifying employees as independent contractors. The FLSA applies only to “employees.” True independent contractors aren’t covered by the FLSA and aren’t W-2 employees subject to applicable federal and state withholding requirements.

The question of who is an “employee” under the FLSA has been litigated in the courtroom for years. While the specific tests for independent contractor classification are different in each area of employment law, the primary question is how much control the employer has over the worker’s activities.

Usually, in an effort to save costs, some employers hire independent contractors to perform services without analyzing the control relationship between them. If an employer primarily dictates the worker’s activities and daily schedule, it’s likely the worker is actually an employee (and is thus entitled to overtime).

All workers classified as independent contractors should be reviewed carefully as a part of the internal audit. Auditors should review any agreements between you and the worker, as well as your working relationship. Specific attention should be given to how much control you have over the worker’s activities.

Why an Audit Matters: the ‘Good-Faith’ Defense

Conducting an internal audit on employee pay is certainly a best practice for all employers. An audit, however, when done properly with legal counsel, may also provide a defense to liquidated damages if you ever face an FLSA wage claim.

An employer has a “good-faith” defense if it can prove that (1) it actually believed its pay practices complied with the FLSA and (2) its actual belief was reasonable when compared to the beliefs of other employers. However, it’s critical for any employer conducting a wage and hour audit to work with legal counsel to properly document the audit and its results. Failing to work with legal counsel may jeopardize your ability to rely on any good-faith defense.

Conclusion

As the old saying goes, the best time for a wage and hour audit was yesterday. Wage and hour mistakes continue to be one of the most costly errors for employers, and the number of wage claims continues to rise. The new year provides you with a great opportunity to review pay practices and identify risks in order to minimize your wage claim exposure. Remember to consult with your legal counsel as you work through your next internal audit.

Elizabeth Alvine focuses on employment and business law in the Vogel Law Firm‘s Grand Forks office. She also contributes to the North Dakota Employment Law Letter and can be reached at ealvine@vogellaw.com.