What is a cost-of-living adjustment (COLA), and why does it matter to businesses and employees? A couple of main reasons are that this calculation plays a role in how organizations approach compensation and how employees maintain their purchasing power over time.
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Key takeaways about cost-of-living adjustments
- COLA helps to counteract the effects of inflation and ensure people can still afford necessities as prices increase.
- The calculation is typically based on the Consumer Price Index (CPI), which tracks the average price of a basket of goods.
- The increase benefits employees with relevant contracts, retirees receiving Social Security benefits, and individuals receiving other benefits.
The Consumer Price Index (CPI) tracks changes in the cost of common goods and services over time. When prices for everyday items like eggs, milk, and laundry detergent change, it affects both household budgets and business operations. That’s where COLA comes in, providing businesses with a method to adjust compensation based on economic changes. In this employer’s guide, we’ll cover how this process works, explain its purpose, and show how organizations can incorporate these adjustments into their payroll systems.
What is COLA and its purpose?
A cost-of-living adjustment is a financial increase in pay or benefits designed to help people maintain a certain standard of living during times of inflation or rising costs of goods or services. Cost-of-living adjustments typically happen once a year following the third quarter of the company’s fiscal year, with announcements in October for organizations whose fiscal year coincides with the calendar year. Employees of companies that operate on a different fiscal year will usually see a salary increase late in the fiscal year, such as in April-June for a company with a fiscal year starting on July 1.
The timeline revolves around the annual publication of the Consumer Price Index (CPI). In a typical year, the US Bureau of Labor and Statistics publishes the CPI in September.
The purpose of annual COLAs is twofold: They improve morale and encourage economic stability through spending. If employees’ wages don’t increase with inflation, their purchasing power suffers. When employees can’t afford the same number of goods they could a year earlier, it can feel like they received a pay cut — even if their pay stays the same. A COLA increase can acknowledge negative feelings and increase employee morale.
The annual increases also stimulate the economy. Inflation can hurt the economy, pushing it toward recession. Living adjustments make it so people aren’t afraid to spend money. When wages or benefits shift with the CPI, people can still afford necessities, which helps keep the economy in balance (or at least away from a recession). That said, a COLA is not a recession preventative.
Peggy James is a certified public accountant (CPA) who has been helping businesses for over a decade. To learn more about how COLA factors into employee pay, we asked her for her two cents.
What does COLA mean in payroll?
“COLA is used to provide salary increases to employees based on inflation, so it’s a mechanism to allow employees to maintain their standard of living as prices of the goods and services they buy increase over time. Many employers plan on COLA salary updates on an annual basis, and I think it’s fair to say that many employees come to expect these each year.”
— Peggy James, Certified Public Accountant (CPA)
That said, not all companies take this approach. “Other employers only provide merit-based salary increases, meaning that a pay raise is based on how the employee has performed over the past year,” explains Peggy.
Pro tip
It’s important for employers to clearly communicate with employees when they’re hired about how salary increases are determined along with any limits on each annual increase. Being transparent with employees early on will help to avoid confusion and frustration down the road.
Now that you understand a cost-of-living adjustment and what it’s used for, let’s learn about how the calculations come together
How is COLA calculated?
When doing payroll by on your own, it can be intimidating to figure out pay increases or raises. Thankfully, the COLA calculation is straightforward. The COLA percentage represents the price change of a basket of goods from one year’s third quarter (July, August, and September) to the next. The formula looks like this:
- (Current year’s 3rd quarter average – previous year’s 3rd quarter average) / Previous 3rd third quarter average x 100 = COLA
To calculate the specific benefit adjustment, multiply the COLA percentage by your employee’s salary. The calculation is the same when determining a benefit increase, such as the Social Security COLA. Once you have the result, add it to the salary or benefit to get the following year’s total.
Let’s break this down with a concrete example.
What is an example of a cost of living adjustment?
Consider that the average CPI for the third quarter of 2024 was 308.729, and the average for the third quarter of 2023 was 301.236. To find the COLA or rate of change, you would start by subtracting 301.236 from 308.729, which equals 7.493. Divide the result by 301.236 for a result of 0.025 (rounding to the nearest 0.001). Finally, multiply that by 100 to get the COLA of 2.5 percent.
Now, use that percentage to figure out the cost-of-living increase for your eligible employees. For example, Danielle Smith earns $50,000 annually. Multiply $50,000 by 2.5 percent and you get $1,250. Therefore, Danielle’s new salary will be $51,250 starting in 2025.
Don’t worry if you find this all a little confusing, as it becomes easier with practice. If you don’t have confidence in your math skills, there’s a number of providers that can help.
Now that we have some number-crunching in place, employers who are focused on the bottom line may wonder how this can impact payroll costs and what their obligations are. Once more we spoke with Peggy James who sheds some light on the subject.
Does an employer have to give a cost of living raise?
“Private companies are not required to give a cost of living raise to employees, but many do. Other companies use a merit-based system to determine if an employee should receive a raise, and in these cases, a raise is often tied to the employee’s annual performance review. “
— Peggy James, Certified Public Accountant (CPA)
To learn more, we asked Peggy to share a scenario from her experience working with small businesses.
“One organization I worked for only provided merit-based raises, and they budgeted for annual raises of 2.5% across all employees,” she says. “Supervisors had the option of giving a larger raise to employees whose performances exceeded expectations, but that would mean giving a smaller raise to other employees in order to stay within budget.”
Factors influencing COLA adjustments
The primary factor influencing COLAs is inflation, typically measured by the CPI. That said, the Social Security COLA usually uses the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
Beyond the price indexes, regional cost of living and political pressures can also influence cost-of-living adjustments. For example, the COLA for California is generally not the same as for Arkansas, which has the lowest cost of living in the country.
Note that not all employees are entitled to cost-of-living adjustments. While minimum wage by state varies, minimum wage workers aren’t entitled to COLAs under federal or most state laws. However, these adjustments are important for most workers.
Importance of COLA for employees
A cost-of-living adjustment helps employees maintain a standard of living and care for themselves and their dependents. The adjustments not only counteract the effects of inflation but can also improve employee morale. This can, in turn, improve productivity and retention rates for your business. Still, the fundamental reason behind COLAs is to maintain purchasing power.
Maintaining purchasing power
Purchasing power refers to the value of a person’s money. When inflation increases, the value of a person’s money decreases — they can no longer buy the same goods or services for the same price as before.
If people can no longer buy the same products and their money has less value, they are more likely to hold on to what they have rather than spend. While saving money has some benefits for individuals, a lack of spending across the board is bad for the economy and business profits.
As a business owner, you should want people to maintain purchasing power. This makes them more likely to spend money on your goods, which is particularly something to pay attention to if consumers perceive your goods or services as luxuries.
For new employers wondering how COLA fits into their growth plans and promotion strategies, once more we asked Peggy to help us tackle a question that often comes up.
What is the difference between a COLA and a raise?
“A COLA is an increase in salary based solely on a metric of the cost of living in a particular area. A raise, on the other hand, refers to any increase in salary, and it can be based on a different metric such as how well the employee has performed their duties or how much revenue the employee has provided to the company over the past year.”
— Peggy James, Certified Public Accountant (CPA)
We’ve covered a lot of ground, and before we go let’s cover what this can look like when running payroll.
How COLA affects monthly payments
COLAs will affect payroll management, but not significantly. The monthly increases are usually minimal. Take the following hypothetical, for instance:
Danielle will receive an annual increase of $1,250, which is only about $104 per month. It is important to pay attention to payroll deadlines so you can implement a COLA beginning in the pay period it was promised to employees.
Bottom line: Understanding cost-of-living increases can help streamline salary changes
For both new and seasoned employers, understanding how cost-of-living adjustments (COLA) work is key to budgeting and managing payroll costs. COLA supports fair salary increases for employees, retirees, and government beneficiaries. But for small businesses, staying on top of these changes can be tricky. Fortunately, many online payroll providers simplify the process by tracking adjustments and consolidating everything in one platform, making it easier for employers to plan ahead. Wishing you success as you grow your team and navigate pay increases — whether its due to COLA or merit-based promotions. Best of luck as you build your team and grow your business this year!
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.