A cost-of-living adjustment (COLA) is an increase in pay or benefits that helps people keep up with rising prices. For your business, it shapes how you budget for compensation. For your employees, it determines how much purchasing power they keep as prices rise.
What you’ll learn
What you’ll learn
Key takeaways about cost-of-living adjustments
- COLA helps offset the effects of inflation and ensures people can still afford necessities as prices increase.
- Organizations typically base the calculation on the Consumer Price Index (CPI), which tracks the average price of a basket of goods.
- The 2026 Social Security COLA is 2.8%, which increases the average retired worker’s monthly benefit by about $56.
The Consumer Price Index (CPI) tracks how the cost of common goods and services changes over time. When prices for everyday items like eggs, milk, and laundry detergent increase, household budgets and business operations feel it. COLA gives you a way to adjust compensation and keep pace with those changes. In this employer’s guide, we cover how the calculation works, why it matters, and how to incorporate these adjustments into your payroll systems.
What is COLA and its purpose?
A cost-of-living adjustment is an increase in pay or benefits that helps people maintain their standard of living as prices rise. Many companies review COLAs once a year, usually timed to their fiscal year. Businesses on a calendar year typically announce COLAs in October, while businesses on a different fiscal year, such as one starting July 1, might apply the increase around April through June.
The timeline follows the Consumer Price Index (CPI), which the US Bureau of Labor Statistics (BLS) publishes every month. The September release each year completes the third-quarter average that COLA calculations usually rely on, and that report usually comes out in October.
The purpose of annual COLAs is twofold as they:
- Support employee morale
- Encourage economic stability through spending.
When wages keep pace with inflation, employees hold on to their purchasing power. When wages fall behind, employees can afford less than they could the year before, even though their pay stayed the same, and that can feel like a pay cut. A COLA increase acknowledges that reality and helps preserve morale.
The annual increases also support the broader economy. Inflation can push the economy toward recession, and cost-of-living adjustments help people keep spending because they can still afford what they need. A COLA alone won’t prevent a recession, but it plays a part in keeping the economy stable.
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 take.
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
Clearly communicate with employees when you hire them about how you determine salary increases, along with any limits on annual increases. Being transparent early on helps you avoid confusion and frustration down the road. Now that you understand what a cost-of-living adjustment is and how to use it, let’s look at how the calculation comes together.
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?
Figuring out pay increases or raises can feel intimidating when you’re doing payroll on your own. Fortunately, 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 works the same way 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-W for the third quarter of 2025 was 317.265, and the average for the third quarter of 2024 was 308.729. To find the COLA, subtract 308.729 from 317.265, which equals 8.536. Divide the result by 308.729 to get 0.028 (rounding to the nearest 0.001). Multiply that by 100 to get the COLA of 2.8 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 2.8%, and you get $1,400. Danielle’s new salary is $51,400 starting in 2026.
This gets easier with practice. If you’d rather not do the math yourself, a payroll service provider can help.
Now that we have some number-crunching in place, you may wonder how this affects payroll costs and what your obligations are. We asked Peggy James, CPA, to walk us through it.
What is the 2026 Social Security COLA?
The 2.8% COLA calculated above is the rate the Social Security Administration (SSA) announced for 2026. On average, retired workers saw their monthly benefit increase by about $56. Social Security beneficiaries saw the increase starting with their January 2026 payment, while the roughly 7.5 million people receiving Supplemental Security Income (SSI) saw it a few weeks earlier, starting December 31, 2025.
We also asked Peggy to share a scenario from her experience working with small businesses.
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)
Social Security wage base for 2026
The same October SSA announcement raised the Social Security wage base, which is the maximum amount of earnings subject to Social Security tax. For 2026, that cap increased to $184,500, up from $176,100 in 2025. It is scheduled to rise to $192,300 in 2027.
Once an employee’s wages hit that threshold, you can stop withholding Social Security tax for the rest of the year.
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. The Social Security COLA specifically relies on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
Beyond the price indexes, some employers also factor in regional cost of living and other local pressures when deciding on their own compensation adjustments. Costs can vary widely by state. For example, Arkansas and Mississippi are consistently among the most affordable states in the country, while states like California and Hawaii are well above the national average.
Not all employees are entitled to cost-of-living adjustments. While minimum wage varies by state, minimum-wage workers aren’t entitled to COLAs under federal or most state laws. Still, these adjustments are important for most of the workforce.
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 their standard of living and care for themselves and their dependents. Adjustments counteract inflation and can also improve employee morale, which in turn supports productivity and retention 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. As inflation rises, that value drops and a dollar buys less than it did before.
When wages don’t keep pace, employees can afford less than they could the year before. That often means cutting back on discretionary spending, and when enough people pull back at once, it weighs on the broader economy and on business profits, including yours.
As a business owner, you benefit when your employees and customers maintain their purchasing power. People who can afford to keep spending are more likely to spend on your goods and services, which is particularly important if consumers view what you offer as a discretionary purchase rather than a necessity.
If you want to know how COLA fits into your growth plans and promotion strategies, we asked Peggy to answer a question that comes up often.
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. Before we wrap up, let’s cover what this means when you’re running payroll.
How COLA affects monthly payments
COLAs affect payroll management, but the monthly impact is usually small. Take the following hypothetical:
Danielle will receive an annual increase of $1,400, which works out to about $117 per month. Watch your payroll deadlines so you can start the COLA in the pay period you promised 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 work is key to budgeting and managing payroll costs. COLA supports fair salary increases for employees, retirees, and government beneficiaries, but staying on top of these changes can be tricky for small businesses. That’s where OnPay comes in. We help you track adjustments and manage payroll in one place, so you can plan ahead.
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.