What Are Cost of Living Adjustments (COLAs) & How Do They Work?

Cost of living adjustments may help employees manage rising prices for basic staples such as housing, energy, and food. A cost of living raise for employees is not based on job performance or a promotion. Rather, the pay increases are given to counteract inflation and help employees maintain their earning power. With inflation continuing to have an impact in 2023, businesses have seen an increased need to implement cost of living raises.

What Is a Cost of Living Adjustment?

COLAs are increases in salaries or hourly rates to help employees maintain the value of their compensation against inflation. These increases are not viewed as merit increases resulting from good job performance. Cost of living raises can be a way to maintain the employee's earning power. Generally, employers calculate the amount of a cost of living pay increase by using a price index, such as the Bureau of Labor Statistics' Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This index measures the rise in consumer prices for households where at least half of the income is from clerical or urban wage occupations, and at least one of the household's earners has been employed for at least 37 weeks over the past twelve months. This represents about 29% of the U.S. population.

What Is Social Security Administration’s COLA Increase for 2023?

Each year, the Social Security Administration applies a COLA to payments made to those receiving Social Security and Supplemental Security income (SSI). For 2023, the COLA increase is 8.7%, which is significantly larger than the COLAs in recent years.

How Does a Cost of Living Adjustment Work?

A COLA is a standard, across-the-board increase for a group of individuals. Employers might give out a cost of living raise where each employee receives the same percentage increase.

Typically, the cost of living in large cities such as New York or Los Angeles is higher than smaller, rural communities. Employers with employees in a number of different cities or states may choose to adjust their cost of living raises based on location. This may help to meet more expensive housing, gas, or food costs affecting workers in certain areas.

In some cases, cost of living pay increases may be a requirement. Minimum wage laws, union agreements, executive contracts, and even retiree benefits such as employee pensions may contain provisions for annual COLAs. Some of these automatic adjustments may be able to be programmed into a compensation system to guarantee that they take effect as stipulated while others may require additional oversight.

What Is Included in the Cost of Living Adjustment?

A COLA is often calculated based on an underlying metric, such as the Consumer Price Index (CPI) or the CPI-W. The indexes calculate price increases in living staples such as housing, food, and energy costs. State law or a union agreement may specify which index should be used to calculate an annual cost of living increase. Employment agreements may also state the specific index that must be used to measure any cost of living raises.

Do Employers Have To Give Cost of Living Adjustments?

A cost of living increase is not mandated unless required by law or agreement, such as annual minimum wage increases, or stated in a union agreement, benefit plan document, or employment contract. When cost of living raises are offered to employees, they may not be needed every year. In some years, inflation remains flat and the cost of living doesn't change, which means that employees' pay value is not diminished.

Why would an employer give a COLA? There are several common reasons, including:

• Concern over employee retention when competing firms begin to offer higher pay rates.
• The need to persuade employees to relocate to a city or state with a higher cost of living.
• To alleviate financial stress placed on employees during periods of inflation.
• Doing so is required by law or under the terms of an agreement.

How To Calculate a Cost of Living Adjustment Payment for Employees

A COLA typically can be calculated as part of an annual compensation plan review. An employer should determine which price index best aligns with their employees' cost of living. If the chosen index rose 6% in the past year, employee salaries or hourly rates would be adjusted by a similar amount.

For example, an employee with a $100,000 base salary might receive a six percent raise, or $6,000 for their COLA, prior to any performance-based increases. Likewise, an employee making $20 per hour might receive another $1.20 per hour, raising their pay rate to $21.20.

How Much Is a Typical Cost of Living Raise?

Over the years, COLAs have varied. In some years, prices are stagnant, and no adjustment is needed. Since 1975, the Social Security Administration has calculated COLAs using the CPI-W. The average annual COLA since that time has been 3.7%, which makes the most recent adjustment of 8.7% greater than a typical year.

Historically, adjustments to the minimum wage were enacted to assist lower-paid workers when the cost of living increases. Many states and localities have a higher minimum wage than the federal amount. And several have implemented annual increases based on increases in the cost of living.

Understand How Cost of Living Impacts Your Business

Competitive wages help to attract and retain employees. When employers fall behind and fail to pay enough to help employees make ends meet, they risk a loss of human capital. To hire the best people in each geographic job market, it's important to understand how cost of living can shift between different locations. If you plan to offer a cost of living raise in the upcoming year, you can do so most efficiently by working with your payroll provider to implement the increase across the board.