Workers' compensation insurance is a form of insurance that provides benefits to employees who suffer work-related injuries or illnesses, including payment of medical treatment, a portion of lost wages, rehabilitation costs and death benefits for dependents. In exchange, employees generally give up the right to sue their employer for negligence, an arrangement often called the compensation bargain.
In the United States, workers' compensation is governed mainly by state law, and almost every state requires employers with employees to carry it, either through a private insurer, a state fund or approved self-insurance. Texas is the main exception, allowing most private employers to opt out. Federal programs cover federal employees and certain workers such as longshore and harbor workers. For accounting purposes, workers' compensation premiums are an employer cost of labor, recorded alongside wages and employer payroll taxes, although the premium is insurance rather than one of the payroll taxes.
Premiums are based on the employer's payroll and the risk of the work performed. A common formula is:
- is the remuneration paid to employees in each job classification, generally gross wages with some exclusions, such as part of overtime pay in many states.
- is the rate per $100 of payroll for the job classification; clerical work might be well under $1, while roofing can exceed $20.
- compares the employer's own claims history with the average for similar businesses. A factor of 0.85 reduces the premium by 15 percent, while 1.20 increases it by 20 percent.
Worked example and accounting
A landscaping company expects payroll of $400,000 for office staff at a class rate of $0.30 and $1,200,000 for field crews at a rate of $7.50. Its experience modification factor is 0.90. The estimated premium is $400,000 divided by 100, times $0.30, plus $1,200,000 divided by 100, times $7.50, which gives $1,200 plus $90,000, or $91,200, then times 0.90, or $82,080.
The company pays a deposit of $20,520 at the start of the policy year and monthly installments thereafter. Payments made in advance are recorded as prepaid insurance, and each month's portion is moved to insurance expense, often charged to the departments where the employees work. Some businesses use pay-as-you-go programs, paying premiums with each payroll based on actual wages.
After the policy year ends, the insurer conducts a premium audit of actual payroll. If field payroll turned out to be $1,350,000, the final premium rises by $150,000 divided by 100, times $7.50, times 0.90, or $10,125. The company should accrue this additional premium as an accrued expense when it becomes probable, rather than waiting for the audit bill, so the cost is recorded in the year the wages were paid.
High-deductible and self-insured programs
Larger employers often choose high-deductible policies or self-insure, paying claims up to a set amount themselves. In those cases they must record a liability for claims incurred but not yet paid, including an estimate for injuries not yet reported, under the rules for contingent liabilities. These estimates are usually prepared by actuaries and can be significant for employers in construction, transport and manufacturing.
Why it matters for businesses
Workers' compensation can be one of the largest employment costs for businesses in physical industries. As part of wider risk management, safety programs, return-to-work policies and accurate classification of employees reduce premiums over time through a lower experience factor. Misclassifying workers into lower-risk categories, or treating employees as independent contractors, to reduce premiums can lead to back premiums, penalties and, in serious cases, fraud charges. Failing to carry required coverage can result in fines, stop-work orders and personal liability for injured workers' costs. Benefits paid to injured workers are generally not taxable income to them under federal tax law.