Last updated: March 2026

Overtime pay: rules, calculations, and the new tax exemption

Most employers calculate overtime wrong. Not slightly wrong. Wrong in a way that creates liability on every paycheck for every nonexempt employee who works past 40 hours. The FLSA requires overtime at one and a half times the regular rate of pay, and the regular rate is not the same as the hourly rate. Shift differentials, nondiscretionary bonuses, commissions, and piece-rate earnings all fold into the regular rate calculation. I've audited overtime calculations for employers in manufacturing, healthcare, construction, and restaurants, and fewer than one in five get the regular rate right. The rest use base pay only and owe back wages they don't know about.

How overtime is actually calculated

The FLSA overtime formula looks simple: hours over 40 × 1.5 × regular rate. The complexity lives inside "regular rate." The regular rate of pay includes every form of compensation except a short list of statutory exclusions (gifts, vacation pay, discretionary bonuses, and a few others). Everything else goes in. A warehouse worker earning $20 per hour with a $2 night shift differential and a $500 quarterly production bonus has a regular rate higher than $20. The shift differential adds to every overtime hour worked during that shift. The production bonus gets divided across all hours worked in the bonus period and adds to the regular rate retroactively.

Here's the math on that warehouse worker. Base pay for a 45-hour week: 40 × $20 = $800 straight time, plus 5 hours at the $2 shift differential = $10 extra. If the quarterly bonus allocates to $38.46 for this week ($500 ÷ 13 weeks), the total non-overtime compensation is $848.46. Divide by 45 hours: the regular rate is $18.85. Overtime premium (the extra half) is $18.85 × 0.5 × 5 hours = $47.13. Most employers would have paid 5 × $30 ($20 × 1.5) = $150 in overtime. The correct amount is $150 base overtime plus $47.13 in additional premium from the shift differential and bonus. That $47.13 per week error compounds to $2,450 per year for one employee. Multiply across a 50-person warehouse and the employer owes $122,500 in back wages before penalties.

The tradeoff with overtime compliance is calculation accuracy versus payroll processing speed. Getting the regular rate right requires your payroll system to track every compensation component and recalculate overtime retroactively when bonuses post. Most payroll software can do this if configured correctly. Most employers never configure it.

The overtime tax exemption (OBBBA)

The One Big Beautiful Bill Act created a federal income tax exemption on overtime pay starting in 2025. Overtime hours are still subject to Social Security and Medicare taxes (FICA), but federal income tax withholding on overtime earnings is eliminated for eligible workers. This is the largest payroll tax change in decades, and it affects every employer with nonexempt employees.

The exemption has limits. It applies to workers earning up to $150,000 in total annual compensation (the threshold is indexed and may adjust). It applies only to hours that qualify as overtime under the FLSA, meaning hours beyond 40 in a workweek for nonexempt employees. Salaried exempt employees don't have overtime hours and don't qualify. Independent contractors don't qualify. The exemption reduces federal income tax withholding on overtime pay to zero, but FICA still applies at the full 7.65% rate for both employer and employee. So is overtime taxed in 2026? Yes, but less than before. The no tax on overtime provision only eliminates federal income tax, not payroll taxes.

When this is wrong: if you earn above the $150,000 threshold, no exemption applies to any of your overtime hours. When this is also wrong: state income tax on overtime is unchanged. States have not adopted the federal exemption, so your state tax withholding on overtime pay continues at the normal rate. When this is wrong for a different reason: if you are an independent contractor, you have no overtime hours under the FLSA and this exemption does not apply to you regardless of income level.

The overtime tax exemption calculator shows exactly how much the OBBBA saves based on your hourly rate, overtime hours, and filing status. It's the only calculator that separates the federal income tax savings from the FICA obligation that remains. Most online estimates overstate the savings because they forget that Social Security and Medicare still apply.

Exempt vs nonexempt

The overtime rules only apply to nonexempt employees. Exempt employees are not eligible for overtime pay regardless of hours worked. The exemption requires meeting both a salary threshold ($35,568 per year under the federal rule that remains in effect after a court struck down the DOL's proposed increase) and a duties test. The salary test alone doesn't determine status. An employee earning $80,000 per year who doesn't meet the executive, administrative, or professional duties test is nonexempt and entitled to overtime. I've seen employers misclassify employees as exempt based solely on salary, then face Department of Labor audits covering two to three years of unpaid overtime across every misclassified position.

The cost of getting exempt status wrong dwarfs the cost of paying overtime. An employee misclassified as exempt who works an average of 5 overtime hours per week at a $50,000 salary ($24.04 per hour) is owed $9,375 per year in overtime ($24.04 × 1.5 × 5 × 52 weeks = the annual shortfall). The DOL routinely assesses liquidated damages equal to the back pay, doubling the liability. Three years of misclassification for one employee: $56,250. For a department of five misclassified employees: $281,250.

Common overtime errors

Five errors account for most overtime liability. Using base pay instead of regular rate when bonuses, commissions, or shift differentials exist. Averaging hours across two workweeks instead of calculating overtime per individual workweek (the FLSA does not allow biweekly averaging unless a specific 8/80 healthcare exception applies). Misclassifying employees as exempt when they don't meet the duties test. Failing to count all compensable time, including pre-shift meetings, required training, and on-call hours where the employee's movement is restricted. Calculating tipped employee overtime from the tipped rate instead of the full minimum wage. Each error creates per-paycheck liability that accumulates silently until an audit or a lawsuit surfaces it.

Guides and tools

Overtime tax exemption calculator (OBBBA) calculates the federal income tax savings on your overtime pay and shows what FICA you still owe. Regular rate of pay explains the full FLSA calculation with examples for bonuses, shift differentials, commissions, and piece rates. How overtime is calculated covers the basics for employees checking their own paychecks. Nondiscretionary bonus overtime breaks down the retroactive recalculation that trips up most employers.

Overtime errors often point to a payroll provider that isn't configured for regular rate calculations. If your software can't handle nondiscretionary bonus retroactive overtime, it's producing wrong paychecks every bonus period. Restaurant employers face a specific version of this problem because tipped overtime uses a different base rate than regular overtime.

Written by a Certified Payroll Professional with 30 years of experience.

This is not legal or financial advice. Consult a qualified professional for your specific situation.