How to calculate compensated absences: optional methods

Compensated absences calculations changed in fiscal year 2024 when the Governmental Accounting Standards Board (GASB) statement 101, Compensated Absences became effective. This guidance applies to GAAP basis governments, and we also carried it over to cash-basis governments to ensure compensated absences liabilities are calculated consistently across all governments, regardless of basis of accounting. Before this guidance, most governments only considered how much leave employees could cash out upon separation. Under the updated guidance, governments must also consider whether employees will use the leave during employment. This article will explain two optional methods governments can use to estimate how much leave employees will use during their employment.

When governments do not need an estimate

For leave that employees can cash out at 100% of both hours and pay, governments do not need an estimate. In this case, governments calculate the liability by multiplying the ending balance by the pay rate at fiscal year-end (FYE). For this type of leave, if we assume the employee uses all their leave or cashes it out, the calculation is the same. Nothing has changed with this type of leave.

When governments do need an estimate

For leave types that cannot be fully cashed out, governments need to estimate how much leave employees will use. For example, many governments allow employees to cash out only 25% of their sick leave upon retirement. In this case, the assumptions you use for the estimate affect the ending liability.

For example, if an employee has 100 hours of sick leave and their pay rate at FYE is $20 an hour:

• If we assume they will use all 100 hours during employment, the liability (before salary-related payments) is $2,000. This is because when they use their leave, they are paid their full hourly rate for all hours.
• If we assume they will cash out all 100 hours of leave upon retirement, and they can only cash out 25% of their balance, they will be paid for 25 hours, not 100. That means the liability before salary-related payments is only $500.

That $1,500 difference in the total liability is why it’s so important to use a reasonable estimate when deciding how much leave is more likely to be used versus cashed out.

Choosing a reasonable estimation method

There is no specific method governments must use to estimate how much leave employees are likely to use. There are several methods that can result in a reasonable estimate. In our first round of audits under the new guidance, we saw many governments put significant effort and work into their estimates and calculations. However, we also noticed governments’ estimates were not always reasonable.

There are two example methods governments might consider to calculate compensated absences liability: the average cost method and average time used method.

Calculation method: average cost method

The average cost method assumes all hours of leave are interchangeable and therefore applies average annual usage rates to the total balance; this method does not use a flow assumption such as last in first out (LIFO) or first in first out (FIFO). This method reflects the nature of compensated absences, which are pooled benefits rather than distinct items like inventory.

How it works

Governments will:

1. Perform a historical analysis of actual sick leave settlements to determine the average proportions for leave that is used, paid out and forfeited
2. Apply those proportions to the current leave balance
3. Multiply the estimated hours by a weighted average pay rate
4. Add the salary-related payments, such as the employer portion of payroll taxes

This method requires historical data for all three leave categories (used, paid out and forfeited).

Example:

Fiscal Year	Used @ 100%	Pay out @ 25%	Forfeit @ 0%	Total Hours
2021	3,225	490	233	3,948
2022	4,204	1,026	105	5,335
2023	3,641	311	188	4,140
Total	11,070	1,827	526	13,423
Proportion (average)	82%	14%	4%	100%
Apply percentages to FYE leave balance (ex: 6,157 hours at FYE)	5,049	862	246	6,157
Multiplied by weighted average pay rate, including salary-related payments (ex: $91.09)	$459,913	$78,520	$0	$560,841

Calculation method: average time used method

Some governments may not be able to get the data needed for the average cost method, such as number of hours of forfeited leave. In those cases, the average time used method may be appropriate.

This method generally requires more effort and assumes a FIFO flow of leave.

We saw many governments try to use a method like this, but often missed step 2 below.

Step 1: Estimate annual leave usage

Governments can estimate how many hours employees use each year. Governments should use three to five years of historical data to calculate the average annual hours used.

Example:

Employee Group	Hours used 2022	Hours used 2023	Hours used 2024	Total	Average Annual Usage
Group #1	3,200	2,200	1,800	7,200	2,400
Group #2	4,100	4,300	5,100	13,500	4,500
Group #3	3,400	2,300	3,300	9,000	3,000

Step 2: Estimate remaining years of service for each employee group

Governments can estimate the average service years of each employee group. We don’t expect governments to estimate this for each individual employee. Governments can base this on the historical average years of service upon termination or retirement, or average separate age and calculate one estimate for each group.

Calculate the estimated remaining years of service for the current employee group by:

• Finding each group’s average years of service before separation based off historical data
• Calculating the current average years of service for the employee group
• Subtracting the group’s current average years of service from the historical average years of service before separation

Example:

Employee group	Historical Average Years of Service before Separation	Average Current Years of Service	Estimated Remaining Years
Group #1	13	6	7
Group #2	15	10	5
Group #3	8	4	4

Step 3: Estimate hours the employee group may use

To calculate the total hours the employee group is estimated to use:

• Multiply the estimated remaining years of service (from step 2) by the average annual hours used (from step 1)

• If the estimate is more than the actual total hours the group has at FYE, use the actual hours instead

For example, employee group 3 is estimated to use 12,000 hours, but at year-end they only have a balance of 10,000 hours. Their hours estimated to be used are capped at their balance of 10,000.

Employee group	Est. remaining years X average annual usage	Balance at FYE	Hours employees are estimated to use
Group #1	16,800	30,000	13,200
Group #2	22,500	50,000	27,500
Group #3	12,000	10,000	10,000

Step 4: Calculate the dollar estimate of hours used

Multiply the hours the employee group is estimated to use by the weighted average pay rate of the employee group at FYE. This amount represents the liability for leave expected to be used.

See above for information on calculating the weighted average pay rate.

Employee group	Hours the employee group is estimated to use	Weighted average pay rate	Dollar value of estimated usage
Group #1	13,200	$30	$396,000
Group #2	27,500	$20	$550,000
Group #3	10,000	$15	$150,000
Total	-	-	$1,096,000

The liability for hours the employee group is estimated to use is $1,096,000, before salary-related payments.

Step 5: Estimate cash-out hours

Subtract the number of hours the employee group is estimated to use from the total leave balance at FYE. This figure represents the potential cash-out hours.

Employee group	Balance at FYE	Hours the employee group is estimated to use	Available for cash out
Group #1	30,000	13,200	16,800
Group #2	50,000	27,500	22,500
Group #3	10,000	10,000	0

Then, apply your government’s cash-out and leave policies, such as:

• Caps on cash-out hours
• Cash-out percentage limits
• Years of service or retirement requirements

Look at your potential cash-out hours and apply your specific leave policies to calculate an estimate of hours that employees will be allowed to cash out. Multiply these eligible cash-out hours by their pay rate at FYE. Add this to the amount from step 4 to decide the total liability, before salary-related payments.

Step 6: Calculate salary-related payments

This includes any payments that are directly and incrementally associated with the leave, such as the employer portion of payroll taxes.

Common issues we’ve seen

Based on our audits, we do not recommend the following approaches:

• Estimating leave usage by dividing total hours used by total hours accrued: this shows usage of annual accruals, not how much of the total balance they are estimated to use. This often results in unreasonable estimates.
• Estimating each individual employee’s future leave when there is a significant number of employees.

How to reach us for more assistance

Remember, the State Auditor’s Office is here to help. If you have additional questions, please submit a Help Desk in the client portal.