What Is Workers’ Compensation and How Does It Work?

Workers' compensation coverage is insurance that covers an employee who has an injury or suffers an illness while executing duties on the job. Regulations vary from state to state, but it's recommended that employers with one or more employees carry the insurance to mitigate risk.

What Is Workers’ Compensation?

About 56 percent of business owners say managing workers' compensation and risk management is their number one HR challenge.¹ Due to its confusing nature, business owners may struggle to understand exactly what workers’ compensation insurance is. Workers' compensation, also often called workers' comp, is insurance that provides employees with certain benefits if they suffer a work-related injury or illness. These benefits include medical expenses, lost wages, and rehabilitation costs. In the event of an employee work-related death, workers' compensation also pays death benefits to the employee's family members. Workers' compensation insurance is mandatory in most states, although rules vary from state to state regarding how many people a business can employ before it is required.

Almost every state in the union requires employers to carry workers' comp coverage. However, some states have a plan to discourage competition from private insurers. Several other states require workers' compensation insurance only for employers with more than a certain number of employees.

Not having workers' compensation insurance where it's mandated can be a criminal offense, and the penalties can be severe. Fines can reach thousands of dollars per day for non-compliance and any loss of revenue due to business closure until coverage is in place. In the event of an accident, the penalties can be even higher, as the employer is responsible for all medical bills, lost wages, and potential litigation.

However, the laws are not only there to protect the employee; they can often eliminate the liability of co-workers and shield an employer from a lawsuit if an employee collects workers' compensation benefits. Most states even maintain a fund to protect an injured worker in case the employer does not have coverage.

Some companies might be exempt from obtaining workers' compensation insurance depending on state requirements. For example, Texas does not require most private employers to carry workers’ compensation, except for a few industries where it is needed.

What Does Workers' Compensation Insurance Cover?

Workers' comp coverage helps employees pay for qualified workplace injury or illness expenses. Depending on state laws, these may include:

• Medical services: Covers medical-related expenses needed to treat an injured or sick employee.
• Rehabilitation services: Covers the care needed to get an employee back to work, such as physical or occupational therapy.
• Lost income: If an employee takes time off to recover, workers' comp will cover a portion of missed wages.
• Vocational training: Covers training that will help a worker develop the skills and attain the education needed to return to work within restrictions set by a physician related to the employee's injury or illness.
• Death benefits: A specified amount is paid to the employee's survivors in the event of a work-related death.

Each state determines the amount and duration of workers' compensation benefits and how those benefits are administered.

What Does Workers' Comp Not Cover?

As important as it is to understand what workers’ compensation is, it's equally valuable to know what workers' comp doesn't cover. An injury at work or on the clock does not always equate to being eligible for workers' compensation benefits. There are several situations where a worker can get injured at work, but the accident may not be work-related.

If a worker is injured while violating company policy, they may not be eligible for workers' comp. This can include careless behavior, such as being intoxicated or under the influence of the illegal use of drugs while on the clock. Recreational injuries suffered outside the scope of work, such as falling and breaking a leg while skiing on the weekend, will not be considered work-related injuries. Similarly, a worker who is injured or killed while commuting to and from work is typically not eligible for workers' compensation.

How Does Workers' Compensation Work?

The question, "How does workers' compensation work?" can vary from state to state, though general steps must be taken to make a claim. First, your employer must be notified of the injury or illness, preferably on the day it happens. They are then responsible for immediately documenting the situation and passing it on for review. The workers’ compensation insurance carrier is responsible for the bill once the claim is reported to them. If the injured employee gets billed, it’s the employee's responsibility to work with the claims adjuster to get that bill paid. All medical-related costs covered are subject to the policy, type of employment, and state laws.

Which Situations Qualify a Worker for Workers' Compensation Coverage?

For an employee to be eligible and receive workers' comp coverage, they must meet all of the following criteria:

• A worker must be classified as an employee. Most business owners, sole proprietors, and partners are not eligible unless required or chosen to be covered by the policy. Consultants, freelancers, independent contractors, and other gig workers may not be entitled to workers' compensation benefits depending on the work performed and if they are covered under their own policy. Employers who misclassify employees as independent contractors can also face stiff financial penalties, which vary from state to state.
• The business or employer must carry workers' comp insurance. Without a policy in place, there is no workers' comp coverage in the event of a work-related illness, injury, or death. In this situation, an injured worker may have the right to take legal action against the employer. Because of the peace of mind workers' compensation often gives an employer, many businesses will purchase workers' compensation insurance even if they aren't required to do so in their state.
• The injury or illness must be work-related. If an employee's accident, injury, or illness happens in the service of the business, it should be covered by workers' comp. There are situations when an incident can occur at work and not be covered by workers' compensation, such as when an employee is violating company policy.
• The employee must adhere to state or federal deadlines for reporting the incident and filing a claim. Because workers' comp varies from state to state, deadlines for filing a claim will also differ. Federal employees must follow federal guidelines on workers' comp timelines. Even if an employee meets all other criteria, missing the filing deadline could mean they cannot collect workers' comp benefits.

Can Workers' Compensation Be Purchased as Part of a Package Policy?

While many forms of business insurance may be sold as part of a package, state laws require workers' compensation to be purchased as a separate policy.

What Are the Difficulties of Managing Workers’ Compensation?

Workers' compensation insurance can involve large payments that could potentially cause cash flow problems for your business.

That's because payments are often based on an estimate of wages paid to employees based on risk (e.g., it's more expensive to cover electricians than clerical workers). Because premiums are based on estimated payroll and not actual wages, insurers may require a large upfront payment. And if the estimate is low at the end of the year, you'll have to pay the difference in one lump sum.

However, a licensed insurance agency can provide competitive quotes, possibly secure discounts when purchased with other types of insurance with the same carrier, and help you manage your plan more efficiently. Furthermore, integrating your workers' compensation policy with payroll services can provide increased benefits such as no upfront deposits, billing based on actual payroll instead of estimates, and minimizing the risk of paying additional year-end premiums.

Who Pays for Workers' Compensation?

Workers' compensation premiums are paid for by the employer. Unlike Social Security, there are no payroll deductions from an employee's wages that would go toward the premiums. The cost of the premiums will vary depending on risk factors, the number of employees it's covering, the extent of the policy, and state mandates.

Calculating Workers' Compensation Premiums

Workers' compensation premiums are calculated on employee classification, based on job duties and the rate assigned to that classification (this is based on industry). Additional factors could affect the rate, such as the size of an employer's payroll and the company's claims experience. Also, depending on the state, potential discounts are available, as well as the possibility of add-ons such as state fees and charges.

If you are currently a Paychex payroll client, our workers' compensation payment service integrates with payroll to calculate your premiums using actual wages instead of estimates, which can improve business cash flow by eliminating large deposits and reducing your risk of additional premium payments at audit.

Protect Your Business With the Proper Workers' Comp Coverage

Workers' compensation insurance is mandatory in most states. As an employer, you can set up and manage the right policy for your business with help from Paychex Insurance Agency.

¹ 2024 Priorities for Business Leaders, Paychex.