What Is a Cost-of-Living Adjustment (COLA) and How Does It Work?

Continued economic uncertainty in the U.S. may bring up the topic of providing cost-of-living adjustments to employee pay. While not based on job performance or promotion, COLAs may help employees manage rising prices for basic staples. With inflation continuing to raise concerns in 2025, businesses may increasingly consider implementing cost-of-living adjustments. Read on to learn more about how a COLA works.

COLAs are increases in compensation intended to help employees maintain the value of their pay against inflation. These increases are not viewed as merit increases but should be considered a way to help employees maintain their earning power.

What Is COLA Based On?

Since 1975, the Social Security Administration (SSA) has calculated the annual cost-of-living adjustments to SSA benefits based on a price index such as the Bureau of Labor Statistics' Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This index tracks the increase in consumer prices for households where at least half of the income comes from clerical or urban wage jobs, and where at least one person has worked 37 weeks or more in the past year. This represents approximately 29% of the U.S. population.

Why Is a Cost-of-Living Raise Important?

A cost-of-living raise is important because it's a compensation practice used to help keep employees' pay on par with rising prices for basic needs, such as housing, energy, and food. The government issues COLAs related to Social Security benefits, but employers may also apply similar percentage increases to employees' yearly wages. Employers who want to keep pace in a competitive labor market may choose to apply these increases as part of their employee compensation plans.

What Is the COLA for 2025?

Each year, the SSA automatically applies COLA to payments made to those receiving Social Security and SSI. For 2025, the COLA increase was based on the rise in the CPI-W from the third quarter of 2023 through the third quarter of 2024.

The SSA announced a 2.5% COLA increase for 2025 in October 2024. The increase took effect with Social Security and Supplemental Security Income (SSI) payments for December 2024, which were distributed in January 2025. SSI pays monthly benefits to those with limited income who are blind, 65 or older, or have a qualifying disability. Additionally, the Social Security Administration announced that the earnings limits for retirement beneficiaries will go up, both for individuals below “full” retirement age and those reaching that age.

How Does a Cost-of-Living Adjustment Work?

A COLA is a standard across-the-board increase for a group of individuals. Employers will often structure cost-of-living raises so that each employee receives the same percentage increase.

Typically, living costs in large cities such as New York or Los Angeles are higher than in smaller towns or rural communities. Employers with employees in several different cities or states may choose to adjust their cost-of-living raises based on location. This may help workers to meet more expensive housing, gas, or food costs 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 programmed into a compensation system to guarantee 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 a COLA increase. Employment agreements may also state the specific index that must be used to measure any cost-of-living raises.

How To Calculate a COLA Increase for Employees

A COLA typically can be calculated as part of an annual compensation plan review. An employer should figure out which price index they’re required to use or which one best aligns with their employees' cost of living.

For example, if the chosen index rose 6% in the past year, employee compensation would be adjusted similarly. Employees with a $100,000 base salary might receive a 6% raise, or $6,000 for their COLA, before 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 Social Security Cost-of-Living Adjustment on Average?

Over the years, COLAs have varied. In some years, prices have been largely stagnant, resulting in either no or minimal adjustment, as shown in the chart below. This year's 2.5% COLA is a slightly smaller percentage compared to the 2024 COLA of 3.2%. Historically, adjustments to the minimum wage were enacted to help 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 the rise of the cost-of-living.

Understand How Cost of Living Impacts Your Business

Keeping employee pay competitive is at the forefront of talent acquisition and retention. Aligning wages with cost-of-living adjustments is a smart addition to your hiring, retention, and compensation strategies for 2025.

Planning to introduce a cost-of-living raise this year? Simplify the process by collaborating with your payroll provider to roll out the increase seamlessly.