Workers’ Compensation is a mandatory type of business insurance that provides employees who become injured or ill while on the job with medical coverage and income replacement. It also protects companies from being sued by employees for the workplace conditions that caused such an injury or illness.

Businesses are required by law in all fifty states to pay for the medical treatment and lost wages of employees who suffer job-related injuries or illnesses. In order to avoid crippling expenses in this regard, companies purchase workers’ compensation insurance policies of one kind or another. Most states give businesses the choice of buying workers’ compensation policies either directly from the state or from a private insurer. Each state determines its own system’s payment schedules, employee eligibility requirements, and rehabilitation procedures. Although provisions of each state’s laws differ greatly, the underlying principle is the same—that employers should assume the costs of injuries, illnesses, and deaths that occur on the job, without regard to fault, and partially replace wage income lost. While income replacement under workers’ compensation is usually a percentage of the actual wage, it is counted as a transfer payment and thus is not subject to federal income tax for the employer or employee. Some state laws exempt certain categories of employees from coverage. Those most likely to be excluded are domestics, agricultural workers, and manual laborers.

Given the mandatory nature of workers’ compensation coverage and the potential expense involved, the cost of workers’ compensation insurance policies is a considerable concern for small business owners. In fact, workers’ compensation premiums stand as most companies’ second-largest operating expense, after payroll. These rates are based on the employer’s total payroll, the classification of the employees, and the employer’s accident record. The wages paid each employee are assigned a rate based on the occupational classification in which that employee works. For example, an employee who does office work will be assigned a rate that is lower than one who works re-roofing. The employer’s cost of workers’ compensation for the office worker will likely be in the range of 0.25 to 1.0 percent of wages earned while the employee who works on roofing projects will cost the company as much as 10 to 15 percent of that employee’s gross wages.

Small business owners have less control over the cost of workers’ compensation coverage than they do over health insurance costs. State legislatures set the level of benefits and employers pay the full cost, so medical cost-containment strategies like co-payments do not apply. Some insurers avoid handling workers’ compensation policies for small businesses because they feel that smaller companies lack the funds to provide a safe working environment. In general, the rates depend upon the type of business, number of employees, and company safety record.

Penalties for failing to carry workers’ comp insurance policies can be severe. In general, business owners who are neglectful in this manner can be held liable for the medical expenses incurred by the worker in their employ. Nonetheless, many businesses engage in what is known as “premium fraud,” in which they either do not carry insurance as required or lower the costs of their policy premiums through fraudulent record keeping. Methods used to fraudulently reduce insurance premiums include underreporting of employee count or the wages they are paid, paying workers under the table in order to falsify the number of employees, misclassifying the kind of work engaged in by employees in order to reduce premiums through a misclassification of their occupation, etc. However, momentum is building to beef up penalties for these kinds of fraudulent actions, which injure insurers and honest employers alike.