How to Handle Vacation and PTO Pay in California

California treats vacation pay as earned wages, not as a benefit the employer can take away. This single rule drives most of the complexity around vacation and PTO in California. Getting it wrong creates legal liability, not just an HR headache.

The Core Concept: Vacation Pay Is a Wage

Under California law, vacation pay accrues as wages the moment an employee earns it. Once accrued:

• It cannot expire. California prohibits use-it-or-lose-it policies. If your policy says vacation not used by December 31 is forfeited, that policy is illegal in California.
• It must be paid out at termination. All accrued, unused vacation must be included in the employee's final paycheck at their final rate of pay.
• An employer can cap how much vacation accrues (e.g., you stop accruing once you reach 120 hours), but cannot take away vacation already earned.

PTO vs. Vacation vs. Sick Leave

If you have a single PTO bucket that covers both sick time and vacation, California treats the entire bucket as vacation wages. The safest approach for employers who want to separate the termination payout risk is to maintain separate sick leave and vacation/PTO balances.

Normal Procedure

Setting up vacation/PTO accrual in QBO Payroll

1. In QBO Payroll, go to the employee's profile.
2. Under Pay types, find Time Off.
3. Set the accrual rate (hours per pay period, or a lump sum at the start of the year).
4. Set any accrual cap you want to apply.
5. Do not configure a use-it-or-lose-it reset, this is not permitted under California law.
6. Save.

QBO will track the accrued balance and dollar value automatically on every payroll run.

Processing vacation pay when time is taken

1. When running payroll for the period, enter the vacation hours in the Time Off section.
2. QBO calculates the payout from the accrued balance.
3. Review and approve.

Paying out vacation at termination

1. Pull the employee's accrued vacation balance from QBO Payroll before processing the final paycheck.
2. The payout is calculated at the employee's final rate of pay, not the rate when the vacation was earned.
3. Include the vacation payout in the final paycheck. Final paycheck timing in California: immediately if terminated/discharged; within 72 hours if the employee resigned without prior notice.

Abnormal Procedures

An employee used more vacation than they have accrued (vacation advance).

You can allow vacation advances at your discretion, but document the arrangement. California prohibits negative vacation banks going forward, you cannot maintain a policy where employees routinely receive vacation before earning it and then owe it back. If an employee leaves with a negative balance, you generally cannot deduct it from their final paycheck under California wage law. Get advice before allowing this.

You currently have a use-it-or-lose-it policy.

It needs to be changed. Replace it with an accrual cap: employees stop accruing once they hit the cap, but they don't lose what they've already earned. Communicate the change to employees clearly and in writing before implementing it.

An employee has a large accrued vacation balance and you're terminating them.

The payout is owed regardless of the reason for termination, the length of tenure, or the size of the balance. Budget for it. If the amount is significant, it may make business sense to encourage vacation usage before a planned termination.

You've been running payroll without tracking vacation accrual.

You likely have an outstanding liability. Work with your NCO team to calculate what should have accrued for each affected employee and determine how to bring it current. Depending on the situation, you may need to issue retroactive payments.

FAQ

Does vacation pay apply to contractors?

No. Vacation pay is an employment law entitlement for employees only. This is one of the key differences between employees and contractors.

Are vacation payouts subject to payroll taxes?

Yes. Vacation pay, including termination payouts, is employment income. Federal income tax, Social Security, Medicare, California PIT, and SDI are all withheld, same as regular wages.

Can we set a waiting period before vacation starts accruing?

Yes. You can require employees to complete a waiting period (e.g., 90 days) before they start accruing vacation. You just cannot require a waiting period before they can use vacation they've already accrued.

What if our vacation policy is more generous than the law requires?

That's fine. California law sets the floor. If your policy gives employees more vacation than the minimum, all of it is still subject to the same rules, no use-it-or-lose-it, paid out at termination.

Does the new 5-day sick leave requirement (2024) affect our vacation policy?

Only if your PTO bucket covers sick time. If you have a separate sick leave policy that provides at least 5 days per year, your vacation policy is unaffected. If you use a combined PTO policy, make sure it provides at least 5 days/40 hours per year to satisfy the sick leave requirement, and remember the entire balance is treated as vacation for termination payout purposes.