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How Cost of Living Raises Work

Cost of living raises are intended to keep your pay the same in relation to rising prices.
Cost of living raises are intended to keep your pay the same in relation to rising prices.

A cost-of-living raise is an increase in pay that's intended to keep the buying power of an employee's salary the same during a period of inflation. Without a cost-of-living raise, the declining value of the dollar would leave workers with less real money in their pockets. Cost-of-living raises are also known as cost of living adjustments (COLAs), cost of living allowances and escalator clauses.

In the U.S., most cost-of-living raises are based on the Consumer Price Index (CPI). The CPI is an approximation of how much someone must spend to attain a certain level of well-being. It measures the price of a "market basket" of goods and services that a typical household buys. Because new products are always coming on the market and consumers tend to shift their buying choices as prices rise or fall, the CPI includes a statistical weighting that adjusts the raw price data [source: BLS: CPI].

The Bureau of Labor Statistics (BLS), which compiles the CPI, bases its measure on the purchases of a sample of wage and clerical workers. This is known as the CPI-W and is the standard most commonly used to determine cost of living raises. But not all cost-of-living raises are linked to the CPI. For example, the pay of federal employees is adjusted in part by the movement of the Employment Cost Index, which tracks pay levels for various jobs, not prices [source: Congressional Research Service].

The biggest group affected by cost-of-living raises is Social Security recipients. Some employees have contracts that include automatic cost-of-living raises. Others work for companies that voluntarily increase pay to keep pace with inflation. In at least 10 states, the minimum wage rate is adjusted according to inflation, so low-wage workers receive periodic raises [source: Cauchon].

Another type of cost-of-living raise, often called "locality pay," takes into account not inflation but local prices. When an employee is transferred to a high-cost area, a company may adjust his or her salary to make up for the loss of buying power. For example, the U.S. military raises pay temporarily for personnel stationed in high-cost-of-living posts.

The amount of the cost-of-living raises varies with inflation. Read on for more details about the average raise.

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