Compensatory Time Might Not Be Legal
It is generally illegal to give employees straight comp time -- one hour off for every extra hour worked -- rather than overtime pay.
Some employers adopt a policy of giving their employees compensatory, or "comp," time -- an hour off at some later date for every extra hour worked -- instead of paying them overtime. But these policies are generally illegal under federal law, at least for private employers (state and local governments can offer comp time, in certain circumstances). The reason? They preclude employees from collecting an overtime premium -- the extra pay to which they are entitled for working more than a set number of hours. (For more information on overtime, see Nolo's article When Must Employers Pay Overtime?)
This means that if you wish to give your employees time off instead of money for extra hours worked, you cannot simply establish an hour-for-hour policy (that is, letting the employee take an hour off for every hour of overtime worked).
Alternatives to Overtime
So what are the alternatives to simply paying the employee overtime? You may be able to rearrange an employee's schedule during a workweek to ensure that the employee does not work overtime. Under federal law, an employee who works no more than 40 hours in a week has not worked overtime and is not entitled to overtime pay. So, for example, an employee who works four 10-hour days and then has three days off need not be paid overtime.
If your state has a daily overtime standard, this may not be possible unless the law explicitly allows you and your employees to agree on an alternative workweek. A daily overtime standard means that workers are entitled to overtime if they work more than a set number of hours in a day, even if they ultimately work fewer than 40 hours in a week. California and Colorado are among the states that have a daily overtime standard. To find out the rules in your state, contact your state labor department; you can find links at the federal Department of Labor's website, here.
You can also adjust an employee's hours during a pay period so that the amount of the employee's paycheck remains constant. To make this work, the employee must take an hour-and-a-half off for every extra hour worked. For example, if an employee who usually earns $1,600 every two weeks (or $20 an hour) works an extra 10 hours during the first week of the pay period, the employee is entitled to $300 in overtime pay -- 10 hours multiplied by one-and-a-half times the employee's hourly rate, or $30. If the employee took 15 hours off in the second week of the pay period, however, his or her paycheck would remain the same -- the employee would receive $300 in overtime pay, but would be docked $300 (15 hours multiplied by $20 an hour) for the time not worked. While you'll have less of the employee's time, it will help keep costs down.
For extensive information on the most important federal laws dealing with employment issues, see The Essential Guide to Federal Employment Laws, by Lisa Guerin and Amy DelPo (Nolo).