Each year, clubs that exceed a predetermined payroll threshold are subject to a Competitive Balance Tax -- which is commonly referred to as a "luxury tax." Those who carry payrolls above that threshold are taxed on each dollar above the threshold, with the tax rate increasing based on the number of consecutive years a club has exceeded the threshold.
A team's Competitive Balance Tax figure is determined using the average annual value of each player's contract on the 40-man roster, plus any additional player benefits. Every team's final CBT figure is calculated at the end of each season. (Note: If a player signs a contract extension that doesn't kick in until a later season, his AAV for the purposes of the CBT doesn't change until the new deal begins.)