The concept of performance-based pay is one with which most of us can identify. We grew up participating in spelling bees, playing competitive sports, and challenging our peers – there was always a winner. We carried this philosophy into other areas of our lives, pursuing school achievements and career goals.
We are taught that those who work hard receive recognition and reward. This fairness is a crucial aspect of performance-based pay that can reassure you about its implementation in your business.
While performance-based pay may seem straightforward, it’s more complex than awarding a trophy to a competition winner. Performance-based compensation has its own set of advantages and disadvantages. Understanding these can be instrumental in determining whether a merit-based pay system is the right fit for your business.
What is Performance-Based Pay?
Performance-based pay plans involve compensating employees for specific outcomes or work that exceeds the typical call of duty. When designing a performance-based compensation system, common criteria include:
- Job category
- Length of service
- Job classification
- The goal of the incentive
- What the payout will consist of (e.g., bonus, stock, or cash)
There is much to consider when deciding whether to implement a performance-based pay structure. Understanding how performance-based pay works is crucial to aligning employee incentives effectively. So, let’s examine the advantages and disadvantages of performance-based pay.
Advantages of Performance-Based Pay
There are many benefits of performance-based pay, recognizing those delivering the highest results to your company. Employees feel appreciated when their work is valued, but sometimes, words of affirmation and encouragement only go so far. Instead, offering monetary recognition can result in higher rewards for your high-performing employees and the organization.
Identify Areas For Improvement
By implementing a performance-based pay system, your company can quickly identify top-performing employees and hone in on workers who may contribute less. Quantifying an employee’s contributions can help you determine the reasons for varying performance levels. This process identifies areas for improvement and opens up opportunities for growth and development within your organization.
Low-performance factors can include an ineffective training process, lack of accountability, and miscommunication from superiors about job expectations. Companies that use performance-based pay can identify areas where their businesses can improve. Offering pay increases based on performance allows you to focus on individuals who need more guidance and strategize on change.
Another way to identify areas of improvement is to incorporate performance appraisals into your merit-based compensation plan. Employers can conduct performance appraisals yearly, semi-annually, or even quarterly. They provide a valuable opportunity to discuss individual performance with your employees and create a customized growth plan. The program monetarily rewards the employee as the individual achieves their performance goals, inspiring a culture of growth and development within your organization.
Increase Retention
Performance-based pay models help employers differentiate between top and low-performing employees. When top performers are paid a higher compensation rate and recognized for their performance, they are more inclined to remain with their organization. Employees on a compensation plan based on performance are more driven to reach goals and earn extra money.
A performance-based compensation plan encourages more valuable contributors to continue their best work because they are paid fairly for their efforts. These workers are also more likely to become your biggest brand ambassadors and attract other qualified employees to your organization.
Better Recruiting
When companies can identify those employees who perform better, they can improve their recruiting processes. Instead of vetting and hiring employees who might not contribute to the organization, they can use data on their top performers to hire candidates with similar attributes, goals, and personalities.
This assessment process can save companies time and money by hiring top candidates from the start. Streamlining the recruiting process by consistently hiring people who are the right fit will also decrease turnover costs.
Disadvantages of Performance-Based Pay
Once you identify potential areas for improvement, performance-based compensation models offer many benefits. However, potential disadvantages should also be considered when weighing the pros and cons of performance-based pay.
A Blurred Line
Unfortunately, it’s incredibly challenging to accurately and proportionally pay employees using this system. There is often a blurred line between job role expectations and levels of compensation. If you do not precisely outline compensation and performance metrics, there could be confusion and miscommunication about company expectations to reach compensation goals.
This confusion can lead to disgruntled and discouraged employees who are not receiving the pay they expected. Additionally, a blanket policy encompassing your organization’s departments is likely inadequate since work significantly differs company-wide.
Use tools to determine the appropriate compensation employees are entitled to based on experience, tenure, and education level. Then, you can decide what type of performance-based compensation structure might work for your employees. This approach ensures that the pay is fair and reflects the employee’s actual work, aligning with the overall goals and metrics established by the performance model.
Misalignment of Goals
For top performers who receive additional compensation for their work, there is the possibility they could eventually reach a cap on their earnings. When employees are motivated solely by the incentive to receive a higher wage, this could become their only focus—forgetting about your organization’s goals.
Those whose contributions impact results might negatively affect company missions, goals, and culture in this situation. Developing a performance-based compensation system that aligns with your organization’s goals is essential. This alignment ensures everyone is working towards the same objectives and is rewarded for meeting benchmarks. Additionally, incorporating metrics that accurately assess job performance will help ensure that employees are fairly compensated based on their contributions to the company’s success.
The Threat of Dissolving Profits
Sometimes, companies use performance-based compensation to motivate employees without fully understanding the potential issues that could result. Weighing the pros and cons of performance-based compensation requires thorough research to evaluate fair pay for certain compensation levels.
Often, the allure of increased income incentivizes higher performance, which is all good and well. However, companies may need a plan for when the cost outweighs the benefits. If the promise of extra compensation causes your employees more stress and impacts their productivity, you may experience the law of diminishing returns.
It’s crucial to strike a balance between the amount of work expected and the additional compensation in a performance-based incentive. If the incentive is too small, it may not motivate your staff to work harder. Conversely, if it’s too large, it could impact your company’s profits. A balanced approach is critical to the effectiveness of a performance-based compensation system.
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Types of Performance-Based Compensation
There are many different ways to create performance-based pay structures. Let’s take a look at the two general types of performance-based compensation:
1. Merit-Based Pay Increases
Merit pay increases or merit bonuses increase an employee’s base pay due to their high performance. They are generally budgeted for and given on an annual basis. Merit-based increases are the most common form of performance-based compensation.
However, according to Salary.com, the external market is progressing in pay faster than merit pay increases alone can match. Therefore, your top performers could potentially leave for a more competitive performance-based paycheck.
2. Variable Pay Programs
Another type of performance-based compensation system is variable pay programs. These compensation plans are based on performance and consist of discretionary and non-discretionary bonuses. Variable pay programs, such as quarterly ones, are typically delivered multiple times yearly.
Many companies use a combination of discretionary and non-discretionary bonuses to create a customized performance-based pay structure. Over the years, the number of businesses committing at least 10% of their payroll budget to discretionary and non-discretionary bonuses has more than doubled.
Furthermore, 53% of organizations utilize individual incentive pay plans with a combination of merit bonuses and shorter-term incentives comprising their performance-based compensation models.
Performance-Based Pay Examples
Now that we have discussed merit increases and variable pay programs let’s take a look at some performance-based pay examples:
Merit-Based Increase Example
Merit-based increases are typically a small percentage of an employee’s overall salary. The average merit increase is about three percent and given to employees on an annual basis. This percentage can vary from company to company and even from employee to employee, depending on performance.
Example
A three percent performance-based salary increase for an employee earning a $50,000 annual salary in 2024 is an additional $1,500 yearly. Therefore, this employee’s salary would increase to $51,500 in 2025.
Discretionary Bonus Examples
Discretionary bonuses reward employees on an as-needed basis when they demonstrate exceptional performance. These types of performance-based bonuses are usually rewarded without taking company goals into account and can include:
- Holiday Bonuses: These types of bonuses are awarded to employees at the end of the year to signify gratitude and appreciation. Typically, a holiday bonus is given equally to the entire staff.
- Project Bonuses: These bonuses are given to employees for completing outstanding work on a particular project.
- Spot Bonuses: These bonuses reward employees for “on the spot” achievements that deserve recognition.
Example
A three percent performance-based salary increase for an employee earning a $50,000 annual salary in 2024 is an additional $1,500 yearly. Therefore, this employee’s salary would increase to $51,500 in 2025.
Non-Discretionary Bonus Examples
Non-discretionary bonuses reward employees, teams, or the entire company for meeting specific pre-defined goals. They may be considered short-term or long-term incentives depending on how long the performance is measured. These types of bonuses include:
- Individual Incentive Bonuses: These bonuses are typically based on measurable and predetermined objectives evaluated during a specific period, such as quarterly.
- Team-Incentive Bonuses: These types of bonuses are focused on specific goals that must be met for an entire team and are rewarded based on that group’s performance.
- Company-Wide Bonuses: These bonuses are based on specific goals the organization meets at a particular time and are awarded to all company employees.
Example
Let’s say an employee making $40,000 yearly receives an incentive bonus of $1,000 in one of four quarters for 2024. This incentive bonus would increase the employee's gross income for 2024 to $41,000.
Other Types of Bonuses
Although not tied directly to performance-based pay, there are other types of bonuses companies use to foster employee engagement and retention:
- Referral Bonus: This type of bonus is given to an employee who refers a qualified candidate for a job position. If the candidate is hired, the referring employee receives a bonus.
- Retention Bonus: This bonus is awarded to high-tenure employees or workers in competitive roles to decrease their potential for leaving.
Example
An employee making $30,000 a year refers a qualified candidate for an open job position. The organization hires the applicant, and they complete their 90-day onboarding period. The company’s referral bonus is $500, so the referring employee’s annual salary for that year is $30,500.
So, is Performance-Based Pay Effective?
Is performance-based pay effective? It can be an effective way to motivate your employees and reward them for being more productive. The advantages include increased employee retention, better recruiting, and higher performance.
However, finding the right balance between job role expectations and compensation is crucial. You don’t want to create a situation where your employees feel increased pressure to perform because they don’t want to lose out on additional compensation.
Understanding your company’s current compensation structure, employee hierarchy, and future goals is essential when determining if it’s right for you. A performance-based compensation system is not one size fits all, so consider a combination of merit increases and incentive bonuses. You want to engage your employees without creating a mindset of overworking themselves to meet goals and earn additional compensation.
If you’ve weighed the pros and cons of performance-based compensation and feel it’s the next step for your company, communicate with your employees and analyze the potential costs. Make sure employees understand how they will receive performance-based rewards, clearly outlining the criteria and metrics used to determine these compensations. Ensure performance measurements are in place to track your goals for your workers and organization to ensure an effective performance-based compensation structure.
How APS Can Help
APS provides an all-in-one platform for managing payroll and HR processes. HR professionals can manage and track performance-based compensation plans to ensure employees are rewarded for their contributions. Human resource management can also focus on employee benchmarks with performance management systems.
Set goals to maintain staff accountability and boost employee engagement. Organizations can eliminate miscommunication, foster company-wide and individual visibility, and promote growth. For more information, please contact us today.
Sources
- Designing and Managing Incentive Compensation Programs
- Advantages and Disadvantages of Merit Pay
- Law of Diminishing Marginal Returns: Definition, Example, Use in Economics
- The Relationship between Performance and Compensation: Does Better Performance Follow the Money?
- Pay for Performance
- Discretionary vs. Nondiscretionary Bonuses: Key Differences
