Your Guide To Pay For Performance Compensation

When you’re considering a job offer, one of the most important things to make sure you understand is the position’s pay structure. A common term you might come across when looking into this is “pay for performance compensation.”

In this article, you’ll learn what pay for performance compensation is as well as its advantages and disadvantages.

Key Takeaways

• There are two categories of pay for performance compensation: merit pay increases and variable pay programs.

• Pay for performance compensation is a pay structure where employees are rewarded monetarily for reaching certain goals, key performance indicators, or benchmarks.

• When done well, pay for performance compensation can increase employee productivity and engagement, but when done poorly, these programs can damage morale and increase favoritism.

What Is Pay for Performance Compensation?

Pay for Performance compensation is a performance-based salary structure where employees are both incentivized and rewarded for meeting goals, objectives, and key performance indicators (KPIs). They may also be rewarded for hitting certain numbers, completing certain tasks, or hitting certain benchmarks.

With this compensation structure, employee’s performance will be evaluated at regular intervals, whether quarterly or annually, and is measured by pre-defined metrics. These pre-defined metrics are usually agreed upon at the beginning of the evaluation period and presented to the employee so that they may track their own progress.

In order to be considered for a performance-based raise or bonus, the employee must meet or exceed the expectations agreed upon at the beginning of the evaluation period. Essentially it means if you do good, you get rewarded, and if you don’t, it means you don’t get rewarded as well.

Pay for Performance compensation, also referred to as performance-based pay or performance-related pay, is an easy incentive for employees to do their best on the job. When your compensation is directly tied to how well or how much you do, it is easy to motivate yourself to put forth a continuous effort and meet the goals set for you.

This is a commonly used compensation structure across all industries. But, it is more common in industries, or departments, where the employee’s performance directly affects the company revenue. Sales are the most common example of performance-based pay.

Two Types of Performance-Based Pay: Merit Pay Increases vs. Variable Pay Programs

Generally speaking, there are two categories under the pay for performance umbrella: merit pay increases and variable pay programs. Companies, or sometimes specific departments, may use one or both of these compensation structures to incentivize and reward employee performance.

Each model has its own benefits and disadvantages. The model chosen by the company, even if it is a mixture of both, will depend on the company’s needs and the employee’s need to be incentivized.

1. Merit pay increases. Merit pay increases are tied to an employee’s base pay. This type of compensation structure does not include bonuses or commissions. Employees are rewarded with an annual pay bump based on their performance.

   These raises are usually awarded annually with the yearly performance review. This is the most commonly implemented pay-for-performance model. Not only does it help to reward high-performing employees, but it is also easier to budget for during the budget planning process.

   While this is the most commonly used model, it does not provide the most incentive. Many companies will employ both merit pay increases and variable pay programs to ensure that their top performers don’t start looking for employment elsewhere.

2. Variable pay programs. Variable pay programs are where performance-based bonuses come into the picture. There are a variety of options that can be utilized, and many organizations will use a combination of different variable pay programs, but they are either discretionary bonuses or non-discretionary bonuses.

   These bonuses can vary from payout period to payout period and may be rewarded quarterly, annually, or both. Typically, they are paid out multiple times per year.

   • Discretionary bonuses. These types of bonuses are not written into employee contracts and are provided on an ad-hoc basis to reward employees for exceptional performance or exemplary achievements.

     Discretionary bonuses are not used as a preemptive incentive. Instead, they are rewarded at the employer’s discretion when they have determined there is a well-earned reward.

   • Non-discretionary bonuses. Unsurprisingly, non-discretionary bonuses are the opposite of discretionary bonuses. These are awarded to individual employees, departments/teams, or the entire company when predetermined criteria are met.

     These are expected bonuses. The employees are aware that by meeting the criteria set for them at the beginning of the payout period, they will receive a monetary bonus. If they go above and beyond, exceeding expectations, they may be awarded additional compensation.

Advantages of Pay for Performance Compensation Programs

Companies would not put pay-for-performance compensation programs in place if they did not believe they have some benefit to the organization. There are certainly advantages for the company when they adopt this type of compensation model.

Some of the benefits of Pay for performance compensation programs include:

• Increase employee engagement. When employees feel they are seen by their superiors and their employers, they are more likely to engage in the company culture.

• Increase employee retention. Again, when employees feel seen and motivated by their superiors, it is much easier to keep them on the team.

• Increase employee motivation. These compensation programs allow employees to see the connection between the work they do and the company’s success. It is also easier to stay motivated when you are rewarded for your efforts.

• Increase employee productivity. The better an employee performs, the higher their reward will likely be. And, when they are rewarded for the work they put in, it makes them want to continue working hard.

• Help to establish or maintain company values. Performance-based compensation can make it clear what is important to the company. It isn’t always sales numbers and new leads.

• Attract, and retain top talent. It will be much easier to attract top talent and keep them from jumping ship if they know that they will be properly compensated for their efforts.

• Provide clarity to employees on compensation and raises. Understanding the raise and bonus structures of a company can give employees peace of mind.

In addition to the above advantages, there are also some additional reasons to use this type of compensation structure:

• By using predetermined criteria and specific metrics to define performance, it is easier for employees to understand where they need to improve.

• They allow for an easy and effective way of handling poorly performing employees.

• They make it more clear when an employee is consistently performing poorly or performing above expectations.

• Managers can set more structured goals.

• Employees know exactly what they need to achieve each payout period.

Disadvantages of Pay for Performance Compensation Programs

While there are certainly many advantages to these types of compensation programs, there are, of course, disadvantages as well. No compensation program or incentivization is perfect. There will always be some downside.

Some of the disadvantages of pay for performance compensation programs are:

• Unrealistic goals. If the goals set by superiors are unrealistic and unachievable, it can lead to a lack of motivation and will damage morale.

• Subjectivity. Some of the pay-for-performance compensation models are open to subjectivity. When subjectivity is involved, it is easy to mistake some situations as favoritism as opposed to performance-based rewards. Unfortunately, some of the situations may actually be favoritism.

• Liability for the company. Pay for performance compensation programs, especially those which involve some level of subjectivity, can open up equal pay challenges if employees feel they are not being treated equally or fairly.

• Teamwork doesn’t make the dream work. Unfortunately, these types of compensation models can negatively impact teamwork. Team members may feel more like they are competitors than allies. Teamwork-based variable pay programs can help to eliminate this issue.

• Bad years. Often with merit pay increases and non-discretional variable pay programs, the pay increases and bonuses are an expectation. If the company has a particularly bad year or the economy is struggling temporarily, these additional payouts may not be possible. Employees will not take this lightly.

Pay for Performance FAQ

1. Is pay for performance good?

   Yes, pay for performance is good. As long as your employer runs the program well, pay for performance can be a great way for employees to get motivated and get some extra cash. This pays off for companies as well in more engaged and productive employees who stick around longer.

   If it isn’t run well, however, pay for performance can result in employees working harder for less pay and more stress. This is because some pay for performance programs can set targets that are all but impossible to attain or forgo extra pay altogether if the company has a bad year.

   In addition, poorly run pay for performance programs can open up companies to lawsuits for favoritism if employees feel they aren’t being treated equally. They can also create division and unhealthy competition within teams, significantly slowing productivity.

2. What is the most common type of pay for performance used by firms?

   The most common type of pay for performance used by firms is merit pay increases. This compensation framework usually gives employees annual salary increases in degrees that are based on their performance reviews.

   With this method, top-performers will get a larger percentage increase than lower-performing employees will. While this provides some amount of incentive for employees to perform well, it doesn’t provide a lot, and it’s used more as a way to retain employees than to motivate them.

   Companies who want to increase performance incentives will use a combination of merit pay increases and variable pay programs, which provide merit-based bonuses multiple times a year.

   Employees may know that they’ll get these bonuses if they meet certain criteria, or they may receive them without warning as a reward for a job well done on a particular project.

Final Thoughts

Performance-based pay structures are becoming more and more common in all industries. When raises and bonuses are tied to compensation, it is easy to keep employees motivated and productive.

While merit pay increases are easier for companies to budget for, variable pay programs tend to be more motivating for the employees. This is why so many companies choose to employ a mixture of these two pay-for-performance structures to keep employees motivated and happy.

Author

Samantha Goddiess

Samantha is a lifelong writer who has been writing professionally for the last six years. After graduating with honors from Greensboro College with a degree in English & Communications, she went on to find work as an in-house copywriter for several companies including Costume Supercenter, and Blueprint Education.