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Pay-for-performance sits at the heart of many organizations’ compensation philosophies, deeply rooted in the belief that employees should be rewarded for their individual contributions. But does it work? Does it really motivate workers and improve business outcomes?
Salary progression and merit increases
Let’s consider the widespread practice of linking salary progression to individual performance.
Typically, during an annual review, merit increases are performance-based. Performance may be combined with position-in-range and market benchmark comp ratios in our beloved merit matrices, but it's the most common factor employers use to differentiate base pay.
Our research shows 74 percent of organizations consider it when making base pay increases. Market adjustments and the cost of labor run a distant second at 48 percent.
However, during my time as a Director of Compensation, I saw firsthand how challenging it is to use performance as the primary lever for differentiating base pay.
Linking pay to performance should drive fairness and motivate employees. In practice, it rarely delivered the desired outcomes. Performance assessments were clouded in bias, and managers struggled to justify pay differences.
Budget constraints often turned differentiated increases into meaningless gestures. The result? A system that looked good on paper but failed to deliver in practice.
These experiences stayed with me, raising a fundamental question: if performance-based merit increases don’t deliver the desired results, what’s missing from the equation?
Before answering this question, let’s first examine how performance became the dominant driver of pay progression, digging into my love of compensation history.
A brief history of performance-based pay
We can trace the origins of pay-for-performance back to the Industrial Revolution when compensation became tied to the number of “units” factory workers produced. Making more widgets meant a bigger payday.
But it wasn’t until 1975 when pay-for-performance, as we know it today, was introduced by the American Compensation Association — now known as World at Work. Perhaps you’ve heard of them.
Corporate culture in the 1980s and 1990s proved a fertile ground for linking comp to individual performance, reflecting the era’s conviction that money was the key to peak productivity. Many organizations adopted performance reviews during this period as the standard for pay increases.
This approach wouldn’t go unchallenged forever. In the mid-2010s, performance reviews began receiving pushback after several studies in organizational psychology claimed they failed to drive results.
Prominent management consulting firms even labelled the practice a useless corporate ritual. Some companies took note, abandoning performance reviews in favor of more innovative models to engage employees and motivate higher performers.
Now pay transparency is forcing an even deeper reckoning. Driven by evolving legislation, many employers are examining the true factors behind pay differentiation.
Will this renewed focus on roles’ compensable factors offer an alternative to merit increases? Or will companies continue business as usual?
Criticisms of pay-for-performance
Performance reviews can be riddled with bias, raising questions about the validity of tying merit to pay progression.
Managers may bring unconscious biases into annual reviews. Positive (or negative) first impressions might create a halo effect that undermines objectivity, giving an unfair advantage to some and penalizing others.
More alarmingly still, there’s ample research, including Payscale’s own Gender Pay Gap Report, showing how these biases adversely impact the pay progression of women, people of color, and other historically disadvantaged groups.
Some managers also struggle to set meaningful goals that strike the right balance between challenging and achievable. This becomes especially difficult for roles that require soft skills, such as leadership and communication, causing managers to default to overly simplistic metrics or vague objectives.
Finally, performance reviews focus almost solely on last year’s achievements. Considering only an employee’s past contributions, and not their future capabilities, is a missed opportunity.
This backward glance limits organizations’ ability to connect pay progression with anticipated needs and retain employees with high potential.
Compounding these problems, pay-for-performance may fall short in two fundamental ways:
Limited pay differentiation: Merit increase budgets are rarely large enough for meaningful pay differentiation for top performers. Base pay increases should make an impact that employees feel.
What's the difference between a 2 percent and a 4 percent increase for a high performer earning $80,000?
Assuming bi-weekly pay periods, it’s $61.54 per check. Not even enough for dinner and drinks at a modestly priced restaurant. For pay-for-performance to work, high performers must actually notice it in their wallets.
Increased internal inequities: Performance-based pay increases can perpetuate internal inequities that persist for years.
Consider the following example. Employee A delivers outstanding performance in their first year on the job and receives a 5 percent pay increase. Employee B has average performance and gets a 3 percent increase.
Suppose both employees receive a 2 percent increase for the remainder of their tenure at the company. In that case, Employee A will come out ahead, even if they’re never able to replicate the same high level of performance.
What does this mean for how your organization approaches merit increases? I’m not advising you throw out your merit matrix and revert to the “peanut-butter method” of giving every employee the same 2 or 3 percent cost-of-living increase. Those days are far behind us.
I am suggesting that employers consider factors beyond performance in making increase decisions.
What should drive your compensation strategy?
This is the real question. Do you only want to reward performance and make market adjustments? Or are there other factors that should come into play?
Consider things such as at-risk talent, experience, skills acquisition, and potential.
Does your compensation strategy give you the flexibility to reward both performance and potential?
Let’s explore other options for base pay progression.
- Segmented base pay “buckets”: With this approach, HR practitioners decide what they want to pay for and allocate increase budget amounts into different buckets. For instance, comp teams might allocate some of their salary increase budget toward retention and another for merit.
- Points system: You might also assign each compensable factor a point value. The number of points you assign to each factor will determine the size of its allocation.
- Pay progression formula: A pay progression formula is like a regression analysis. Take the base amount and add percentages to the different factors. For example, merit might account for 25 percent of your budget, while experience may be weighted at 10 percent.
- Multi-dimensional merit matrix: My personal favorite is the multi-dimensional merit matrix. It considers performance as an essential variable in base pay increases, while including other factors such as potential and attrition risk.
I’ve seen organizations introduce multi-dimensional merit matrices for allocating pay increases. Those who are successful have compensation planning software that allows managers to evaluate employees across different factors.
This isn’t a plug for Paycycle — Payscale’s compensation planning software. If your HRIS system has a compensation planning tool, it might be perfectly adequate in giving managers what they need to make increase recommendations.
However, not all compensation planning tools are created equal. Some HRIS systems simply don’t provide enough guidance to people managers, making for a messy increase cycle.
Before you introduce a different base pay progression system, make sure you have the right tools for the job.
The future of pay-for-performance
With salary budget season in full swing, it’s a great time to assess how you’ll approach pay increases this year. You might want to change your tactics and consider different (and more varied) compensable factors.
Ideally, you want a comprehensive performance reward strategy that extends beyond annual merit increases to create meaningful pay differentiation and ongoing recognition.
You might consider one-incentive programs, such as targeted bonuses, LTI, or profit-sharing arrangements, to reward exceptional contributions.
Also, think holistically about your employee value prop. What monetary and non-monetary rewards might you offer high performers? These could be everything from remote work options to professional development opportunities.
Remember: recognition of outstanding performance shouldn't be relegated to annual review cycles. With well-designed employee recognition programs, you can foster a culture where exceptional performance is consistently acknowledged throughout the year.
Despite my misgivings about merit and performance as the only factor for year-end increase cycles, I wouldn’t advise organizations to throw the performance-based baby out of their increase pool.
Instead, the future of performance-based pay will belong to organizations that consistently recognize outstanding performance while also accounting for other factors in base pay progression.
Are you ready to challenge the conventional wisdom and embrace true pay differentiation?
