Compensation encompasses myriad schemes that organizations use for providing their employees money in return for their labor. When designing and implementing a compensation system, organizational decision makers must ask many questions and address many issues. How much should we pay our employees? Should pay be based on the job or on the person? Should employees be paid fixed rates, or should pay vary as a function of seniority or performance? What is the appropriate pay structure across the organization; that is, how much compensation discrepancy should there be between good and poor performers or between new and long-tenured employees? Researchers have studied compensation issues for many years and have generated a wealth of research evidence on some important issues, but other issues remain lightly researched. In this entry, a sample of this evidence is outlined and described. First, issues and evidence regarding base pay levels are addressed. Second, the types of variable pay and incentive plans are outlined. Third, the evidence and issues concerning the structure of pay in the organization but within and across organizational levels are described.
The issue of how much to pay employees for their work has perplexed compensation decision makers for many years. An influential theoretical approach in economics, the neoclassical theory approach, suggests that market forces compel organizations to offer basically the same market rate for work and that any differences in base pay levels across organizations will be short-lived. Research evidence, however, suggests there are large differences in the rates of pay organizations offer for the same work and that these choices have a substantial relationship with important attitudinal and behavioral outcomes in organizations. Other economic viewpoints as well as theory in the fields of organizational behavior and human resource management provide interesting insights into these issues. In recent years, economists developed a theory known as the efficiency wage theory, which suggests that organizations may reap substantial benefits from paying higher-than-market rates to their employees. In establishing a very high base pay rate, an organization may garner several advantages over competitor organizations. Offering high pay rates may simplify recruiting processes by attracting a large number of applicants from the marketplace and perhaps a larger number of qualified applicants. Selection processes may also be simplified because it may take less persuasion to entice applicants to accept job offers. The organization may also realize advantages in terms of employee productivity. For example, organizations may be able to insist on or expect higher-than-average effort, efficiency, and performance levels in return for higher pay rates. From the perspective of the individual employee, a person may work harder because he or she realizes the advantages of higher pay in the given organization. Employees may also be more effectively retained in the organization because they realize that they cannot find a similarly paying job in the marketplace. Inducing employees to give more effort as a result of high pay levels is known as the incentive effect of efficiency wages, and the attraction of greater numbers of high-quality applicants is known as the sorting effect of efficiency wages.
Why do some organizations choose to pay efficiency or higher-than-market pay rates? One reason is that some organizations rely more on their employees to generate revenue. Organizations that require highly skilled or specialized employees to generate income or those that are structured in unique ways may have a greater need to pay above-market rates. For example, some organizations have very few supervisory employees and make extensive use of self-managed work teams. Under these conditions, it may be necessary to pay employees high pay rates to ensure that they are performing at high levels. Research also suggests that the need to pay employees high rates may also be driven by the business strategy of the organization. Some organizations try to be successful by maintaining very low-cost structures, while other organizations focus on innovation or providing goods and/or services of the utmost quality. Low-cost organizations may pay low rates because employees are not as valuable in terms of creativity or quality, and therefore high effort levels and low turnover rates are minimized in importance. Innovative organizations require workforce stability and high skill levels among employees and often pay high rates as a result. Finally, organizations that have difficulty monitoring the behavior of employees because of the large size of the organization or the geographic dispersion of employees may pay efficiency wages to spur employees to work harder. Research also shows that organizations make several other important decisions about setting pay rates for their employees. For example, many organizations pay rates for jobs that are central to their functioning or core jobs (e.g., a baker in a bakery, a physician in a hospital, a logistics specialist in a freight-moving company) more than other jobs. That is, many organizations pay “efficiency” or special wages to only certain groups of employees, but average or below-market rates for other groups of jobs.
In addition to setting base pay or pay rate levels, organizations must also make decisions about whether or not to provide financial incentives for performance (e.g., merit pay raises, bonus). The use of financial incentives or pay-for-performance schemes continues to be hotly debated in the popular press and also among researchers. On the one hand, some researchers argue that providing financial inducements to individuals in return for good performance can reduce intrinsic motivation levels of employees. This argument is contained in a theory known as cognitive evaluation theory. According to this approach, if offered money as an extrinsic motivator, individuals will lose some of their basic interest in performing the tasks that are being rewarded. Perhaps more important, providing financial incentives for high performance may lead employees to focus only on the tasks that are necessary to receive the reward, while ignoring other tasks that are important but not specifically rewarded. On the other hand, other theories suggest that providing financial incentives for performance is an effective means of increasing performance levels among employees and, in addition, has no negative effect on the intrinsic motivation levels of employees. Researchers pursuing this line of investigation often rely on the psychology models of B. F. Skinner, which suggest that individuals will repeat behaviors that are effectively rewarded. Several cognitive motivation models are also frequently used to explain a positive relationship between the use of financial incentives and employee performance. These models (e.g., the expectancy theory of motivation and goal-setting theory) suggest that individuals make decisions about behavior and effort levels as a function of their beliefs that (a) behaviors will lead to high performance, (b) high performance will be rewarded, and (c) the rewards for high performance are desirable. If financial incentives are properly administered, individuals will link these cognitions and perform at high levels in return for financial rewards.
There is considerable research evidence to support a positive relationship between financial incentives and individual performance, especially in terms of performance quantity, and virtually no evidence that financial incentives reduce intrinsic motivation levels. In a recent study that cumulated research findings across a 40-year time window, there was a strong positive relationship between the use of financial incentives and the quantity or amount of work that individuals produced. The relationship between the use of financial incentives and the quality of employees’ performance (i.e., how well they work), has rarely been studied. The aforementioned study found only six published investigations on this topic over the same 40-year period. While the average relationship in these studies was positive, it was not a strong positive relationship. Much more research needs to be conducted on the issue of financial incentives and performance quality.
It is clear that nearly all organizations in the United States use some kind of financial incentive or pay-for-performance program. Some surveys suggest that more than 90 percent of U.S.-based organizations state that they pay their employees based on performance. The question is this: What type of pay-for-performance program should be used? Clearly, the most popular pay-for-performance program is merit pay. Merit pay is defined as permanent increases to base pay (a permanent pay raise) based on individual performance evaluations. Merit pay is what is known as a behavior-based financial incentive program. In these types of programs, a rater (or group of raters) evaluates the behavior of employees, compares and contrasts levels of performance among individuals in the group, and finally assigns pay raises based on the relative levels of performance. These types of programs offer several advantages to individual employees and employers: They can be used for any type of job, they allow for correction of factors beyond the control of employees when evaluating performance (e.g., faulty equipment), and they focus on the behaviors underlying effective performance. They also have several disadvantages. In particular, judgments of performance are often quite subjective, and employees may not believe that their ratings accurately reflect the quality of their behaviors.
Some research suggests that the key factor in the failure of merit pay plans is that employees do not believe that pay raises are accurately linked to performance levels. Another limitation of merit pay is that raters often fail to make clear or adequate distinctions among employees. Performance ratings tend to be biased upward; many decision makers are uncomfortable giving very low performance ratings to individuals who may deserve such ratings. Merit pay plans are also often limited by the small size of pay raises awarded. Some research suggests that pay raises must be as high as 7 percent before individuals will report that the pay raise is meaningful. Given that average pay raises in the United States over the past 15 years were typically less than 4 percent, most awarded merit pay raises are likely not effective in terms of encouraging high performance levels in the future. In general, although merit pay plans are extensively used by organizations, the research evidence concerning their effectiveness can best be described as “mixed.” There is clear evidence that the use of financial incentives relates positively to performance, but error and other failures in the administration of merit pay tend to reduce its overall effectiveness in practice. When administered effectively, merit pay raises tend to be positively related not only to individual performance but also to compensation satisfaction, or happiness with pay raises, and negatively to intentions to quit the organization.
Some organizations use what are known as results-based financial incentive plans. These types of plans, sometimes referred to as piece rate compensation plans, provide rewards to individuals for results, rather than the behaviors that may or may not lead to results. Results-based plans are typically used when there is an available objective outcome (e.g., sales volume or units produced) and when behaviors cannot be monitored effectively. The advantages of these types of compensation systems include the clear link between the outcome (sales volume or units produced) and the incentive (e.g., a percentage of the sales volume or a certain amount for each unit produced). Although these advantages are clear, these types of plans are fairly rare in the current business environment, in part because objective outcomes are difficult or impossible to obtain in most modern jobs and because most of today’s work outputs are collectively rather than independently produced.
Although individual incentive plans are the most popular forms of compensation, many organizations also include seniority provisions in compensation packages for employees, use group, unit, or organization-based incentives, and a growing number of organizations use skill-based compensation plans. Research clearly demonstrates that providing pay increases based on tenure or seniority can lower turnover rates. There is consistent and clear evidence that workforces are more stable to the extent that pay is based on seniority, but there is little evidence that these workforces are high performing. Seniority provisions provide rewards for performance only in the broadest sense possible, that is, minimum performance necessary to avoid firing or discharge, and therefore provide primarily retention inducements.
Group- and organization-based incentives (productivity gain-sharing, team-based pay, and profit-sharing plans) are gaining in popularity and offer several advantages over individually based incentive plans. These types of plans may encourage teamwork and collaboration across functional units and help develop a spirit of common fate in the organization, each of which may lead to increases in performance. These types of plans may also lead to mutual monitoring behavior among employees such that wasted time, effort, and resources are diminished when employees understand that their pay raises or bonuses are linked. There is consistent evidence that profit-sharing plans (bonuses awarded to employees based on organizational profitability) relate positively to organizational performance. These results, however, are not clear in terms of the causal direction of the relationship; perhaps only highly profitable companies adopt profit-sharing plans. A primary disadvantage of group-based incentive plans is known as the line-of-sight problem. A given employee in an organization may not believe that his or her behaviors are related to the overall performance of the group, unit, or organization. In these cases, group-based incentives may encourage shirking or free riding because the person believes that the same reward will be received regardless of his or her effort level.
Skill-based pay, also called pay for knowledge, pay for skills, and multiskilled compensation, is a relatively new compensation innovation. Regardless of the terminology used, it represents a distinct deviation from traditional compensation systems that pay employees for the jobs, not the skills, they hold. Traditional job-based systems are concerned with the nature of the task, while skill-based pay is concerned with the nature of the attributes possessed by employees. Under these plans, an employee’s pay level is set for the skills he or she holds at the current time, and the individual is given additional pay increases when he or she acquires a new skill and demonstrates competency in it. Moreover, pay increases are awarded whether or not individuals actually use the skills in the course of their day-to-day work. Multiskilled employees are desired by organizations because they can increase workforce flexibility and productivity. For example, an organization replete with multiskilled employees can more effectively handle periodic absences and unexpected quits than an organization using job-based pay, because many skills are essentially held in reserve in the workforce. The disadvantages of skill-based pay plans are that they are difficult to administer, involve a complete renovation and integration of the human resource management system, and can sometimes, although rarely, lead to prohibitively high pay levels in the organization. Although these types of plans are still fairly rare, there is evidence that they increase the flexibility and productivity of the workforce in general and that these types of plans are typically received favorably by employees.
The preceding review is but a brief sample of the types of compensation plans available to employers and employees, as well as a synopsis of the implications of adopting any given plan or combination of plans. Because compensation is one of the largest costs that organizations incur in doing business, often more than 70 percent of total costs, organizational decision makers are continually looking for ways to more effectively compensate their employees, and researchers are continuing to develop and test ideas that may lead to more effective compensation management in the future.
- Bloom, M. 1999. “The Performance Effects of Pay Dispersion on Individuals and Organizations.” Academy of Management Journal 42:25-40.
- Cowherd, D. M. and Levine, D. I. 1992. “Product Quality and Pay Equity between Lower-level Employees and Top Management: An Investigation of Distributive Justice Theory.” Administrative Science Quarterly 37:302-321.
- Gerhart, B. and Milkovich, G. T. 1992. “Employee Compensation: Research and Practice.” Pp. 481-569 in Handbook of Industrial and Organizational Psychology, 2d ed., edited by M. D. Dunnette and L. M. Hough. Palo Alto, CA: Consulting Psychologists Press.
- Gerhart, B. and Rynes, S. L. 2003. Compensation: Theory, Evidence, and Strategic Implications. Thousand Oaks, CA: Sage.
- Gerhart, B., Trevor, C. O. and Graham, M. E. 1996. “New Directions in Compensation Research.” Research in Personnel and Human Resources Management 14:143-203.
- Jenkins, G. D. Jr., Mitra, A., Gupta, N. and Shaw, J. D. 1998. “Are Financial Incentives Related to Performance? A Meta-analytic Review of Empirical Research.” Journal of Applied Psychology 83:777-787.
- Lawler, E. E. III and Jenkins, G. D. Jr. 1992. “Strategic Reward Systems.” Pp. 1009-1055 in Handbook of Industrial and Organizational Psychology, 3d ed., edited by M. D. Dunnette and L. M. Hough. Palo Alto, CA: Consulting Psychologists Press.
- Pfeffer, J. and Davis-Blake, A. 1992. “Salary Dispersion, Location in the Salary Distribution, and Turnover among College Administrators.” Industrial and Labor Relations Review 45:753-763.
- Shaw, J. D., Duffy, M. K., Mitra, A., Lockhart, D. and Bowler, W. M. 2003. “Reactions to Merit Pay Increases: A Longitudinal Test of a Signal Sensitivity Theory.” Journal of Applied Psychology 88:538-544.
- Shaw, J. D., Gupta, N., Mitra, A. and Ledford, G. 2005. “Success and Survival of Skill-based Pay Plans.” Journal of Management 31:28-49.