Organizations often seek to link pay to a measure of performance in order to attract, motivate, and retain the best employees. The organization can link pay increases to the performance of an individual, a group, or the whole company. There are many forms of individual performance-related pay, the most popular being merit-based pay, because it can be applied to many jobs and covers a broad range of performance criteria. Under a merit-based pay system, an employee’s pay increase is based on a supervisor’s assessment of performance over a previous time period, usually the prior 12 months. Reward for past performance is intended to increase performance in future time periods. Pay increases made under a merit-based pay system accumulate in base pay, so that subsequent increases build on the increase of the previous year. In some organizations, the merit-based pay system is the only means for achieving a pay increase. It also serves as the mechanism for moving employees through the pay range for the job.
The annual cycle of a merit-based pay scheme commences with the establishment of performance objectives, either by the supervisor or jointly between the employee and the supervisor. Progress toward these objectives is monitored over the ensuing months, although the formal rating of the employee usually occurs at the end of the evaluation cycle. The supervisor is required to rate the performance of an employee against the objectives established at the beginning of the cycle, typically on a three-, five-, or seven-point scale. Each of these rating points is then associated with the amount of a pay increase (usually expressed as a percentage), so that the higher the rating, the higher the amount of the merit-based pay increase. The size of the pay increase can also vary depending on the position in the pay range. Typically, employees at the bottom of the pay range with high performance ratings will get a larger increase than an employee near the top of the pay range with a high-performance rating. In some cases, the intention is to enable the employee to reach the top of pay range at the same time as he or she is ready to be promoted (and therefore eligible for further merit-based increases).
The magnitude of the merit increases will also be a function of the merit-pay budget made available by the organization, which reflects not only the financial circumstances of the organization but also their view of how much of a merit-pay increase is necessary to affect employee behaviors. There has been some research that has attempted to determine this “optimal” amount, though there is no agreement on the quantum. A further difficulty is that merit-based pay is not supported by all employees. Past research has demonstrated that merit-based pay is attractive to some occupations (for example managers) and to certain demographic groups (such as white-collar workers, high-income earners, and younger employees), but it might not be the best remuneration approach for all occupations, individuals, or organizations.
- Brown, M. 2001. “Merit Pay Preferences among Public Sector Employees.” Human Resource Management Journal 11:38-54.
- Heneman, R. L. 1992. Merit Pay: Linking Pay Increases to Performance Ratings. Reading, MA: Addison-Wesley.
- Lowery, Petty, M. and Thompson, J. 1996. “Assessing the Merits of Merit Pay: Employee Reactions to Performance Based Pay” Human Resource Planning 19:26-37.
- Milkovich, G. T. and Wigdor, A. K. 1991. Pay for Performance: Evaluating Performance Appraisal and Merit Pay. Washington, DC: National Academy Press.