Pay-for-performance reward systems are one of the major types of variable-based pay plans. In compensation terms, the guaranteed salary a person receives in each paycheck is referred to as base pay. Variable pay is a monetary component that is offered in addition to base pay. Thus, variable pay plans, including pay-for-performance, involve money that is at risk of being lost. What distinguishes pay-for-performance reward systems is that the variable pay component is awarded on the basis of individual or group behavior or productivity. Such systems are seen as encouraging the retention of high-performing individuals, although skill-based pay or competency-based pay systems are seen as more consistent with high commitment workforces.
Pay-for-performance, then, is a type of variable pay that is based on behavior, productivity, or the attainment of some other goal of importance to the organization. Pay may be allocated, and also measured, at the individual, group, or organizational level. The award is an additional at-risk (i.e., unlike base salary it is not guaranteed) component that is added to base pay but does not become a part of the calculation of base pay in the future. The questions with pay-for-performance include (1) how to measure work and (2) how to convert this assessment into monetary payouts.
The four basic steps in setting up a pay-for-performance plan include the following:
- Introduction phase: Plan the switch from the old to the new compensation plan
- Design phase: Determine basic design, including consideration of various legal issues
- Formula phase: Determine basic measures and formula for converting performance to money
- Implementation phase: Introduce and communicate plan to employees
Individual Level Pay-for-Performance
Pay-for-performance may be measured and awards made at the individual level. In some ways, this may be thought of as being similar to the older concepts of piece rate, that is, a portion of individual pay is based upon the quantity or quality of individual performance. Performance may be evaluated at the individual level using objective measures of performance, performance appraisals, 360 evaluations, or evaluations of progress toward goals. A matrix is then set up in order to convert performance into pay increments; this matrix may consider simultaneously a number of performance and profitability indicators.
Organizational Level Pay-for-Performance
Pay-for-performance may also be calculated at the team, group, or organizational level and may be based upon metrics, including cost, quality, delivery, waste, production, downtime, and safety. Organizational level schemes often involve participative management and a suggestion system. Some common organizational level pay-for-performance methods include profit sharing, gain sharing, and goal sharing. The actual payout is based on a combination of performance and overall profitability. Employee involvement and trust are key components to a successful organizational-level pay-for-performance plan.
Pay-for-Performance Distinguished from Merit Pay
Both pay-for-performance and merit pay involve rewards for individual performance or productivity. The fundamental difference is in the nature of the payouts. With merit pay, the associated wage increase is added to the base salary. Thus, in future years, the base salary is increased by the merit pay award from previous years. With pay-for-performance, the additional pay must be earned or is at risk every year.
Pay-for-Performance Distinguished from Skill-and-Competency-Based Pay
Skill- and competency-based pay can be considered types of pay-for-performance but are usually distinguished. Whereas pay-for-performance rewards performance or productivity, skill-based pay provides monetary incentives for acquiring various skills, knowledge, or abilities. Competency-based plans provide rewards for the acquisition of various behavioral competencies; skill- and competency-based plans are often differentiated based upon the level of worker, lower (skill) or higher (competency). The skills or competencies need not be directly related to the current job being performed but may be related to organizational needs, roles, or more general skills.
Skill- and competency-based pay plans may include a component that is added to base pay or may involve an annual payout. The incentive to acquire skills is consistent with various plans for high commitment workforce and with individual career development.
Links to Career Development
Pay-for-performance plans at the individual level may be seen as more consistent with protean career principles than with career development within a high commitment workforce. Because the emphasis in a pay-for-performance plan is on productivity and performance, individuals may be unwilling to take time out for personal development unless they see such efforts as consistent with long-term personal goals.
Skill-based and competency-based plans are very consistent with internal career development programs and with the concept of a high-commitment workforce. Both reward directly individual investments in training and development.
Organizational level pay-for-performance plans may require an investment in development, especially among lower level employees. Such plans require greater employee commitment and an understanding on the part of employees of quantitative variables and quality-improvement methodologies. Retention rates tend to be higher among high-ability or high-performing employees under a pay-for-performance plan. Turnover rates will be higher among low-ability employees. Thus, pay-for-performance can be seen as encouraging career development among highly talented employees, as the plans are an inducement to such employees to stay with the organization. On the other hand, they may have no or a negative effect on career development among low- and mid-range employees.
Evaluation of Pay-for-Performance
Pay-for-performance involves the use of a variable or an at-risk pay component based upon either individual or group performance. As might be expected, these plans tend to lead to greater satisfaction and acceptance when performance and productivity are high, and tend to be seen more negatively during bleak economic times. In addition, the acceptance of such plans will depend on the fairness of the performance measurement systems. Skill- and competency-based methods are probably more consistent with a high commitment workforce, and an associated emphasis on career development, than are pay-for-performance plans. A recent study found that despite the increased costs of pay-for-performance reward systems, they did result in substantial positive utility.
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