7 Steps to Effective Merit Compensation Plans

Mar 14, 2017

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Thinking logically, using merit pay to reward high performers and encouraging low performers to leave or improve should work. But after decades of using merit pay to improve employee performance, the industry consensus seems to be that merit plans don’t improve employee engagement.?

In spite of all the recent noise about the ineffectiveness of merit pay plans, we see a different problem. The fundamental issue, as we see it, is when the real purpose of a pay increase is disguised as merit pay.

Why Merit Pay Plans Fail

As in most human endeavors, the original principles of merit pay get lost during the implementation, or over time as routine procedures lose their purpose.

  • When companies fail to fund their programs, it sends the message that pay for performance is not important.
  • If everyone gets a merit increase and high performers get just a bit more, the annual pay increase becomes an entitlement. Employees see through the ruse when their employer calls pay increases “pay for performance” when the employer is only responding to market changes or inducing people to stay.
  • Supervisors often cannot explain the reasons for a salary change. If they can’t give an increase, they sometimes blame it on HR or management instead of explaining the real circumstances.
  • Almost all of us think we are “better than average.”[1] Many people have a difficult time with being labeled average, especially when it affects income. Try explaining your “averageness” to your spouse.
  • Most people have an innate need to feel their earning power is increasing. When it doesn’t, they become dissatisfied and look for other avenues of growth.
  • The metrics and evaluations used to differentiate among employees are often lacking or deeply flawed.

Recommendations for an Effective Merit Pay Plan

None of these issues negate the principle of merit pay, and with careful planning and diligence, you can overcome each one of them. But for most organizations, a little tweak here or there won’t solve the issues. It requires a fundamental, strategic, organization-wide approach.

  1. First, make a commitment to truth and transparency. Provide clear and consistent policies and communicate them well. Identify your employee groups and tailor your communications to each audience. Make sure every individual knows the factors that affect pay and how you calculate increases.
  2. Second, agree on the strategic compensation plan and the purpose of each of its components. Understand that you should base merit pay on sustained performance of regular job duties, not on projects or events. You are not rewarding past achievements—you are paying for expected future performance.
  3. Do not lump merit pay with other compensation increases. If you are providing a general increase for everyone, say so. If you are adjusting for market changes, don’t call it pay for performance. If your past practices have made an annual “merit” increase automatic, consider designing an organizational change to a different mindset.
  4. Define what you mean by performance and devise accurate, credible ways to measure it. Use multiple information sources. If teamwork is a component, get feedback from the team. For customer service, include customer-centric behaviors, not just customer feedback metrics. For sales, consider the difficulty of making the sale, not just the sales numbers, and consider sales assists in the calculations.
  5. Train managers and supervisors on how to discuss compensation and hold them accountable for doing it well.
  6. Measure results. Get feedback from employees. Talk with those who are leaving to understand If the program was a factor. Include the merit plan in your pulse surveys and publish the results and the action you will take.
  7. Implement the right technology. The minimum requirement is a robust compensation tool integrated with talent management and business analytics. Managers should have every detail they need to consider at their fingertips when they are deciding on compensation. Ease their administrative burden as much as possible so they can focus on making the right decision.

Communication is the Key to Effective Compensation Planning

Finding the right mix of incentives to drive performance and retain talented employees requires an open dialogue. Consider your communications carefully to develop the kind of trust that fosters effective two-way communication.

If you find any of our suggestions controversial, or you would like to start a conversation, please share this article with your comments.


1. Scicurious. "The Superiority Illusion: where everyone is above average." Scientific American. August 06, 2013. 

Pixentia is a full-service technology company dedicated to helping clients solve business problems, improve the capability of their people, and achieve better results.

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