Merit Pay as an incentive

Merit pay or a merit raise is any salary increase the firm awards to an individual employee based on his or her individual performance. It is different from a bonus in that it usually becomes part of the employee’s base salary, whereas a bonus is a one time payment. Although the term merit pay can apply to the incentive raises given to any employee – exempt or nonexempt, office or factory, management or non-management – the term is more often used for white collar employees and particularly professional, office, and clerical employees.

Merit pay is the subject of much debate. Advocates argue that only or other rewards tied directly to performance can motivate improved performance. They contend that the effect of awarding pay raises across the board (without regard to individual merit) may actually detract from performance, by showing employees they’ll be rewarded of how they perform.

Detractors present good reasons why merit pay can backfire. One is the dubious nature of many firms’ appraisal processes. Since the appraisals are unfair, so too will be the merit pay you base them on. Similarly, supervisors often tend to minimize differences in employee performance when computing merit raises. They give most employees about the same raise, either because of a reluctance to alienate some employees or because of a desire to give everyone a raise that will at least help them stay even with the cost of living. A third problem is that almost is that almost every employee thinks he or she is an above average performer so getting a below average merit increase can be demoralizing.

One study focused on the relationship between performance ratings and merit pay raises for 218 workers in a nuclear waste facility. The researchers found a “very modest relationship between merit pay increase and performance rating. Yet, while problems like these can undermine a merit pay plan, there seems little doubt that merit pay can improve performance. But you must be sure to conduct the appraisals and allocation fairly and effectively.

Merit Pay Options

Two adaptations of merit pay plans are popular. One awards merit raises in a lump sum once a year and does not make the raises part of the employee’s salary (making them, in effect, short-term bonuses for lower level workers). The other ties merit awards to both individual and organizational performance. Traditional merit increases are cumulative, but most lump-sum merit raises are not. This produces two potential benefits. First, the rise in payroll expenses can be significantly slowed. Traditionally, someone with a salary of $30,000 per year might get a 5% increase. This moves the employee to a new base salary of $31,500. If the employee gets another 5% increase next year then the new merit increase of 5% is tacked on not just to the $30,000 base salary, but to the extra $1,500 the employee received last year. Lump-sum merit increase can also be more dramatic motivators than traditional merit pay raise. For example, a 5% lump-sum merit payment to our $30,000 employee is $1,500 cash, as opposed to a traditional weekly merit payout of $29 for 52 weeks.

Typing lump-sum merit pay to both individual and organizational performance is another option. You might measure the company’s performance by, say, rate on return, or sales divided by payroll costs. Company performance and the employee’s performance using his or her performance appraisal receive equal weight in computing the merit pay. Here an outstanding performer would receive 70% of his or her maximum lump sum award even if the organization’s performance were marginal. However, employees with marginal or unacceptable performance would get no lump-sum awards even in years in which the firm’s performance was outstanding. The bonus plan at Discovery Communications is an example. Executive assistants can receive bonuses of up to 10% of their salaries. The boss’s evaluation of the assistant’s individual performance accounts for 80% of the potential bonus; 10% is based on how the division does, and 10% on how the company as a whole does.

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