What Is an Employee Pay-for-Performance Compensation Plan?

By Indeed Editorial Team

Updated October 23, 2022

Published September 29, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Implementing a performance-related compensation plan in your workplace can be beneficial to the company. It can also help motivate employees, improve their overall job satisfaction, and increase their productivity. Learning more about this plan can help you decide if it's the right fit for your workplace. In this article, we explain what a pay-for-performance plan is and how it works, share the advantages of using this type of program, and offer advice if you decide to use it at your company.

Related: What Are Compensation Strategies and Why Are They Important?

What is a pay-for-performance plan?

A pay-for-performance plan, or performance-related pay plan, refers to company programs that pay employees based on how well they do at work. Often, companies that use this plan have clear guidelines for behaviours or performance evaluation results that increase pay. For example, employees must reach a sales goal or a particular score on a performance evaluation to receive an additional payment.

Related: What Is a Performance Review? (Definition and Examples)

How does this performance plan work?

There are two standard performance-based compensation plans, merit pay increases and variable pay increases. Companies often use a combination of the two. If you're thinking about implementing a performance compensation plan at your company, it's best to consider these two options:

Merit pay increases

A merit pay increase plan is when an employee's base pay increases due to their high work performance. With this pay plan, employees go through annual evaluations and may receive a base pay increase the following year. Merit pay increase rewards top employees for their contributions to the company.

Variable pay increases

A variable pay increase plan is when a company pays discretionary or nondiscretionary bonuses to employees who meet or surpass company standards. Employees typically earn discretionary bonuses for excellent work performance. Employees can gain non-discretionary bonuses to employees for reaching a predetermined goal, and teams, branches, or entire branches of the company may be eligible to receive them. Nondiscretionary bonuses are either long-term incentives or short-term incentives, based on the evaluation period. Here are some examples of both bonus types:

Discretionary bonus types

Some examples of discretionary bonus types include:

  • Project bonuses: reward employees for finishing a project. You can view this as a completion bonus.

  • Retention bonuses: reward employees for staying with the company for an extended amount of time. Companies often award retention bonuses to avoid talented employees leaving the company.

  • Spot bonuses: reward employees immediately or "on the spot." These bonuses reward achievements even though they were not expecting a reward.

Non-discretionary bonus types

Some examples of non-discretionary bonus types include:

  • Attendance bonuses: reward employees for not missing work due to illness for a determined amount of days. These bonuses encourage attendance at work.

  • Hiring bonuses: reward new hires for signing a contract with the company. These bonuses entice desirable candidates to accept a job offer.

  • Production bonuses: reward individuals or teams for reaching a set goal for production. Production bonuses motivate employees to work hard to achieve production goals.

Related: Everything You Need to Know About How Grade Pay Works

Advantages of this performance-based compensation plan

Providing performance-related pay to your employees can have benefits for your workspace. It may help your company achieve goals while motivating employees to do their best work. Here are some advantages of using the pay-for-performance plan:

Establishes company values

Ensure that the goals set for employees align with your company's overall objectives. This alignment can give employees a better understanding of their role and how their efforts contribute to reaching the goals. Aligning payments with company values shows the positive behaviours that you want employees to exhibit. When employees receive bonuses for demonstrating certain behaviours, it may help promote a cohesive company culture where everyone understands expectations.

Boosts motivation and morale

Financial rewards can be an effective way of motivating many employees. When employees realize that meeting specific goals may result in a base pay raise or a bonus, it may push them to put in their best work. Financial rewards can boost morale at work by showing that you want them to succeed and are willing to reward them for their hard work.

Related: How To Motivate Employees

Increases productivity

Performance-based compensation plans often align employees' pay directly to their contributions at work. It's helpful to outline goals you want your employees to meet within a certain period. This clarity may help with efficiency, enabling employees to complete more tasks in less time. For example, your employee may receive a certain amount of money if they make two sales a day. With this compensation plan, your employee may work hard to make those two sales, knowing that they can earn compensation with additional pay if they succeed.

Offers employees more control

In a traditional pay scheme, employees often have a set salary, with few opportunities to increase their income. Employees who work for with these plans have the unique power to increase their wages. To gain some extra money, these employees may decide to increase their productivity during certain times of the year, such as around the holidays. When employees have control over productivity and additional income, it may make them feel like they have the power to improve their standing at work.

Attracts and retains top talent

Companies with performance-based compensation plans are often attractive to potential hires due to the financial incentives and potentially higher compensation for excellent performance. A performance-based compensation plan also helps to retain top-performing employees, as it gives them the chance to earn additional income. This payment scheme also shows employees that the company recognizes and rewards their talent and efforts.

Provides clarity on raises

Companies that use a performance plan tend to outline what employees need to do to earn a raise. As a manager, it's helpful to describe goals that employees need to achieve to earn a bonus. This way, employees understand the ways their performance contributes to their pay. For example, an employee may need to complete a project successfully to receive a raise.

Reduces the need for oversight

Providing employees with clear objectives they need to meet to receive performance-related pay may make your job easier. Employees working towards set goals often require less supervision at work, as they already know what they need to do to reach the goals. As a result, they may feel driven to take more initiative. This initiative can help reduce the need for close supervision to ensure that they're doing their job.

Adds flexibility

Using this method often allows for flexibility in how employees work. You may not need to focus on how many hours they work or what strategies they used to reach goals, but instead can focus on whether they achieved the expected results. Employees can concentrate on performing their jobs in the way that best suits them, rather than completing their tasks during required hours or using specific methods.

Disadvantages of this performance-based compensation plan

While using a performance plan may benefit employees and the overall company, it can bring about some potential obstacles. Being aware of these may help you decide if it's the right compensation plan for your company. Here are some possible disadvantages to consider before moving forward with the program:

Affects teamwork

This plan often focuses on individual performance. As a result, employees may focus less on being teammates and instead focus on meeting personal goals. For example, they may focus on improving their own skills or productivity instead of assisting a new colleague who may need some guidance. In some cases, the ability to finish a task may rely on the efforts of other colleagues, and conflicts may arise if employees feel everyone isn't contributing evenly.

If this occurs, consider including team-based measures into your performance evaluations. For example, setting a team-incentive bonus that the team receives only if each teammate reaches a particular sales mark. This inclusion may help promote collaboration and shows that you value working together to achieve a common goal.

Related: Teamwork Skills: Definition and Examples

Puts focus on the quantity of work

Use quantifiable measures when determining objectives that earn pay raises. For example, you may inform employees they need to make a certain number of sales to receive a bonus. This number gives them a clear goal to work towards. Think about how this may lead employees to focus more on the quantity of work rather than the quality.

To avoid this, consider informing employees that you also expect their work to meet your expectations. Communicate quality standards simultaneously as you share your quantity goals to ensure they meet your expectations.

Related: SMART Goals: Objectives for Your Career

It makes implementing changes more difficult

Once you implement a compensation plan, it's challenging to change or remove. Employees who enjoy the benefits may grow accustomed to them, and it can reduce morale if they no longer have the opportunity to earn additional income. If you're thinking about changing your compensation plan, carefully consider how these changes may affect employees.

If you decide to switch to a performance-based compensation program, consider having trial periods to discover what bonuses or goals lead to the best productivity. By testing out the plan first, you can get a better idea of whether it's the right fit for your workplace. Testing out the plan may help you avoid having to make changes later.

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