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Today we’re discussing a complex and nuanced topic: performance-based compensation.

Pay-for-performance compensation programs are increasingly popular with employers and also employees who are attracted to the potential for lucrative payouts based on their individual performance.

According to a survey from salary.com, 75% of organizations indicate that performance-based pay is part of their compensation philosophy. Likewise, 65% of employees indicated a preference for bonuses based on personal performance.  

But before you go all in for a performance-based compensation policy, it’s important to think about it from all angles.

While research has proven that successful performance-based compensation programs can “raise job satisfaction, lower absenteeism and turnover rates, and have a sizable effect on company performance,” a poorly designed or executed plan can be counterproductive to your organization’s performance and harmful to your employees’ morale. 

It’s essential that you ensure your compensation philosophy fits your current business model and employees' wants and needs.

In this article, I explain what pay for performance is and give you the full details so you can go ahead and make an informed choice. 

What Is Performance-Based Compensation?

Performance-based compensation is when an employee's pay, bonuses, and/or financial incentives are directly tied to both their individual work performance and/or the business’s overall performance.

The main aim behind this approach is to motivate employees to excel in their roles and positively impact a business’s success by linking their financial rewards to their results.

Some common methods for performance-based compensation include: 

Merit-based pay raises

In a merit-increase ‌compensation structure, employees receive increases to their base salary based on their individual performance. 

This ‌pay-for-performance mode is implemented by conducting set performance reviews to assess employees’ successes and agree on salary increases.

Bonuses

Bonuses are one-off financial rewards given to employees because they’ve achieved certain targets or demonstrated excellent performance. Incentive bonuses can be linked to individuals, teams, or your entire organization.

Performance metrics can be based on financial performance (i.e., hitting a certain point of profitability), customer satisfaction results, or any other key metrics your organization is trying to drive (for instance, some organizations include diversity, equity, and inclusion metrics as part of their executive bonus targets).

Bonuses can be structured in various ways, but are usually a combination of both company performance and individual performance and can be paid on regular intervals (monthly, quarterly, annually, for holidays) or even given on the spot. To streamline the distribution of these bonuses, consider using top-tier payroll software that can automate the process. 

It’s also common for bonus targets to be specified by job level (i.e., as a percentage of your base salary) with more senior-level roles being allotted higher bonus targets.

This is especially true in bonuses tied to your annual performance review process. Your employees set goals, are assessed based on their performance, and allocated a bonus payout based on an algorithm combining both the organization’s and their successes.

Commission

Frequently found in sales teams, commission-based compensation means that employees earn a percentage of the sales they generate. 

An effective method of increasing their take-home pay based on the effort they make. Commission plans incentivize and reward employees for generating sales, acquiring new customers, or achieving specific sales-related objectives.

Commissions are typically calculated as a percentage or “commission rate” of the revenue or sales volume generated by the employee.

Commission plans can be structured in a number of ways, but a few common setups include 

  • Straight commission: Wages are completely allocated based on sales.  
  • Salary + commission: An employee receives a base salary, plus a commission on top based on sales.  
  • Graduated commission: An employee’s commission rate goes up after hitting specific thresholds or tiers.  
sales thresholds
Image source: Namely.
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Recognition and awards

Public awards and recognition for employees who excel might not always be purely monetary-based, but they can certainly elevate motivation and morale in your workplace. 

Employee recognition programs can provide social, monetary, and even peer-to-peer recognition. More advanced recognition programs allow colleagues to receive points as part of their public recognitions that then can be redeemed for rewards of their choice (i.e., gift cards).  

You can offer nice things like travel vouchers, gift cards, experience days, or other non-monetary rewards (just be careful you follow your local tax laws in providing your employees with any incentives of monetary value).

Profit-sharing

This is when your employees receive a portion of your business’s profits. This approach can generate a sense of ownership and inclusivity—often influencing employees to contribute to your organization’s financial success.

Profit-sharing allocations can be equally distributed to all eligible employees or allocated as a proportion of their salaries, based on job level or performance.

For further guidance, check out how to set up a profit-sharing plan.

Pros Of Performance-Based Compensation

A ‌pay-for-performance system can offer many advantages—both for your business and your employees. They’re particularly effective in larger companies with more predictable metrics. 

“While salaries, in my opinion, should always be based on market comparisons for similar roles at similar sized companies, bonuses can be used to reward those who go above and beyond,” said Compt CEO and founder, Amy Spurling. “This works best when the achievement goals are quantifiable and clear so that there is no subjectivity and bias is removed.”

Let’s take a look at some of the main benefits of implementing such a pay structure.

Motivates team members and increases productivity 

Money is a major motivating factor when it comes to employee retention and pay-for-performance compensation can significantly increase ‌employee engagement and motivate your team to work harder.

For instance, a manager might introduce a performance-based compensation strategy for a team of software developers.

A relevant goal might be to complete a complex project within a tight deadline—with project bonuses up for grabs if they successfully deliver the project defect-free, on time, and on budget. 

This ‌incentive plan offers high motivation for team collaboration and encourages the creation of innovative solutions while still meeting quality, time, and budget requirements.

Provides clarity on both performance expectations and compensation 

Performance-based pay provides a clear system of how an individual’s performance is tied to increases in their base salary.

Linking how an individual’s performance impacts their compensation removes ambiguity about how pay increases and bonuses are earned and empowers them with the feedback needed to be successful in the future.

Helps attract and retain talent

Offering a performance-based compensation model can attract top talent seeking to enhance their recognition and financial growth. 

If you can demonstrate that your business has a track record of financial success and leverages that success to reward top performers, you can both attract and retain top talent at your organization. 

Identifies areas for improvement

Regular and effective performance management helps not just in addressing performance opportunities for your employees, but also allows you to pinpoint areas of your company that might need improving.  

Additionally, aligning compensation perks that are designed to incentivize improving performance in struggling areas of the business can provide added motivation for your employees and leaders to turn their business area around. 

Helps develop skills 

When your team is regularly rewarded for high performance, it can incentivize them to up their individual performance levels.  High performance actually can be contagious—your employees will feel motivated and empowered to perform at their full potential.  

As John F. Kennedy once famously said, “A rising tide lifts all boats” and a high-performing environment can do exactly that.  

Providing clarity into performance expectations and rewarding hitting those expectations with competitive compensation encourages your employees to grow and develop the skills they need to be successful now and into the future.

Cons Of Performance-Based Compensation

While performance-based compensation can be an effective way of increasing employee motivation and driving productivity, there are some potential pitfalls to consider.

Subjectivity

It’s important to acknowledge that there can be some level of subjectivity in year-end performance review processes. 

Biases, like recency bias (giving more weight to recent events) and the halo/horns effect (having a positive or negative impression of someone that causes them to be treated more/less favorably), can introduce variability that you do not want to have in your year-end review process. 

If your employees perceive the pay-for-performance process to be unfair, it can have a significant impact on their morale, job satisfaction, and overall perception of leadership and the organization.  

In order to have a successful performance-based compensation program, it’s essential that your managers are aligned on goals and role expectations going into the year-end review process and that your leaders properly calibrate their results across the organization to ensure consistency (this is where performance management software or other performance-related tools can really help).

Complexity

Related to the above, implementing a pay-for-performance model can be administratively complex, as HR leader Angela Justice points out.

“Especially in the beginning, the administrative complexity of such systems can pose challenges. There's also the risk of employees perceiving unfairness, and if not managed well, pay inequities can emerge.”

Creating and running an effective pay-for-performance model is, as Jessica Zwaan puts it, “haaard”.

It requires a combination of forecasting, budgeting, and performance management which, let’s face it, needs a significant amount of due diligence, oversight, time, energy, and effort to get right.

A toxic work culture 

Incentive pay schemes can result in unhealthy competition in the workplace. For instance, when individual incentives are only linked to personal productivity, some team members might just look out for themselves and not engage in teamwork and collaboration.

In this kind of negative environment, individuals can hesitate to help each other or share knowledge—impacting overall team dynamics and potentially the business’s overall success.

“If everyone knows there is one pie and it can only be divided so many ways, competition could be toxic,” Spurling said. “It also means that those who know they are not in the running may just give up and not perform.”

To avoid this, she suggests some performance-based bonuses to incorporate both the team and individual achievement into the calculation. For example, if you must exceed your quota (50% of your bonus) and the team must also exceed theirs (50%) in order for you to be paid, you will foster collaboration. 

Another consideration here is that it could lead to some employees burning themselves out to meet targets.

Short-term focus

Lastly, another possible downside of this pay strategy is that your team focuses solely on short-term goals that offer immediate incentives.

“If a salesperson is only compensated for numbers of sales made, for example, that person has no incentive to consider the long-term needs of the enterprise, behave ethically, or consider the organization's needs over their own,” says Robert Bird, professor of Business Law at the University of Connecticut.

You might also find individuals deprioritizing professional development in favor of more concrete financial rewards.

Considerations For Making Performance-Based Compensation Work

Implementing a performance-related pay system can certainly offer many benefits, but its success depends on a strategic approach. 

For example, early-stage companies may struggle with performance-based compensation. 

“Their business models are frequently in flux and it is very hard to define clear, measurable, objective goals,” Spurling said. “It’s better to work with a market-based compensation approach until your business model matures, has more predictability, and can be better quantified. This is typically more attainable for later-stage companies.”

To make sure your system is effective, consider the following factors:

  • Address potential biases by being consistent with your performance review metrics and processes. This helps your employees maintain trust in the system.
  • Be objective and ensure your performance metrics fit with your overall business aims.  Set clear criteria and ensure your teams know what's expected of them.
  • Give regular feedback to employees in relation to their performance. Timely feedback helps employees ensure they meet their goals and are on the right path. 
  • Provide skills development opportunities to help employees reach their potential. 
  • Foster team collaboration by balancing individual performance incentives with team contribution recognition. Create a culture of knowledge sharing to boost teamwork opportunities.  
  • Be transparent about your performance-based compensation structure and how it links with performance. Transparency reduces uncertainties and builds employee confidence levels. Here's some advice on how to discuss compensation.
  • Be flexible with your strategy and be prepared to make changes when your business needs change. Accept feedback and refine your compensation system regularly. 
  • Be vigilant about negative impacts such as employees only working on short-term goals or unhealthy competition and address issues promptly.

Now you need to ask yourself: Will performance-based compensation work for my business and team?

It certainly offers an effective way to give your employees rewards for productivity and can be a great motivation tool. The upsides include better retention and recruiting opportunities, enhanced employee engagement, and sustainable business growth.

But it’s vital to introduce such a scheme clearly and carefully to avoid alienating your employees or adding pressure to their roles. 

Considering your organization’s current pay philosophy, current compensation review processes, overarching goals, and employee hierarchy is essential when choosing to go down this path.

A performance-based compensation system can be as unique as your business and employees, so don’t feel you have to follow a set structure.  

That said, many organizations offer some combination of merit increases and performance-related bonuses—it’s important to offer a market-competitive compensation program to attract the best and brightest talent.

Your goal is to engage your employees without creating an unhealthy, overworking mindset. If you decide to go ahead, set aside time to discuss the scheme with your teams once you’ve established the potential costs. 

Create the most relevant performance metrics to track the goals you want to set to ensure a successful and smooth performance-based compensation scheme.

‌Further Resources To Get Started With A Performance-based Compensation System  

To get you started, here are some more useful resources to help:

Join The People Managing People Community

You can also join the conversation and find further support over in the People Managing People Community, a supportive community of HR business leaders sharing knowledge and best practices to build successful organizations.

You might also want to consider taking one of these compensation certifications to help you get more confident handling compensation matters.

Alex Link
By Alex Link

Alex is a HR Director for a Fortune 4 organization with a passion for developing the leaders of tomorrow. He has a Masters of Science in Human Resources and Labor Relations and has extensive experience in HR, Leadership Development, Talent Management, Learning and Development, and more. When not focused on helping people realize their career aspirations, he enjoys playing guitar, reading sci-fi fantasy novels, relaxing with his wife, and playing with their two young children.