Designing Incentive Compensation Plans: A Complete Guide

Salesperson, customer success manager, store manager — all are roles where employee performance directly impacts business success. And that’s why these employees’ compensation often includes extra rewards such as sales commissions, bonuses, and other perks. 

These pay arrangements are called incentive compensation plans, which reward employees who meet certain business goals or performance metrics with payouts, typically on top of a base salary. But creating the right kind of incentive-based compensation plan for your workplace requires some thoughtful planning. Here’s how to design an incentive compensation plan and how, when done well, it can benefit a workplace and drive success. 

{{rich-takeaway}}

5 Ways to Create an Incentive-Based Compensation Plan 

Organizations risk disengaged workers, along with payouts that they can’t afford, when they aren’t strategic about the plan design of an incentive compensation program. Here are five steps required to create an incentive program that will harness the best features of this compensation approach.    

1. Consider your culture.

Incentive-based compensation is standard in many roles. For example, sales teams and executives often consider commissions or profit-sharing a given. But not every team thrives under this model. When asked whether a company should implement incentive pay, the first question Paul Wise, principal product adoption manager at CaptivateIQ, a maker of sales commission automation software, asks is this: "What's the culture, and how will it be perceived?”

After all, commissions and bonuses are a form of “risk pay,” he said, with no guarantee that employees will earn them. Economic downturns, industry volatility, or a competitor’s unexpected product launch could all have an outsized impact on an employee’s productivity and an organization’s success.

For incentives to drive performance, there has to be an intrinsic motivation.

“If, in your culture, introducing incentive compensation will feel like a takeaway, meaning you're taking money out of my pocket, then your culture for that role, for that department, may not be suited at this moment for incentive pay,” Wise explained. 

What’s more, for incentive pay to work, you need a workforce motivated to be top performers. Some employees meet job requirements but lack the drive to go above and beyond. "For incentives to drive performance, there has to be an intrinsic motivation,” said Jennifer L. Massey, founder and CEO of Integra HR, an HR consulting and training and performance development firm.

2. Consider the metrics.

Incentive compensation plans correlate worker performance to specific metrics, including organizational goals and business strategy. But, often, employers don’t take the time to determine realistic metrics, Wise said.

Sometimes goals are set so high that even top talent can’t meet them, which demotivates employees at every level, he explained. Or, conversely, some employers set goals too low, and every employee earns a bonus, which is costly for an organization. 

It’s looking at data, perhaps bringing in a specialist, and then tying everything back to your revenue generation.

To set the right benchmarks, look back at six or 12 months of data, such as sales data, rate of on-time project completion, and other company goals you’re tracking, Wise recommended.  

As part of the analysis, also talk to your employees to fully understand what each individual is doing and whether it aligns with their job description, said Delaney Silver, an HR professional with expertise in talent management. Some employers may want to reward a certain behavior, but conversations with employees and managers may uncover that that behavior actually isn’t what’s driving the business. In fact, it may be another behavior altogether.

As you analyze past sales or productivity, consider regional, national, and industry trends too, Massey suggested. A certified compensation specialist can help. “It’s looking at data, perhaps bringing in a specialist, and then tying everything back to your revenue generation, and making sure that those goals align,” she said.  

3. Tie incentives to specific roles.

In organizations with an incentive compensation plan, employees may earn rewards based on both the business’s overall success and their individual performance in their specific roles. Employers should be careful to set clear, measurable targets for each position, so employees know what’s expected. 

For example, a sales rep’s incentives might consider lead generation and closed deals across a sales cycle. A vice president of customer success’s rewards might be based on net revenue or customer service satisfaction scores from surveys, Wise said. And a human resources manager might be measured based on non-regrettable departures trends or the time it took to hire new people. 

{{rich-highlight-1}}

4. Ensure transparency.

Transparency builds trust — especially in compensation. Employees should know how much they can potentially earn and how they can do better. Because incentive programs tie pay to individual, company, or shared performance, employers must be transparent about how well employees and the business are meeting their goals.

Any organization with an incentive compensation plan should prioritize regular check-ins between managers and their direct reports to ensure everybody is kept abreast of their individual progress. Company-wide updates should also be held to provide clarity even if full financial statements can’t be shared. Those broad updates also are an opportunity to praise high performance and nudge workers where needed, Wise noted.   

“That will give people a good sense of where things are heading,” he said. “And then remind them that, ‘Hey, we're not doing so hot on the customer satisfaction. Don't forget, that's 20% of your bonus. Let’s maybe put a little bit more effort into that area.’”

5. Adapt compensation strategy as needed.

Companies should regularly reevaluate their compensation strategy, adjusting quotas and incentives to match market shifts, new product launches, overly ambitious goals, or other business needs, Wise suggested. 

“Most companies I've been a part of that have set too aggressive of goals have come back on those goals and said, ‘Hey, let’s reassess in July or August,’ or ‘Hey, we missed our goals, but we're going to take a little bit of a discretionary pot and dole it out, because we know you guys worked really hard,’” he said.

In other years, the business and its employees could exceed every expectation. “[In] blowout years, they’ll say, ‘Hey, we have to raise the quota a little bit, so we can keep pushing towards the end of the year,’” Wise explained. 

{{rich-highlight-2}}

7 Types of Incentive Compensation Programs 

When people hear “incentive compensation,” sales commissions or bonuses are often the first things that pop into their minds. But incentive compensation plans cover a broader array of payment types. 

Sales commission: Salespeople earn a certain percentage of their sales. 

Bonus pay: Whether delivered as an annual incentive or more frequently, this perk is often tied to an organization's performance, such as stock value or gross margin.  

Long-term executive plan: Designed as a retention bonus for executives, this plan typically links performance in a given year to a cash or stock award. Payouts are often phased over several years, and the executive forfeits the award if they leave early, Wise noted.  

Management by objective: Employees are given specific goals to achieve within a set period. Meeting those objectives earns employees a bonus.  

Profit-sharing plans: Employees earn rewards based on the company’s revenue growth, often through annual bonuses or more frequent payouts. Some companies, especially startups with demanding workloads, offer both short-term and long-term incentives tied to revenue growth, Silver said.

Project-based bonus: Employees earn a bonus when they meet certain goals on a project, such as completing it before deadline or under budget.

Team incentives: This perk recognizes collective team efforts. Employees work toward their own objectives, support their team members, and work toward shared goals together, ensuring overall team success and an incentive payout.  

{{rich-highlight-3}}

Incentive-Based Compensation vs. Fixed Compensation

Many employers adopt a mixed compensation strategy, offering incentive-based compensation to some employees and fixed compensation to others.  

Some employers and employees prefer the stability of a fixed compensation plan because it provides a predictable paycheck. After all, some workers can be risk-averse, unmotivated by the promise of a bonus for extra work, or may work in roles — like administrative and operational functions — that don’t directly impact revenue. 

Companies should also consider the effort required to build and maintain effective incentive compensation programs. Without the time or resources for ongoing adjustments, a fixed-pay structure may be the better choice. It will avoid the frustration or distrust that can crop up when targets aren’t met and bonuses aren’t earned.

But, when designed with the right mindset and plan, incentive programs can boost employee motivation, retention, and reliability, Silver said. “You know your business and you know how to be successful. It's unlocking that. That’s what an incentive compensation structure is, unlocking how you can make your business grow, how you can make your business boom.” 

{{rich-highlight-4}}