Every business wants to inspire its employees to do their best work, and pay is a powerful motivator. Our 2023 State of People Strategy Report found that 83% of HR professionals believe compensation and performance should be linked — yet 72% said their approach needs improvement.
The aptly named pay-for-performance compensation model rewards employees based on how they perform in their roles. The idea is simple: The better your employees perform, the better your business does, and the more your employees get paid. But before you tie employee salaries to goals and outputs, there are a few things you should consider.
Pay-for-Performance Advantages
1. The promise of higher pay can motivate employees.
The promise of higher pay in exchange for performing at a higher level can be a powerful motivator. Financial incentives can not only inspire your people to work harder, but they can also act as a form of indirect feedback, indicating to employees that they’re doing their job well. For example, paying a salesperson commission whenever they make a sale sends a strong feedback signal — keep making sales and continue to move the needle on organizational goals.
2. Strong performance-compensation connections can boost engagement.
HR respondents who draw a strong connection between employee performance and compensation are also more likely to have engaged workforces. Lattice’s 2023 State of People Strategy Report found that nearly two-thirds of companies with a good or great connection between performance and compensation have engaged workforces. On the other hand, only 11% of organizations with weak or no performance-compensation connection consider their employees engaged. It’s in your business’s best interest to create a work environment and compensation structure that keeps these highly motivated and engaged employees around as long as possible.
3. Variable pay shows employees the direct value of their contributions.
Linking compensation and performance can also help your employees see, in a tangible way, the benefit they bring to your company and its operations. This can help employees find a sense of purpose and meaning in their work, which can in turn boost job satisfaction across your organization.
4. Pay-for-performance can help justify employee pay increases.
The pay-for-performance model is designed to reward your top performers and ensure employee pay remains competitive for your industry. Since pay-for-performance programs only increase employee pay when their performance justifies that increase, this prevents your company from investing too much cash or too many resources into low performers or people who aren’t cut out for the job in the long term. You can ensure any money you put toward employee pay is an investment in your company’s success.
Performance vs. Pay Band Position
Pay-for-Performance Risks
1. Not all employees will want their compensation linked to performance.
Keep in mind that there are a lot of people — and that likely includes a good portion of your employees — who don’t want their performance and compensation linked. Some individuals are more risk-averse than others and value stability above all else. So even if there’s the potential to make more money by moving to performance-based pay, they’d prefer the comfort of a steady, reliable paycheck. Using a pay structure that employees don’t like can push them to look for a new job with a different pay structure.
2. Competition can lead to a negative workplace environment.
Linking performance and compensation can create a highly competitive work environment, which could adversely affect your company culture and employee engagement. Rather than motivate employees, the payment plan can inadvertently incentivize the wrong thing: dishonesty. For example, if your employees receive variable pay, like commission or a bonus, based on how many accounts they open, some might be incentivized to create invalid accounts to increase their numbers — and increase their compensation in the process.
3. Not all roles suit the pay-for-performance model.
Certain positions lend themselves better to a pay-for-performance model than others do. For example, sales positions are typically a great fit for a pay-for-performance plan; the more the salesperson sells, the more they’re paid. On the other hand, paying commission to your receptionist or data entry clerk wouldn’t make sense because there’s no direct way to link their performance with compensation. That said, most positions that can drive revenue or reduce business expenses are good candidates for this pay structure.
What to Consider Before Implementing a Pay-for-Performance Model
If you do decide that linking individual performance and compensation is the right structure for your business, there are a few things you’ll want to keep in mind to make the transition as smooth as possible.
1. Perfect your performance management processes.
Your first order of business must be ensuring your business has a clear, well-documented, and easily understood performance appraisal process. After all, how can you tie compensation to performance if your employees don’t know how their performance will be evaluated?
Just remember, performance management extends well beyond reviews. It means creating a culture of continuous feedback for managers, peers, and employees, as well as establishing goal-setting and quantitative rankings. Luckily a performance management system can help streamline and store all of these processes, so your employees know exactly where they stand year-round — not just during reviews.
2. Decide which employees will qualify.
Again, not every individual will want to be paid based on performance and not all roles will lend themselves well to this pay structure. It’s your business’s job to determine which roles should qualify and communicate this to managers and employees. Of course, you’ll need to do more than just tell employees they're eligible for a bonus or equity refresh. You’ll also need to outline:
- What the eligibility criteria are
- What performance review cycle will be referenced
- What goals the individual will be expected to achieve
- What metrics will be used to measure success
- What variable pay they’re eligible for and how frequently it can be awarded
- What should happen if they fall short of performance expectations
Remember, a pay-for-performance model is intended to motivate employees to do their best work. If this compensation structure is having the opposite effect and demotivating individuals, it might be time to reevaluate if this is working for your employees, team, or business.
3. Determine how you’ll reward employees.
There are quite a few ways businesses can reward employees beyond base salary. Variable pay is compensation a business awards an individual based on their performance, which can come in many forms. When crafting your compensation strategy, here are a few different types of payment mechanisms your business can use to incentivize outstanding performance:
- Merit Increase: A merit pay increase, or raise, is the most common type of pay-for-performance mechanism. While merit increases can also help adjust employee salaries to combat inflation or improve an individual’s compa-ratio, they are often issued following the performance review cycle to reward an employee for their hard work.
- Commission: Commission is compensation given to an employee to reward them for completing a task; for a salesperson, this could mean completing a sale, while for a recruiter it could mean placing a candidate. In most cases, a commission is given in addition to base pay, although companies can choose to solely compensate individuals with straight commission.
- Discretionary Bonus: Discretionary bonuses, sometimes called spot bonuses or one-time bonuses, are handed out, as the name suggests, at the discretion of the business. These individual incentive bonuses are often a surprise to employees and can be given for any number of reasons, like to reward stellar performance, celebrate a holiday, or retain an employee.
- Nondiscretionary Bonus: Nondiscretionary bonuses, on the other hand, are given when an individual achieves predefined goals or objectives. For example, a customer service rep might receive a project bonus for maintaining client satisfaction scores above a specific threshold. Employees are aware of these bonuses and the payout depends on the degree to which they meet their performance goals.
- Equity Grant: Aside from cash, businesses can also grant individual employees more stock options or equity “refreshes.” When your employees have a vested interest in the success of your business, they may be more likely to work hard to ensure your company reaches and exceeds its goals.
- Profit Sharing: Profit sharing is when a company meets or exceeds its goals and shares a portion of its profits with employees as a thank you. These company-wide bonuses can be in the form of a cash bonus or a retirement plan contribution.
However your business decides to compensate employees for their performance, just be sure to communicate what employees should expect. While some variable pay can be a surprise, like end-of-year profit sharing or a spot bonus, the success of a pay-for-performance model depends heavily on your employees knowing what’s expected of them and performing at or beyond that level.
4. Improve pay transparency.
A pay-for-performance strategy only works with employee buy-in. But in order to achieve that buy-in, your business needs to be transparent about how your compensation plan works and why your employees are rewarded the way they are. In a 2022 survey of more than 2,000 US employees, Lattice found that 67% wanted more pay transparency from their organizations.
To help, we recommend finding a pay-for-performance system like Lattice Compensation that can:
- Seamlessly include performance data in your compensation review process
- Use company compensation guidelines and compa-ratios to ensure consistency across your entire organization
- Make it easy for managers to allocate raises to their deserving direct reports
- Generate employee-centric compensation communications so everyone can understand exactly how their compensation package is changing
Here’s where Lattice can really shine. As you may have noticed, the success of a pay-for-performance strategy relies heavily on documentation. From setting and signing off on employee goals to getting pay increases approved, pay-for-performance is a long, intricate process involving many key stakeholders — employees, managers, directors, HR, finance, and more. Using compensation management software guarantees each of these correspondences is logged and timestamped, so your business can ensure nothing falls through the cracks.
Using the right solution, your business can build a culture of high performance and make sure your top talent knows how they’ll be compensated and why they’ve earned a raise or bonus. Lattice Compensation can ensure your managers and employees know exactly how every salary increase is determined, so they know they’re fairly compensated for their performance and experience.
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When it comes to linking performance and compensation, there’s no right or wrong answer. There are both pros and cons to a performance-based compensation structure, and it’s up to human resources teams and leadership to determine whether such a structure is right for your organization. While it may require a bit of work to implement, a pay-for-performance strategy can recognize and reward your employees so they stay with your business for a long time.
Think linking employee compensation with performance could help your business? Download our ebook How to Reward Top Talent With Pay-for-Performance to learn how to align your best people around business results and implement this pay plan for your employees.
