It’s always nice to be rewarded for hard work.

While this once looked like a gold star sticker on a report card when we were kids, as an adult a reward for hard work, dedication, and a strong performance can instead be in the form of merit pay.

You’ll most commonly find merit pay in sales positions, as it provides a performance-generated salary based on an employee meeting or exceeding specific company goals. It’s also popular in education, as teachers can be awarded merit pay after being evaluated based on student test scores or supervised judgments.

A full breakdown is often found in the compensation and benefits section of the employee handbook, but even so, it can be tricky to understand how to create the right plan for your business, why you should have merit pay, and what could go wrong if executed incorrectly.

Merit pay vs. pay for performance

No matter your industry, leaders in all sorts of organizations use similar strategies as a way to improve performance. Two common ways are to implement merit pay and pay for performance, and they’re easily confused for one another. In order to get it right, you’ll need to understand how they’re similar and how they’re different.

For starters, merit pay incentives are typically given to individual workers based on individual performance. Your company may designate specific funds to use as merit pay incentives and set specific parameters for workers to meet or exceed to be awarded these incentives. The incentives within merit pay plans are offered to employees as an equal opportunity to earn.

On the other hand, pay for performance is usually based on an annual salary increase due to performance. As an example, your organization may decide to set aside a specific percentage of their overall sales for a company-wide salary increase. It’s also common to see stock options awarded to individual high performers as part of a pay for performance plan.

In summary, merit pay is typically only used to reward individual performance, and pay for performance can be based on individual, team, or organizational performance. Also, merit pay is typically a one-time reward, while pay for performance can be seen as a long-term and ongoing program.

Advantages of merit pay

When done correctly, a merit pay system can not only increase your company’s bottom line but also bring some pretty big advantages to the table.

• Increases employee retention: Merit pay can help any organization better determine who among their teams are the high performers and who are the low performers. When you’re able to reward the high performers and the individuals who are always helping the company hit its goals, this can aid in retention because no employer wants to lose a top performer.
• Clearly communicate company objectives: When your company makes merit pay known, it sends a powerful message about how you’d like to see your employees perform and what they need to contribute to see this pay. Not only will this confirm that you value your employees and their hard work, but also provides a way for you, the employer, to recognize individual performance on a one-time basis.
• Employees know where they stand: As an employee, there’s nothing worse than feeling uncertain about where you stand within the company. Are you appreciated? Is your work noticed? You, as the employee or Human Resources manager, can make the range of merit pay known to your employees to see where their current performance falls within the merit pay range and what they’ll need to do to improve. If an employee receives less than the top percentage available, communicate how they can receive the top merit during the next cycle.
• Boosts motivation amongst employees: One clear advantage of merit pay is that it builds motivation to all of your employees, no matter their role within the organization. Thanks to clear communication as to what is needed to earn this incentive, they know what is needed of them to succeed. When a clear picture is painted of what is needed to receive the award, they can do what is needed to be awarded this increase in pay. Even the most skilled employee can become unmotivated, so merit pay can ensure this rarely occurs.
• Useful during the recruitment process: As a recruiter or hiring professional, having merit pay programs built into your company language about employee bonuses, it’ll likely draw in candidates when recruiting top talent. If a candidate is between two companies, what you offer in terms of merit pay and potential pay raises could sway them to choose you over one of your competitors.

Disadvantages of merit pay

On the other hand, when your organization doesn’t take the time to build out a merit plan that works for your organization, its industry, and your employees, you’re bound to experience some challenges along the way.

• Concerns for bias and favoritism: Whether we want to admit it or not, sometimes managers play favorites. They expect others to go above and beyond where others may not have to. The value of any particular employee can be subjective and determined by their supervisor. Without having clear standards set in place, others could argue “why?” when merit pay is awarded to others. For instance, some may say that the best salesperson on the team is the best because they have the easiest territory.
• Struggles with communication: Merit pay oftentimes has some limitations, so it’s up to the supervisor or manager to properly communicate to each employee the value that they contribute to the team and what superior performance looks like within their role. This can be an ongoing challenge with some supervisors, while others could find it relatively easy. Because of this, the effectiveness and understanding of how merit pay words can vary drastically from department to department.
• Negatively affect teamwork: Something to watch out for with merit pay is the competition it can cause between employees. While competition can sometimes be good, in this case, employees may begin to act in self-interest rather than the interest of the company. It can also go against the objectives your organization sets forth for teamwork and cooperation.

How to determine merit pay

Based on the Fair Labor Standards Act (FLSA), merit pay isn’t required but it can be added to or incorporated within an employee’s base salary as a bonus or an increase.

Whether you’re a small business owner or the CEO of a Fortune 500 company, it can be hard to know how and when to award a pay increase, especially ones that are tied to performance. It’s common to provide an annual wage increase to maintain a competitive drive, it may be unclear how and why you would give a pay increase that encompasses both a salary boost and an individual performance evaluation.

Establish a budget and percentage

When determining merit pay, take the time to consider the budget of your organization while then developing performance-based metrics.

This way, you’ll have a better understanding of what you can pay without going over budget, and what going “above and beyond” looks like for each individual role within your company and how you can tie it back to the success of the organization as a whole.

Once you have a dollar amount in mind, determine how performance will relate to an employee receiving their merit pay. You’ll also want to be sure that the same percentage is given to each employee. For example, your high performing sales leader should receive the same percent increase as a high-performing web developer.

Create performance scorecards

You’ll also want to create employee performance scorecards. These will help you to determine whether the employee was a high performer, exceeded their goals, and went above and beyond what they were asked to do.

This scorecard will likely weigh some of the evaluation criteria more heavily so that certain goals and achievements are given more value and impact the overall performance “score” more than others.

Determine goals

In order for your business to determine who should receive merit pay, figure out the goals for the entire organization. Have a strategic plan for the year, and then drill down further into the objectives of each department. Doing so will allow you to have clear metrics for each employee and the goals they’ll need to meet to receive a merit increase.

Establish clear communication

Finally, it’s all about clear communication to all employees so they know what will be expected of them in the future.

Utilize the right software

In order to make determining merit pay easy, and free of mistakes, it’s in your best interest to use compensation management software that can not only report on company compensation data and manage salaries through one dashboard, but also develop what the merit pay model should look like.

These tools can streamline the management of various types of compensation, not just merit pay, but also base pay, commissions, overtime pay, bonuses, and stock options.

Something to work towards

No matter how big, how small, or how often you decide merit pay is necessary, it can go a long way with showing that you’ve noticed the hard work and dedication your employees have shown.

As long as you take the time to do merit pay the right way, your employees are sure to feel appreciated and strive for greatness in the future.

Looking for more ways to award a teammate who has gone the extra mile? Check out the 17 types of employee benefits your organization can offer.