What is Pay for Performance? The Ultimate Guide

Compensation is a powerful tool for motivating employees. With the right approach, you can use it to drive exceptional performance, improving productivity across your organisation and even boosting your company’s bottom line. But get it wrong, and you could end up rewarding employees for simply clocking in — leaving their true potential untapped. 

In this article, we’ll dive into the pay-for-performance model and talk about the different ways it could transform your organisation. Along the way, we’ll highlight some potential pitfalls to watch out for and share our tips for building a compensation strategy that inspires your team to excel. 

‍

What is pay for performance?

‍

Pay for performance is a compensation model designed to drive results by aligning employee motivations with company objectives. It works by setting performance goals for each employee and awarding them either a bonus or a raise if they meet or exceed those targets. Pay for performance is often seen as a fairer way to manage compensation since it directly rewards top contributors for going above and beyond.

Effective performance-based pay needs to be backed up by a comprehensive performance appraisal and management process. Managers should be able to accurately assess performance and set realistic and measurable targets for each employee. Having this set process in place helps ensure performance reviews (and, by extension, compensation practices) are fair and not influenced by unconscious bias. 

‍

Different types of performance-based pay 

‍

Organisations typically implement pay for performance in one of two ways: merit-based pay increases or variable compensation. Read on for a closer look at each approach. 

Merit-based pay increases 

In a merit pay model, employees earn salary increases (raises) when they meet or exceed their goals. Raises are usually awarded on a yearly basis as part of the annual compensation review. Because pay increases are usually permanent, it’s important to set clear eligibility criteria to ensure you’re rewarding consistent high performance rather than one-off achievements. 

However, there are some disadvantages to this approach. Most notably, the yearly review cycle means there’s often a long wait between achievement and reward, leaving top performers waiting months for recognition. This delay can tempt high achievers to seek better offers elsewhere, posing a potential retention challenge. 

‍

Variable compensation 

Variable compensation is another type of pay-for-performance model, which involves rewarding employees at different times throughout the year. There are a few different types of variable compensation, including:

• Discretionary bonuses awarded by managers on an ad-hoc basis 
• Non-discretionary bonuses tied to specific, pre-defined goals
• Commission based on revenue or results directly attributed to the employee

This type of compensation strategy works particularly well for roles where results are easily measurable, such as sales — though it can be used for any employee. It’s particularly effective at motivating employees to meet short-term objectives. However, this is also a downside of variable compensation, since it can encourage employees to focus only on those metrics they’ll be rewarded for and neglect other aspects of their roles. 

‍

Pros and cons of the pay-for-performance model 

‍

The pay-for-performance model can have some big benefits for a business — but that doesn’t mean it’s the right fit for every organisation. Below, we’ll break down some of the main advantages and disadvantages of pay for performance to help you determine if this approach would work for your company. 

Advantages of pay for performance

• Boosts motivation and engagement: When employees know their efforts are directly tied to rewards, they’re more likely to stay focused and driven. This leads to a culture where everyone is engaged in their work and motivated to succeed. 

• Enhances performance and productivity: The pay-for-performance model encourages employees to strive for higher levels of productivity because they know they’ll be rewarded. This can lead to measurable improvements in productivity and even profitability. 

• Aligns employee motivations with company objectives: Pay for performance ties employees’ motivations directly to the company’s strategic objectives. This results in a goal-oriented workforce where everyone is working towards the company’s success.

• Helps to attract and retain top talent: A well-structured pay-for-performance system can help employees attract top candidates — and retain their best employees for longer. That’s because high-performing employees are often drawn to organisations that reward and recognise outstanding contributions.

• Fosters a culture of growth and development: Setting clear performance expectations pushes employees to improve, leading to personal growth and long-term career advancement. Regular performance reviews and feedback ensure employees have the tools they need to move forward.

‍

Disadvantages of pay for performance

• Can impact teamwork and collaboration: Pay-for-performance models can incentivise employees to prioritise meeting their own goals over helping others. This can lead to problems with collaboration and teamwork. In the worst cases, it can create a toxic culture based on unhealthy competition.

• Leads to stress and burnout: Constant pressure to meet and exceed targets can be stressful for employees — particularly if their goals are unachievable. This can create an unpleasant company culture and lead to high levels of burnout.

• Carries a possibility for bias and subjectivity: Accurately evaluating performance isn’t easy, especially in roles where work can't easily be measured. But when managers are asked to grade employees subjectively, things like favouritism or unconscious bias might impact their assessments.

• Can lead to mismatched motivations: Some types of pay-for-performance models can encourage employees to chase short-term wins at the expense of long-term success. In other situations, employees may focus on quality over quantity, completing a lot of work to a subpar standard just to secure additional pay. 

‍

Best practices for effective performance-based pay 

‍

Want to reap the benefits of pay for performance at your organisation? Here are some best practices to keep in mind as you put your strategy together. 

Link goals to company objectives 

Incentivise the right things by tying employee targets directly to company goals. For example, if improving customer satisfaction is a priority for your organisation, set measurable targets related to this, such as closing a certain number of support tickets each month. 

Identify key performance indicators (KPIs) 

To accurately assess performance, establish clear, measurable key performance indicators (KPIs) for each role. Of course, this is easier for some roles than others (e.g. sales). But it’s important to find creative ways to track achievements even for positions that are less obviously quantifiable. 

Involve employees in goal-setting

Encourage managers to work with each employee to set goals that are ambitious but achievable. This gives employees a sense of ownership and accountability, which can make them more likely to succeed. It also helps them see their work in its wider organisational context, which can boost motivation. 

Integrate opportunities for professional development

Incorporate opportunities for personal and professional development into your programme to encourage employees to improve. This ultimately benefits everyone since it allows employees to earn more through high performance while enabling them to contribute effectively to the company’s success. 

Communicate clearly and regularly 

Ensure employees fully understand their goals and how to achieve them — or risk creating frustration and resentment. Scheduling regular check-ins allows managers to keep an eye on progress and provide feedback and guidance where necessary.

‍

Getting the balance right for your organisation

‍

Pay for performance can be a game-changer for an organisation. When it’s done right, it can increase productivity, improve business outcomes and help move the organisation towards its goals. Employees also benefit from a positive work environment where everyone is encouraged to work to their full potential. 

However, this model also carries risks for both employers and employees — especially when it’s not managed effectively. One of the biggest downsides is that it can cause a lot of stress for employees if they’re not able to achieve their goals and make the income they need to meet their expenses. 

Setting realistic and achievable targets is part of the solution. But it’s also important to ensure the right balance of fixed vs. variable pay — which is different for every organisation, team and individual employee. While variable compensation can help motivate employees to go above and beyond, employers still have a responsibility to ensure their people can meet their living expenses. That means paying fair and competitive base salaries is crucial. 

‍

Learn more 

‍

Want to dive deeper into the world of compensation and rewards? You’re in the right place! Here are a few articles from our archive to get you started: 

• Optimising Compensation: Power of Salary Bands
• Removing Bias From Performance Reviews: 7 Key Strategies
• Bonus vs. Raise: What’s the Best Way to Reward Employees?
• How to Reward Employees When You Can’t Afford a Raise
• What Employers Need to Know About Equity Compensation

‍