Merit pay involves rewarding employees based on their performance. For example, a company might increase a productive employee’s base salary, or create a commission system to allow employees to add performance bonuses to their base salary. The defining element of merit pay is that the financial reward is tied to performance, creating several advantages.
If a merit pay system succeeds, it motivates employees to work harder and achieve more. For example, suppose a company pays a base salary to salespeople but also gives them a commission, or percentage, of each sale they make. The more sales employees make, the more money they bring home, which rewards the salespeople and increases the company's revenues at the same time. Similarly, base salary increases can motivate employees to achieve whatever goal the company sets. For example, a company might motivate efficient project planning by offering salary increases to employees who routinely finish projects on time without sacrificing quality.
Clarifies Company Expectations
Merit pay helps employees understand whose example they should follow to succeed in an organization. A company that wants to foster innovation, for example, can use merit pay to reward creative thinkers in the organization. Other employees will see the accolades and rewards and adjust their behavior to improve their chances of making more money. In this way, an organization can promote the specific positive behaviors it believes will make the company, as a whole, more effective.
Improves Staffing and Employee Retention
An organization that bases salary decisions on other factors, such as seniority, might not be as attractive to prospective employees as a company that uses a merit system to determine salaries. For example, a bright newcomer likely will choose a company that immediately rewards her abilities, rather than a company that rewards less-capable, but more experienced, employees. Merit-based salary increases will also help retain effective employees who meet the company’s performance goals.
To generate these benefits, a merit pay system requires careful planning and maintenance, according to the book “Organizational Psychology: A Scientist-Practitioner Approach,” by Steve M. Jex. For example, the performance measures tied to merit pay must accurately distinguish among employee contributions. Merit salary increases will be hard to assign, for instance, if employees collaborate and share responsibilities. Another concern is credibility: for merit salary increases to be motivational, employees must understand how they work and believe they’re fair. Finally, the amount of money involved must be enough to motivate employees. Tiny salary increases won't be enough to push employees to work harder.