Merit pay

From CEOpedia

Merit pay is a compensation system in which salary increases are tied directly to individual employee performance rather than seniority, position, or hours worked, linking pay progression to assessed contributions and achievements (Milkovich G.T., Newman J.M. 2008, p.367)[1]. The high performer gets a 6% raise while the average performer gets 2%. Excellence pays, literally. That's the theory. In practice, merit pay systems generate endless debates about fairness, measurement, and whether money really motivates.

Newton, Massachusetts introduced merit pay for teachers in 1908—making it one of the oldest formal performance-based compensation systems in American history. A century later, merit pay remains controversial in education while becoming standard practice in corporate settings. By 2023, roughly 90% of large U.S. companies use some form of merit-based pay increases, though the percentage of payroll allocated to merit pools has shrunk from 10% in the 1980s to around 3-4% today.

Mechanism

Merit pay operates through a structured process:

Performance evaluation

Rating employees. Managers assess employee performance against predetermined criteria—goals met, competencies demonstrated, behaviors exhibited. Ratings typically use scales from 1-5 or descriptors like "exceeds expectations"[2].

Calibration. Many organizations conduct calibration sessions where managers compare ratings to ensure consistency across departments and prevent grade inflation.

Merit matrix

Pay-for-performance grid. Merit matrices link performance ratings to pay increase percentages. A typical matrix might specify:

  • Exceeds expectations: 5-7% increase
  • Meets expectations: 2-4% increase
  • Below expectations: 0% increase

Position in range. Sophisticated matrices also consider where the employee falls within their salary range. Those below midpoint might receive larger increases to move them toward market rate[3].

Budget allocation

Merit pool. Organizations budget a percentage of payroll for merit increases—typically 3-5% of the total salary budget.

Manager discretion. Within budget constraints, managers allocate increases among their direct reports based on performance differentiation.

Advantages

Merit pay offers benefits:

Performance motivation. Tying pay to performance creates incentives for employees to work harder and achieve better results[4].

Talent attraction. High performers gravitate toward merit-based environments where their contributions will be recognized and rewarded.

Retention of top performers. When the best employees receive the largest raises, they're less likely to seek opportunities elsewhere.

Cost control. Unlike across-the-board increases, merit pay allows organizations to target compensation dollars toward employees who add the most value.

Alignment. Merit criteria can reinforce strategic priorities by rewarding behaviors and results the organization values most.

Disadvantages

Merit pay creates problems:

Measurement difficulties

Subjective evaluation. Many jobs resist objective measurement. Evaluating a researcher's contribution or a manager's leadership involves judgment that different evaluators might render differently[5].

Rating inflation. Managers dislike giving low ratings and the difficult conversations that follow. Over time, most employees cluster in the "exceeds expectations" category, defeating differentiation.

Behavioral effects

Short-term focus. When raises depend on annual performance ratings, employees may prioritize activities that produce visible short-term results over long-term value creation.

Competition over collaboration. If the merit pool is fixed, one employee's gain is another's loss. This zero-sum dynamic can undermine teamwork[6].

Gaming. Employees learn what gets measured and rated, potentially optimizing for evaluation criteria rather than actual value.

Fairness concerns

Perceived inequity. Even well-designed systems generate perceptions of unfairness. Employees compare their raises and ratings to peers, often without full information.

Bias. Rating systems can perpetuate or amplify biases related to gender, race, or other characteristics, particularly when criteria are subjective.

Implementation requirements

Making merit pay work requires:

Clear criteria. Employees must understand exactly what performance looks like and how it will be evaluated[7].

Meaningful differentiation. If everyone receives similar increases regardless of performance, the system loses motivational power.

Manager training. Supervisors need skills in performance observation, documentation, feedback, and difficult conversations.

Communication. Employees need to understand how the system works and believe it operates fairly.

Adequate funding. Merit pools must be large enough to create meaningful differences between high and average performers. A 0.5% spread between ratings provides little incentive[8].

Alternatives

Organizations use various approaches:

Bonuses. One-time payments tied to performance don't compound into base salary, giving organizations more flexibility.

Skill-based pay. Increases based on acquiring new skills or certifications rather than subjective performance ratings.

Team incentives. Rewards based on group performance encourage collaboration but may allow free-riding.

Profit sharing. Distributing a portion of company profits ties employee rewards to organizational success.


Merit pay — recommended articles
Compensation — Performance management — Employee motivation — Incentive system

References

Footnotes

  1. ↑ Milkovich G.T., Newman J.M. (2008), Compensation, p.367
  2. ↑ Heneman R.L. (2002), Merit Pay, pp.45-62
  3. ↑ WorldatWork (2023), Compensation Programs
  4. ↑ SHRM (2023), Merit Pay Advantages
  5. ↑ Milkovich G.T., Newman J.M. (2008), Compensation, pp.398-412
  6. ↑ Heneman R.L. (2002), Merit Pay, pp.89-104
  7. ↑ WorldatWork (2023), Implementation Guide
  8. ↑ SHRM (2023), Merit Pay Best Practices

Author: Sławomir Wawak

Retrieved from "https://ceopedia.org/index.php?title=Merit_pay&oldid=6656"