Merit Pay - Definition and FAQs

A definition of merit pay, its pros and cons, and frequently asked questions.

Merit Pay

October 14th, 2019

Merit pay, or pay-for-performance, is a financial incentive whereby an employee is offered a bonus, increase, or promotion based on work performance as determined by criteria set by the employer. Merit pay is most common in sales positions as it provides a performance-generated salary based on an employee meeting or exceeding the company's goals.

Conditions for and Benefits of Merit Pay:

Merit pay is not required by the Fair Labor Standards Act (FLSA) but can be added to or incorporated into the employee's base salary as a bonus or increase. Merit pay is a good way to motivate employees to achieve your company's goals as it directly links their individual effort and ambition to a reward. This encourages employees to meet and exceed company goals, which increases the company's bottom line. It can also work towards fostering a strong, highly productive workforce with a high rate of employee retention.

Merit Pay as a Bonus:

The employer will typically hold a review meeting with each individual employee to discuss his or her work performance for a certain time period. This performance is then measured against a set of standards, as determined by the employer, and the results are used to determine a pay increase or promotion.

What is Merit Pay for Teachers?

Merit pay for teachers works in the same way as general merit pay. It is compensation based partly on the evaluation of an employee's job performance. This evaluation can be based on measurable factors such as student test scores, supervisory judgments, or a combination of factors. Teacher merit pay may be given as a one-time performance bonus, as a salary increase, or as an advancement on the monthly salary.

However, merit pay is not common in the public education sector as there has been a lot of opposition from teacher unions because of the difficulty in determining an appropriate basis for merit evaluation. The success of a school is hard to define and any bonuses need to be pre-budgeted, leaving teachers to compete for a share of a fixed amount which may result in divisive competition among teachers. There is also no universal standard as to what constitutes a good or great teacher, therefore it is nearly impossible to determine criteria to evaluate a teacher's performance.

How To Determine Merit Pay:

1. Develop a strategic plan for the year.

2. Break this plan down to departmental objectives.

3. Create the metrics that individual employees must meet to earn a merit raise.

In order to offer fair, unbiased incentives to employees that will not cause frustration and disharmony among employees, companies must have clear, well-planned outlines for their merit programs.

You should include a degree of flexibility to your metrics, particularly if your business is in a competitive industry and it is important to hold on to your top talent. In this case, companies can offer an incentive to high performing employees to stay with their company.

The standard merit increase for 2018 was 3%. However, employers can offer more or less than 3% as well as other perks, such as free gym membership, vacation time, or prime parking spaces. In order to decide on your merit increase, you can look at your overall merit budget as well as which departments are key to achieving your company goals. With this strategy, the departments that are more instrumental in obtaining the company's goals are allocated higher merit increases. Otherwise, you can use the average pay of each employee or group as a benchmark for determining merit pay.

Merit Pay Systems:

  • Salary, promotions, bonuses, and increases based on employee performance.
  • Team performance bonuses for the completion of project goals.
  • Executive bonuses to ensure accountability for organizational goals.

Pros and Cons of Merit Pay:

Pros

Cons

Merit pay communicates the company's objectives to employees and confirms what the company values from their employees.

Without clear measurables, merit pay can be subjective, leading to concerns about favoritism.

Earning merit pay let's employees know where they stand with the company.

Determing measurables and merit budgets uses time and resources that could be better spent elsewhere.

Merit pay recognizes high performing employees and so aids in employee retention, allowing employees to be paid for what they are worth.

Depending on the communication skill of the supervisor, employees who do not earn merit pay may not fully understand why not or what they can do to earn it. Lack of clear communication can lead to employee frustration.

Merit pay differentiates between an individual's performance and the company's performance.

Merit pay may create problems in employee relationships due to jealousy, fear, favoritism, negative competition, and insecurity.

Merit pay can be used to reward individuals for one-time tasks that they may otherwise not receive recognition for.

It can be difficult to determine clear, objective measurables that will not cause negative feelings in employees.

Team Members Involved in Merit Pay Systems:

- Human Resources (HR).

HR departments are usually responsible for creating a compensation program to drive a merit pay system.

- Accounting.

The accounting department tracks payout metrics (revenue, margin, profitability), determines a merit pay budget, keeps track of the actual cost of compensation, conducts financial analyses, and forecasts future revenue.

- Management.

The management team establishes the company strategies, identifies the market and product priorities, and reviews the plan's outcomes.

- Employees.

If a merit pay system is implemented in a company, then it should be inclusive of all of the company's employees, including the executives, managers, and front-line employees.

How To Effectively Implement Merit Pay Systems:

1. Provide clear and consistent policies.

You will need to effectively communicate your company's policies to your employees. Consider the fundamentals of your company's strategy and goals, individual and team goals, a reward structure, methods of calculation, potential payouts, and the timeline of the merit pay system. Then ensure that each individual understands and agrees to these policies.

2. Agree on a compensation plan and the purpose of its components.

Merit pay should be based on sustained individual performance of regular duties, and not on projects or events unless otherwise stipulated. You will need to clearly define and agree upon individual and team goals and the methods of measurement and evaluation.

3. Do not include merit pay with other compensation increases.

Merit pay should be different and separated from general increases for all employees or salary adjustments for market changes.

4. Define employee performance and credible ways to measure and evaluate it.

Use multiple information sources for this so that you can consider all aspects of employee performance as well as develop accurate and credible ways to evaluate performance.

5. Train managers and supervisors to clearly communicate the evaluation of employee performance.

Managers and supervisors should be held accountable for effectively implementing merit pay systems and communicating these systems in an objective, clear way to employees.

6. Get feedback from employees.

Talk to your employees, especially those who are leaving the company, about the effectiveness of your merit pay system and measure the results. Then take appropriate action.

7. Use the right technology.

You can ease managers' administrative duties by providing compensation tools integrated with talent management and business analytics. The right technology will allow managers to make informed decisions on compensation.

Final Thoughts:

Merit pay relies heavily on effective communication. For it to work, all participants must understand and agree with the plan's structure, rules, and parameters.

FAQs:

What are the advantages of merit pay?

  • Merit pay directly links an employee's individual effort and ambition to a reward.
  • It encourages employees to meet and exceed company goals, which increases the company's bottom line.
  • It can also work towards fostering a strong, highly productive workforce with a high rate of employee retention.

Take a look at our pros and cons of merit pay.

Is merit pay the same as pay for performance?

Yes, but merit pay may sometimes be used as a one-time reward while pay for performance is always an on-going and long-term incentive program. Merit pay is also usually based on individual performance, while pay for performance may be based on individual, group, or organizational performance.

How much should a merit raise be?

In 2018, the standard merit increase was 3%. However, as merit pay is not required by the Fair Labor Standards Act (FLSA), employers can offer more or less as well as other perks, such as free gym membership or vacation time.

What is a lump-sum merit pay?

Lump-Sum merit pay is a single cash payment, separate from the base salary and provided in place of a salary increase.

What are the disadvantages of using a pay for performance plan?

  • Concerns about favoritism.
  • Inefficient use of time and resources.
  • Communication difficulties.
  • Subjectivity.
  • Problems in employee relationships.
  • Divisive, competitive attitudes.

Does merit pay motivate employees?

Merit pay can incentivize and motivate employees as they are rewarded for their individual effort and ambition. It can also be used to reward employees for a one-off project that they may otherwise not receive recognition for and to recognize high performing employees.

On the other hand, merit pay does sometimes lead to jealousy, fear, insecurity, and negative competition among employees. It can lead to a divisive and competitive atmosphere instead of cooperation among employees if performance measurables are not clearly outlined and communicated. Employees may feel that merit pay is subjective and subject to favoritism.

What is a merit bonus?

Merit pay, or pay-for-performance, is a financial incentive whereby an employee is offered a monetary bonus based on work performance as determined by a set of criteria set by the employer.

What is teacher merit pay?

Teacher merit pay is compensation based partly on the evaluation of a teacher's job performance. This evaluation can be based on measurable factors such as student test scores, supervisory judgments, or a combination of factors and may be given as a one-time performance bonus, a salary increase, or an advancement on the monthly salary.

What is considered base pay?

A base salary is a fixed amount paid to an employee by his or her employer in return for the work he or she has performed. A base salary does not include benefits, bonuses, or other compensation that may be offered by an employer.

Take a look at our guide to compensation plans.

How does merit pay differ from a bonus?

The difference between merit pay and a bonus is that merit pay is usually added to or incorporated into the employee's base salary while a bonus is a one-off payment.

What is a merit matrix?

A merit matrix is a mathematical grid that is used to accurately and efficiently determine salary increases.

What is a merit increment?

A merit increase is an increase in an employee's normal salary based on a previously agreed-upon performance policy and compensation plan.