What is Incentive Pay?

Definition, pros and cons, and frequently asked questions.

What is Incentive Pay?

July 22nd, 2020

Incentive pay is a financial or non-monetary reward offered to employees for performance rather than the total number of hours worked. Incentive pay is used as a motivational tool to boost morale and ensure employees perform at their best. Rewards can be offered individually or as part of a structured performance metric.

💡 Incentive pay motivates employees to meet targets and boost productivity.

Difference Between Incentive Pay and Merit Pay:

Incentive pay and merit pay are similar in that they are both used to reward individual employees for their performance. However, incentive pay may also be offered as an organizational incentive to all employees for meeting certain company goals.

Casual vs. Structured Incentives:

Employee incentives can be classified as casual or structured. Casual incentives can be given to an employee at any time as a reward for outstanding performance or to retain high-level executives. This can include a cash bonus or non-monetary items such as small gifts, lunches, or vouchers.

Structured incentives are usually cash-based but can also include stock options or paid holidays. Structured incentives, including commission and year-end bonuses, are set according to specific sales or production targets, and paid at a percentage rate.

Types of Incentive Pay:

A company may choose to incentivize its employees with cash-based bonuses or non-monetary incentives. Examples of incentive pay include:

  • Cash, including commission, year-end bonuses, sign-on bonuses, and performance bonuses.
  • Shares or company stock options.
  • A company car.
  • Paid holidays.
  • Gifts or vouchers.
  • Health club membership.

When Should a Company Offer Incentive Pay?

Depending on the size and structure of the company, incentive pay may be used to boost productivity, retain key employees, increase sales, or boost employee morale.

  • Companies with large sales teams may want to introduce a commission system to encourage employees to obtain higher sales figures.
  • Companies that are production-based would benefit from an incentive pay system based on the amount of product produced.
  • Performance-related pay can be offered to non-sales staff based on overall performance, improved performance, or consistency.
  • Incentive bonuses may be offered to retain key employees or boost company morale.

💡 Incentive pay should be customized to the size and function of the company.

Introducing Incentive Pay — The SMART System:

Companies thinking of introducing incentive pay should ensure that performance goals are SMART, i.e., specific, measurable, attainable, relevant, and timely.

Employees need to know the specific metrics by which their performance will be evaluated and the exact thresholds they will need to achieve to obtain incentive pay.

The threshold for achieving a company incentive has to be measurable and recordable.

Incentive goals and thresholds should be realistic and attainable for every employee and every department.

The metrics used as the basis for incentive programs should be relevant to the type of work the employee or department is involved in.

Incentive goals and thresholds should be given meaningful and realistic time frames.

Pros and Cons of Offering Incentive Pay:



Incentive pay effectively communicates the company's objectives and values to all employees.

Incentive pay can create distrust and jealousy between employees.

Incentive pay motivates employees to meet targets.

Incentive pay can result in employees only focusing on measurable incentive tasks.

Incentive pay boosts morale and increases employee retention.

If targets are set too low, the company suffers financially. If targets are set too high, employees lose their motivation.

Offering incentive pay directly results in boosted productivity.

It can be difficult to create clear and objective measurables for every department without causing employee distrust.

Incentive pay provides recognition for hard work.

Managers responsible for rating performance may be swayed by personal relationships.

Incentive pay can be used to reward individual performance or department/company performance.

Rewarding staff financially may be a way of "buying compliance" rather than creating a healthy company culture.


What is considered incentive pay?

Incentive pay is any form of compensation awarded for performance rather than hours worked.

Do you get taxed on incentive pay?

Yes, according to the IRS, incentive bonuses count as supplemental income and are subject to federal and state taxes.

How is incentive pay calculated?

Structured incentive pay is calculated as a percentage of sales or production targets reached. The amount paid is based on the company's performance metrics and targets reached.

What are the different types of incentive pay?

  • Cash bonuses.
  • Commission.
  • Non-monetary rewards.

Is a company required to pay incentive pay?

No, incentive pay and company bonuses are classed as supplemental income and paid at the discretion of the organization.

Why do companies offer incentive pay?

Companies offer incentive pay to boost productivity, increase sales, retain key employees, and improve employee morale.

Is a year-end bonus classed as incentive pay?

Yes, any type of company bonus is considered incentive pay.