What are the benefits of a merit based system?

Learn how to implement an effective merit pay system. Includes definition, pros and cons, and answers to frequently asked questions.

1. Pay & salary
2. Merit Pay: Definition, Advantages and Disadvantages

By Indeed Editorial Team

Updated February 28, 2021 | Published November 23, 2020

Updated February 28, 2021

Published November 23, 2020

There are four main ways companies compensate employees for their work. These payroll types are annual salaries, hourly wages, bonuses and commissions. When it's time for companies to increase employee pay, there are also various methods they may choose, and one popular approach is merit pay. In this article, we define merit pay, discuss its history and the philosophy behind it, answer some frequently asked questions and list some of its advantages and disadvantages.

Related: How To Ask for a Raise

What is merit pay?

Merit pay is the type of compensation a company uses to reward higher-performing employees with ongoing additional pay. Merit pay is sometimes called incentive pay or pay-for-performance, and it involves giving employees base pay increases or bonuses based on their performance. Merit pay may take the place of simple pay raises, compensation increases based on employee seniority or general cost-of-living adjustments.

Related: What Is an Average Cost of Living Raise? Definition and How To Calculate

The history of merit pay

The concept of merit pay has its roots in behavioral psychology, the study of how thoughts and actions relate. In the early 1900s, scientists realized that even though people are rational and make their own decisions, incentives and deterrents can influence their actions.

The first time this theory was applied to employee compensation was in Newton, Massachusetts in 1908. Through the following decades, employers used various ways to determine pay increases—usually some combination of seniority, merit and predicted increase in living costs. By the 1990s, merit pay had become a common way for employers to manage employee raises.

How does merit pay work?

A company using merit pay establishes a set of criteria to measure employee performance. The company also creates a schedule for reviewing employee performance against those benchmarks, usually with check-ins scheduled at monthly or quarterly intervals leading up to the review date. Employers also determine the dates when merit pay increases go into effect for each fiscal year. For merit pay to be a successful compensation approach, a company must be able to produce accurate, detailed data to measure employee performance.

Related: What Is a Reasonable Raise?

How much do companies give as merit increases?

Most companies establish a percent scale for merit pay. They usually offer employees a small percentage of their existing salary or pay rate. It's common for a department or business unit to allocate its overall percent increase according to employee performance during their merit evaluations. For example, the average 3% increase may be given to individual employees in increments of .5%, with top performers getting over 3% increases and others receiving less than 3%.

How to know if a company offers merit pay

The only way to know if a potential employer offers merit pay is to ask. Once hired, employees can access the specific policies and procedures a company has in place about merit pay increases in their employee handbooks. Since companies may test different approaches for pay increases, employees should always stay current in their knowledge of their company compensation policy.

Some potential advantages of merit pay

Companies may choose merit pay as their compensation model based on its potential benefits. These advantages include:

• Attracting top talent: Offering merit-based pay can help a company attract confident talent. Top employees who know their worth and believe in their skills are generally eager to have their pay tied to their performance.

• Clarifying expectations: When compensation is related to their performance, employees have clear guidance regarding what their employer considers exceptional work. In that way, merit pay can help differentiate critical tasks and low priority undertakings.

• Identifying employee rankings: Employers can use merit evaluations to create a ranked list of employees by strength. Top performers receive the highest merit pay and underperforming employees receive less or no merit pay.

• Making company objectives clear: When companies tie compensation increases to accomplishing goals, they make their business objectives real to their employees. Presenting an actionable to-do list that leads to more pay takes vision and mission statements from concepts to reality.

• Increasing productivity and efficiency: When employees know there are financial rewards for quality work, they are more likely to self-motivate. Merit pay can help combat workplace complacency.

• Generating healthy competition: In a positive corporate culture, merit pay can inspire employees to compete to produce the best results. When pay increases are directly related to accomplishing company goals, both top performers and the business itself are winners.

Some potential disadvantages of merit pay

While merit pay can have many benefits, there are also a few potential drawbacks, such as:

• Subjectivity of application: Even when merit pay is based on objective goals, managers may still award it subjectively.

• Perceived favoritism: Employees who are not satisfied with their merit pay may feel like there is manager favoritism toward other employees, regardless of their performance reviews.

• Use of resources better spent elsewhere: Merit pay systems require a business to develop competencies, determine measurements and create performance baselines in addition to scheduling and holding actual evaluations, so they require a lot of resources. Not all businesses can implement merit pay because they need to use those resources for the profit-driving aspects of the business.

• Managerial burden: Thoughtful completion of the merit pay process takes a lot of work from managers. Since no two managers are the same, some may be more up to the challenge than others. Managers who have better communication skills, for example, may find it easier to express what employees need to do to qualify for merit increases.

• Morale implications: Merit pay can have negative implications on company morale. Some employees may be discouraged by what they see as unequal rewards for the same work, while others may feel like they are being compensated similarly to other employees whose work they view as subpar.

• Unfounded expectations: Merit pay can lead employees to expect the same increase year after year, regardless of budgetary restraints and changes in employee behavior.

• Unhealthy competition: In less positive company cultures, the promise of merit pay may encourage employees to act selfishly instead of in the company's best interest.