Merit pay is one of the most frequently used methods to pay an employee based on individual performance.  The essential goal of a merit pay program is to link pay to performance in a manner that is consistent with the mission of the organization.  There are generally two conditions required to make the system work.

1. variations in employee performance must be measurable and measured
2. managers must be provided with the necessary tools to determine the appropriate rewards

Merit pay involves giving employees a permanent pay raise based on past performance. Often the company’s performance appraisal system is used to determine performance levels and the employees are awarded a raise, such as a 2% increase in pay. One potential problem with merit pay is that employees come to expect pay increases. In companies that give annual merit raises without a different raise for increases in cost of living, merit pay ends up serving as a cost-of-living adjustment and creates a sense of entitlement on the part of employees, with even low performers expecting them. Thus, making merit pay more effective depends on making it truly dependent on performance and designing a relatively objective appraisal system.

To motivate employees effectively, the size of the merit increase must be significant enough to make a noticeable difference to employees.  Generally speaking, any merit increase of 2% or less is regarded as being inconsequential.  Some studies show that a merit increase of less than 7% is unlikely to have ANY IMPACT on employee performance…yikes!  One alternative more and more companies are turning to in today’s tight economic times is the use of lump sum payments in lieu of a merit increase to base pay.  As a result, the employee receives the pay increase in one payment, hopefully motivating him/her, and the company continues to pay the same base salary, while controlling salary budget costs in the long-run.

When determining the payout to individual employees, several factors can be considered, based on the organization’s culture and budget:

• Where is the employee’s pay in the current salary range for his/her job?
• How well is the employee performing? Has performance increased since the last merit pay?
• Is the employee considered a “critical talent”?
• What is the long-term potential for the employee with the organization?

Ultimately, to be successful, the merit pay program must ensure that awards provided to the best performers will be substantially greater than increases awarded to average, or below-average performers.  Furthermore, especially in today’s economic climate, it is advisable to NOT reward below-average performers at all. A well-designed system will give the employee a personal stake in seeing that their efforts result in increased productivity and success for the organization as a whole.