- Performance-based pay is compensation that's tied to employees' contributions to a company.
- This form of compensation is great when both the company and employee perform well, but it's a double-edged sword.
- Although many employers believe performance-based pay structures motivate employees and encourage positive attitudes, employees often feel that it puts too much pressure on work.
- This article is for business owners considering performance-based pay models for their employees.
Performance-based pay has gained popularity among employers over the years. Unfortunately, it might not be as effective as some believe. Rather than motivating employees, certain types of incentive-based pay structures end up having negative effects, research finds.
What is performance-based pay?
As the name suggests, performance-based pay is compensation that's tied to employees' contributions to a company. Think of a car salesperson who works on commission: If no cars sell that day, the business doesn't generate revenue, so the employees don't either.
This pay structure ensures that only the top-performing employees survive. Many businesses say it's a great way to improve employee performance.
However, people in careers that use this payment structure don't necessarily make more money. The U.S. Bureau of Labor Statistics shows that retail sales workers make only $24,340 per year on average. Real estate and advertising sales agents average twice that amount, which is less impressive when you consider that a house costs around $200,000 and a Super Bowl ad costs $5.6 million. The commissions on these sales are few and far between, split up among a large sales force. In short, performance-based pay is great when both the company and employee are performing well, but it's a double-edged sword.
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Performance-based pay can also be difficult for employers to track, as employee performance may ebb and flow. Companies that want to keep better tabs on their payroll should consider using one of the best online payroll software solutions, especially when transitioning to a structure like performance-based bay.
Key takeaway: Performance-based pay is compensation directly tied to an employee's contributions to a company, or the company's financial performance over the pay period. This can be a way to provide high-performing employees with additional compensation, but overall, employees compensated this way don't earn more than hourly or salaried employees.
Research examines performance-based pay models
A study published in the Human Resource Management Journal revealed that workers who receive performance-based pay, such as those whose pay ties into individual or companywide performance, work harder but end up with higher stress levels and lower levels of job satisfaction.
The research found that employees who receive performance-based pay or know how well their employer performs financially are more likely to feel that they are being encouraged to work too hard. That pressure offsets the gains in employee productivity that the pay structure is designed to produce, the study's authors said.
The study is the first to reveal the flaws with performance-based pay models, said Chidiebere Ogbonnaya, the study's lead author and a research fellow at the University of East Anglia at the time of the study. He added that many employees receiving performance-based pay feel immense pressure or do not have enough hours to complete work tasks.
"By tying employees' performance to financial incentives, employers send signals to employees about their intention to reward extra work effort with more pay," Ogbonnaya said in a statement. "Employees, in turn, receive these signals and feel obliged to work harder in exchange for more pay."
Although employees may value these earnings and see the pay structure as a positive, the ultimate beneficiary of their extra effort is the company.
"As a consequence, performance-related pay may be considered exploitative, or a management strategy that increases both earnings and work intensification," Ogbonnaya said.
What about organizational performance-based pay?
When the researchers looked specifically at pay tied to company profits, they found that performance-based pay positively impacted job satisfaction, employee commitment, and trust in management if the profit-related pay was distributed equitably across the organization. When profit-related pay was given only to a small portion of the workforce, the study found lower levels of job satisfaction, employee commitment and trust in management. In other words, sharing the wealth is highly popular.
Kevin Daniels, one of the study's authors and a professor at Norwich Business School in the U.K., said the study shows that employers should implement efficient, equitable processes for distributing organizational profits to ensure deserving employees are not overlooked.
"If profit-related pay is spread across the workplace, employees may show greater acceptance and respond with positive attitudes," Daniels said.
The study was based on surveys of 1,293 managers and 13,657 employees at 1,293 workplaces in the U.K.
Key takeaway: Employees respond better to performance-based pay when it's based on company profits (rather than individual performance) and distributed equitably across all levels of the business.
Does pay increase performance?
Many studies have shown that pay does not contribute to performance, at least not directly. No matter how much you pay employees, they'll eventually cycle through their normal routines. If those routines include slacking off and underperforming, then that's what will happen.
Moreover, a study from Harvard Business School found that not all employees respond well to incentive-based pay. For example, accounting or human resources professionals may want a steady salary instead of being paid commission for each report they complete. Still, pay increases and bonuses for bulk work, even in operational environments, can be beneficial.
There's also a chance of corruption: If employees get in desperate financial situations outside of work, they may cheat the system to get more pay. This issue caused Wells Fargo retail bank employees to fraudulently open customer accounts to meet aggressive sales quotas, resulting in a $575 million lawsuit at the end of 2018.
Key takeaway: Not all employees respond well to incentive-based pay, though there are ways to implement it without damaging employer-employee relationships.
Pros and cons of performance-based compensation
There are advantages and disadvantages to adopting a performance-based pay model.
- It improves recruitment and retention of high-performing talent. For top performers, understanding what's expected of them and achieving or surpassing those expectations (and reaping the rewards) incentivizes them to stay. In turn, your HR team can analyze the qualities of these top performers and identify those traits in prospective candidates to build the ideal workforce.
- It reveals areas for improvement. Performance-based pay affords business leaders the insight to find the "weak links" by assigning quantifiable values to team members' contributions. By first identifying the low performers and then analyzing why they're performing below expectations, you can discover areas in your business that need improvement, such as training processes, supervision and communication.
- It can increase productivity. By nature of this compensation structure, employees who contribute more to the company are paid more, encouraging higher productivity. Companies that use pay-for-performance compensation usually use a calendar or schedule to track deadlines, and team members can use those expectations to complete work more efficiently.
- It sets clear expectations. Performance-based pay puts the control of compensation largely in the employee's hands, enabling them to increase their own wages. This not only affords the employee more power over their pay, but also establishes clear expectations for raises, reducing miscommunication and fostering transparency around the subject of pay.
- It risks valuing quantity over quality. Businesses that decide performance-based pay is right for them should be painstakingly aware of the adage "quality over quantity." Because quantifying accomplishments is the natural rubric for this pay structure, you should impress the importance of high-quality work on your team when giving assignments to avoid rushed, subpar work.
- It can negatively affect company culture. Not everyone is built to flourish with performance-based compensation. Team members who aren't comfortable in a competitive environment may not appreciate the structure. It can break down collaboration and teamwork, as performance-based pay tends to focus on an individual's achievements over a team's accomplishments. As the study above mentioned, it can also lead to higher stress and lower employee morale, both of which greatly hurt company culture.
- It's hard to change. Once a team has adjusted to performance-based pay and the benefits it affords – especially for go-getting team members who thrive on the challenge of surpassing a goal – it's very hard to change. Even if you find another pay structure would work better for the company as a whole, attempting to change it may cost your company its top performers.
Tips for making performance-based pay work
If you want to implement performance-based pay in order to motivate your employees, it helps to make it fun. Remind your team members that their success and paychecks are in their own hands, in a way that empowers and excites them. Put up leaderboards and set goals, displaying progress toward those goals to motivate your team.
You could also purchase prizes, like a bicycle, the latest gaming console, Bluetooth headphones, a laptop, gift cards or event tickets. Put all of the prizes in a display case. This will keep employees excited and give them something to focus on to work harder.
Alternatives to performance-based pay
Performance-based pay is expected in the investment industry, such as for hedge fund and portfolio managers, but comprehensive pay structures are more common in most other industries. Generally, employees experience performance-based pay only in the context of bonuses and extra rewards, not as their full compensation.
You should consider several other compensation structures before deciding if performance-based pay is right for your workforce. Hourly pay and salary are the most common forms of compensation for employees and often include "indirect compensation" in benefits like insurance and yearly raises.
Commission is a type of compensation more closely related to performance-based pay. It can be offered in conjunction with salary and usually reflects a percentage of an individual's or team's contributions to the company.
Performance-based pay isn't for everybody. While some employees thrive on it, others need a steady, predictable paycheck. With a properly executed incentive plan, performance-based pay can work for companies of any size, but be sure to consider your employees' needs and the alternatives first.