Principles of Merit Pay
By Lyle Leritz, Ph.D.
Research Manager
(800) 627-3697 - info.eri@erieri.com - www.erieri.com
Copyright© 2012 ERI Economic Research Institute - 8575 164th Avenue NE, Redmond, WA 98052
A merit program is a form of performance-related pay and
is one of the most powerful tools at the disposal of compensation analysts. Performance-related pay traces its
roots to psychology and incentive theory. The basic tenet
of incentive theory is that people respond to rewards, and
organizations can increase performance with the proper
motivator. To many of us, this might seem like common
sense; however, common sense has not always been at the
forefront of compensation systems. Even as late as the early
1900’s, many organizations viewed employees simply as inputs to a process and had little understanding of what might
motivate higher performance. A series of breakthrough
studies in the mid-1920’s would change that understanding.
that individual differences in performance are measurable
and important to the organization (typically as they relate
to productivity and profit), and that employees have control over their performance. Additionally, the size of the
increases must be large enough to warrant the necessary
effort to attain them. A trivial increase for top level performance is not likely to be viewed as significant. It should
be noted that, in most systems, earned merit increases are
a permanent part of an employee’s salary (as opposed to
lump sum payments). Finally, it is important that effective
communication exists between employees and management and that managers have the requisite tools for administering rewards.
Beginning in 1924, George Elton Mayo and his colleagues
conducted several experiments at the Hawthorne Works
factory in Chicago to study the effect of different working
conditions (e.g., lighting, altering break schedules, etc.)
on productivity. Initial analyses seemed to indicate that
changing the working conditions, indeed, led to changes in
productivity. In fact, most changes led to increased productivity, even when that change was reverting to a prior condition from which productivity had also increased. Closer
examination led researchers to conclude that productivity
changes were not simply due to the changes they were implementing, but were, in fact, due to the increased attention
workers were receiving from the researchers. While this did
not directly address compensation and performance, it did
create a shift in managerial thinking toward the needs and
motivations of employees.
The benefits of a well-designed merit system include attracting and retaining high performing individuals, as
well as motivating employees to increase and maintain
productivity. If every employee is rewarded with similar
pay increases, there is a risk of high performing employees
leaving for an organization that rewards their talent. Alternatively, such employees may stay but lack the motivation
to perform at a high level. In either case, an organization
is left with moderate performing employees at best. As
with any system, there are cons to even well-designed systems. Since many criteria used to measure performance are
highly subjective, it can be difficult to objectively evaluate
employees. Rewarding individual work in team-based settings can also prove difficult in a merit-based system as individual goals may start to take precedence over team goals.
Any negative impact such a system might create should be
evaluated and addressed before it is implemented.
There are two basic concepts in motivation theory: intrinsic and extrinsic. Intrinsic motivation describes motivation
that resides inside an individual and is not based on external rewards. It is observed when an individual engages in
an activity for its own sake in the absence of external incentives. Intrinsic motivation is a powerful force; however,
it is not typically germane to discussions of merit pay. In
contrast, extrinsic motivation refers to factors outside of an
individual that motivate performance. These factors include
monetary rewards, grades, opportunities, promotions, and
so on. Extrinsic factors are not limited to attaining positive rewards, they also include avoidance of negative factors
(e.g., fear of punishment). However, it is generally preferable to use positive motivators, especially in an organizational setting. Merit pay is generally considered a positive
motivator.
Broadly speaking, a merit-based system is designed to reward productive employees with increases in compensation. For a merit-based system to be effective, it is critical
Copyright© 2012 ERI Economic Research Institute
In addition to individual considerations, there are organizational factors to consider. These factors include, but are
not limited to, the cost of measuring performance, organizational culture, managerial-employee relationships
(e.g., trust), how competitive an organizations' wages are,
pay range width, and the cost of implementing the system.
An organization with a distrusting culture and poor linkage between pay and performance is not likely to benefit
from a merit-based system. Equally, in an organization that
does not pay market competitive wages, employees might
view merit rewards as a band-aid on a larger problem (this
is not to say they will not work to achieve those rewards,
but the long term motivational effects are dubious). Narrow
pay ranges can also undermine merit increases. In such a
case, high performers will reach the top of a given pay range
relatively quickly and be left without room for wage growth.
Range width is moderated by increase size, such that larger
increases close the gap quicker than smaller increases.
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The expected tenure for an employee in a given range is an
important determinant for how wide the range is and how
large increases can be. For example, if employees in entry
level positions (which tend to be in narrow ranges) are expected to be promoted to the next range in a relatively short
period, then it is acceptable to use large increases for top
performers. A 10% increase for high performance would
put top performers at the highest end of a 30% pay range
in three years. One would expect those performers to be
promoted out of that pay range by the time that happened.
Such a design is undesirable if promotions are not expected
to occur that soon (which is the likely scenario in most situations). On the other hand, small increases can present a
different problem. Given a 40% pay range, a 2% increase
for high performance would take 10 years for someone just
to reach the midpoint from the minimum (assuming they
received the highest rating each year).
The implicit assumption in the addressed issues is that increases should not put an employee’s compensation above
the maximum value specified for the range. Compensation managers use a variety of tools in assessing the relative position of a given employee including compa-ratios
and control points. A compa-ratio is simply a ratio of actual
pay to the structure midpoint. Specifically, salary is divided
by the midpoint value (and typically multiplied by 100 to
be expressed as a percentage). Values greater than 100 are
above the midpoint; values less than 100 are below the midpoint. Compa-ratios can be used to examine distributions
and concentration of wages within a range, as well as make
outliers more identifiable. An alternate approach is to use
control points in assessing range position. A control point
is defined as the point within a given range that indicates
a fully-qualified, competent employee. Control points are
more flexible than midpoints, in that they are not defined
simply by the center of the range; rather, they can be somewhere above or below that. Additionally, control points can
be used to establish different “centers” for multiple jobs
within the same range. It is fairly common to use control
points in broadbanding systems.
There are three general types of merit pay systems, performance only being the simplest. In a performance-only system, employees receive increases based exclusively on their
performance. Typically, this system is used in conjunction
with fixed increase percentages. In particular, all employees
with a given performance rating receive the same increase
(see Figure 1). The advantages of a performance-only system are they are simple to implement and easily understood. Additionally, employees with the same performance
Copyright© 2012 ERI Economic Research Institute
Figure 1
Rating Increase
4
5%
3
3%
2
2%
1
0%
receive the same increase. There are several disadvantages
which make performance-only systems less than ideal. In
particular, larger dollar amounts are awarded to people
higher in the pay range for the same performance (which
can lead to the out-of-range issue previously discussed).
Additionally, employees with varying base pay but the same
performance receive different actual dollar increases for the
same performance.
An alternative is to anchor increases to the midpoint (or a
control point) of the range. In this system, employees receive increases based on their performance rating and the
midpoint of their pay range. See Figure 2 for an example for
three employees in a pay range with a midpoint of $1,700
and a performance rating of 3. The advantage of this approach is that it allows high performers in the lower portion
of the range to progress more rapidly, while, at the same
time, slowing down employees who are above the midpoint.
This approach is most often seen with control points and
broadbanding systems. While this approach slows down
employees who are near the range maximum, it does not
have as much control as systems that use both performance
and position in range for determining increase amounts.
Figure 2
Midpoint: $1,700
Rating: 3
Increase: 3% of midpoint ($51)
Employee
A
B
C
Current Pay
$1,500
$1,900
$1,800
Increase
$51
$51
$51
Increase %
3.4%
2.7%
2.8%
2
Two dimensional systems utilizing performance ratings
and position in pay range are more flexible and robust than
other systems. They are also more complex and difficult
to administer. Nonetheless, this is the recommended approach for most compensation programs. Figure 3 presents
a simple two dimensional matrix with performance ratings
as one dimension and position in range as the other. Notice
that the higher an employee is on the pay range, the smaller
the available increase (for a given performance level). One
of the goals of these systems is to move the pay rates for employees with the same performance ratings toward a common target point (notice in Figure 3 that employees rated at
level 2 will not exceed the 3rd percentile unless they improve
performance). Additionally, movement is accelerated for
high performers who are in the lower portion of the range.
Figure 3
Rating
1st
Pay Quartile
2nd
3rd
4th
4
9%
7%
5%
3%
3
7%
5%
3%
2%
2
5%
3%
2%
0%
1
2%
0%
0%
0%
One major constraint impacting any merit system is the salary increase budget. Budget size is determined by a number
of factors including current revenue levels, past budget sizes, and salary increase surveys purchased from various survey firms (e.g., ERI’s Salary Increase Survey). A compensation analyst must set the increases such that the combined
cost does not exceed the budget. The more complicated the
system, the more difficult it is to hit (or more importantly,
to not exceed) that target. There are a number of procedures
for assigning increase percentages across performance ratings and position in range. A general model is outlined as
follows.
The first step is to estimate the percentage of employees that
will receive each rating. Rating systems vary where some
might be as simple as binary, others might be on a ten point
scale (both of those being extreme examples, typical rating
scales are between three and five points). There are a number of methods for estimating the number of ratings includCopyright© 2012 ERI Economic Research Institute
ing use of past rating distributions, speaking to managers
about current employee performance and potential ratings,
and reviewing any organizational rules and definitions regarding ratings (for example, a performance appraisal system might dictate that only 10% of employees can receive
the highest rating). Once estimates have been established, it
is possible to estimate the expected mean performance rating. This is done by multiplying each rating by the expected
percentage receiving that rating and summing the results
(basically a weighted mean, see Figure 4).
Figure 4
Rating
4
3
2
1
Expected
Ratio
Receiving
0.10
0.45
0.40
0.05
Product
0.40
1.35
0.80
0.05
Expected Mean: 2.6
After a satisfactory distribution of expected ratings is established, it is possible to begin development of a merit increase matrix, with ratings (and associated proportions) as
one dimension and actual range distribution breakdowns
as the other. The first step is to determine which cell is the
most populated, or where the average employee is located,
and what increase to assign to that cell (often the best value
to start with is the overall budget). Using the starting cell
as a base value, the remaining cells are populated based on
compensation philosophy (e.g., slow movement beyond the
midpoint) and value on rewarding performance (e.g., higher increases for top performers). Unless there is a minimum
increase, certain cells should be designated as not receiving
an increase (e.g., lowest rating, 4th quartile in range). Further refinements can be made in cases where high performance should outweigh range position. The main focus is
to get as close to the salary increase budget as possible. The
impact of each cell is calculated by multiplying the percent
increase by the proportion in range and again multiplying
by the proportion in the rating category.
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Figure 5 shows a complete matrix using an overall budget
of 4%. For example, the cell at the 2nd quartile for a rating
of 4 shows a 7% increase, and the cell impact is 0.315 (that
is, its contribution to the total budget is 0.315 percentage
points). Specifically, the calculation is (7.0 * 0.10 * 0.45).
The sum of each cell impact constitutes the total payout.
The sum of all the cell payouts in Figure 5 is 3.9%, which is
just shy of the 4% budget. Also notice, the simple average
of the cell increase values happens to be 4%. This will not
always be the case as the cell payout is a weighted average
and impacts the actual budget, so the focus should be there.
More often than not, initial matrix values will produce a
payout that is above or below the budget. In these cases, it is
a matter of making modifications to cell values in a trial and
error process. While this is only an estimate on the actual
payout, coming in slightly under a given budget is typically
preferred to going over budget. In particular, it allows for
wiggle room with the increases, or alternatively, the potenFigure 5
Pay Quartile (Ratio)
Rating
(Ratio)
4 (.10)
3 (.45)
2 (.40)
1 (.05)
1st (.28) 2nd (.45) 3rd (.19) 4th (.08)
8.5%
7.0%
5.0%
3.0%
7.0%
4.0%
3.0%
2.0%
4.0%
3.0%
2.0%
0.0%
2.5%
1.5%
0.0%
0.0%
Cell Average:
Payout:
4.0%
3.9%
Copyright© 2012 ERI Economic Research Institute
tial for other discretionary rewards (e.g., a one-time bonus
for top performers). However, generally the estimated costs
should come as close to the budget as possible.
The last major component of a merit-based system is the
timing of the increases. The two most common methods for
granting increases are hire-date and common-date. Hiredate increases are granted based around individual date of
employment, while common-date increases grant everyone
an increase on the same date. Hire-date timing reduces the
financial impact of an organization-wide increase in payroll and tends to spread the administrative impact evenly
throughout the year. Additionally, managers are likely to
have more time to evaluate each employee. On the other
hand, when based on hire-date, performance can be difficult to judge equally across employees as the benchmark
is relative and not specific to anything inherent about the
organization (e.g., a product cycle). Moreover, calculating
and managing salary increase budgets is often more difficult with hire-date systems. Conversely, in a common-date
system it is generally easier to project and manage salary increase budgets. Furthermore, the connection between specific business goals, individual performance, and increases
is often more apparent to employees in a common-date system. A major disadvantage of hire-date systems is the managerial burden of completing many employee evaluations at
one time. Also, some organizations cannot handle a single
company-wide increase (often due to cash flow timing).
Designing and implementing a merit-based increase program requires care and consideration of many factors.
Indeed, as demonstrated at the Hawthorn Works factory
nearly a century ago, it is important to understand which
factors impact performance behaviors and which rewards
are effective at increasing those behaviors.
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