What is meant by “pay for performance?”

Pay-for-performance is a generic term for any compensation system that uses dollars to create an incentive for individual contribution to the organization. It is a reward that is earned as a function of having performed or achieved in relation to some preset standard or set of goals.

Merit pay and pay-for-performance are usually used interchangably to describe a system that gives an annual increase to an employee based on performance that is permanently added to base pay. However, confusion has been created because merit pay has historically been used as a form of guaranteed annual salary increase unrelated to performance.

How is it different from incentive pay? Incentive compensation typically places more dollars at risk with more defined performance standards that measure performance against pre-established goals. In a traditional merit system, annual payments are added to base pay. Some organizations are now attempting to control compensation costs by delivering merit payments in a lump sum bonus that is not added to base pay. As this begins to happen, merit plans begin to look more like incentive plans. The main difference is in the size of payments-the average merit pool may be five percent while incentive payments average between 10 and 15 percent.

Pay- for-performance can include merit pay, incentives, commissions, production incentive programs (such as gainsharing), and even benefits. As the distinctions between them becoming fuzzy, some compensation experts prefer to think of them all as variable pay -pay that varies based on some kind of performance, whether organization, division, team or individual.

The key question is whether an individual's contribution to an organization can be measured and the individual paid for that contribution without confusing pay-for-performance with other issues, such as cost-of-living adjustments. Such measurement can be made, but it requires that the jobs at issue be designed to identify specific responsibilities and the job duties that constitute those responsibilities.