Employ
Recruit
Summary: Pay for performance links compensation to results. This guide explains how it works, what to watch out for, and how to build a system that rewards productivity and drives growth.
Pay for performance, PFP, or P4P is an employee compensation model that makes employees eligible for increased pay based on their job performance. Employees are normally provided with set levels of productivity that are expected for their base pay. If they exceed these levels, they can receive additional pay.
P4P is also often called performance-based pay or performance-related pay.
How Does Pay-for-Performance Compensation Work?
Pay for performance compensation systems can be constructed in a wide variety of ways. However, most follow this general strategy:
Establishing Metrics
When an organization wants to establish a pay-for-performance system, it normally starts by establishing a method for measuring performance. It will carefully choose one or two metrics that can fairly represent performance, focusing on quality and value creation and not always simply a volume of work.
For a production line worker, measuring the number of items they produce might be a reasonable way to estimate performance. However, for a salesperson, measuring the volume of sales calls they make wouldn’t give a measure of the value of their work. Instead, a metric like the number of customer conversions can more accurately measure how well a salesperson performs.
The more complex a person’s role, however, the more metrics may be needed to fairly judge their level of performance. A company’s revenue may dramatically increase over the course of a year, for example, but this may simply be because a long-awaited product is finally released. Therefore, rewarding the company’s CEO based solely on increased revenue would not accurately represent their performance.
Fixing a Baseline
One of the first steps taken when an organization initiates a P4P compensation system is typically to set baseline levels of achievement for its workers. These levels are usually the lowest acceptable levels of performance that can be allowed for a sustained period of time without the employee being put at serious risk of losing their job.
Since all employees are expected to maintain these levels or higher, they’re considered average performance levels. A baseline level for a salesperson might be converting 20 customers a week. For a production line worker, it could be producing 100 items a day.
Setting Achievement Levels
Next, the organization will choose to either set thresholds for different bands of compensation or gauge performance on a continuum. If it sets thresholds, these levels can act as performance targets used to motivate employees. When a worker hits a target, they automatically receive additional compensation at a pre-agreed level. For example, if the salesperson hits a target of 25 customer conversions a week, they would receive additional pay, while the production worker might get an extra reward if they managed to produce 120 items in a day.
However, if the organization chooses to gauge performance on a continuum, it will reward all increases in performance with related increases in pay. Instead of having to hit preset levels to access rewards, all employees have to do is perform above the baseline. So, if the salesperson makes just 23 conversions in a week, they are still rewarded, while the production worker can gain extra compensation for producing 107 items.
Selecting Rewards
Organizations have to decide how much of their employees’ pay should be performance-based. These rewards should normally reflect how possible it is for employees to achieve greater results.
For example, an executive might receive a relatively low level of base pay, say $200,000/year, but be offered performance bonuses that enable them to earn much more, like $400,000/year. This means that their pay-for-performance compensation would represent two-thirds or 66% of their potential earnings.
For a production line worker who is unlikely to be able to double or triple their daily production level, this wouldn’t be a reasonable pay structure. Instead, the worker might receive a salary of $1800 a month with additional pay available up to $200/month. In this case, the worker’s P4P compensation would only represent up to 10% of their possible monthly income.
Selecting Reward Intervals
Employees can receive extra compensation on a daily, weekly, bi-weekly, monthly, quarterly, annual, or other schedule. Employers have to weigh the benefits of frequent rewards against the additional administrative burden that frequently measuring performance and calculating and paying extra compensation represents.
Different Types of Pay for Performance Systems
Companies around the world use pay for performance compensation systems to motivate and reward their employees. These systems come in many different forms and may not always involve a simple monetary reward for reaching a simple target.
The possible types of P4P systems include:
Performance-Based Non-Discretionary Bonuses
Many examples of P4P are like the examples we looked at above, with a salesperson hitting conversion targets or a line worker reaching production targets and receiving additional compensation. These bonuses are non-discretionary, which means that if the workers show a measured increase in production, their rewards are assigned automatically.
Variable Discretionary Bonuses
Discretionary bonuses can also be used to reward high performance, albeit on a flexible basis. Rather than rewarding all employees for increased performance, the employer may decide to reward the staff member who shows the highest performance per month, for example.
Workers can also be given on-the-spot bonuses for increased productivity or for hitting one-off targets. These bonuses may not repeat and may not be pre-planned, which means they may not be linked to pre-set targets meant to incentivize workers.
Merit Pay
Merit pay is one of the most common forms of pay for performance and one that’s implemented in companies across a wide range of industries. This system involves giving employees raises in their basic pay based on their performance and is usually linked to performance evaluations.
Raises can be individual or linked to salary bands within an organization. Rather than being rewards for hitting short-term goals, they represent permanent pay increases that reflect the value and contribution an employee makes.
Non-Cash Incentive Compensation
Employees can also be rewarded with non-cash incentives instead of simply giving them more money. These can include additional time off, remote working opportunities, trips, gift cards, hotel stays, etc. Employers may use these incentives to motivate their employees while saving money in the process by using rewards that may cost them less than their market value.
Team Bonuses
So far, we’ve focused on individuals attaining performance goals and being rewarded. However, it’s also possible to reward entire teams for good performance. In many cases, whole teams are given targets to strive for. If the team either reaches the goal collectively or every member hits their target, they’ll be rewarded. They might receive a discretionary bonus to show appreciation for their hard work, or non-discretionary bonus levels can be provided automatically when they reach target levels. Usually, these bonuses are divided among team members equally, so each person has the same stake. Other incentives, like trips abroad or extra time off, are also common rewards.
Advantages of Pay for Performance
There is still a lot of debate in the business world on how effective pay-for-performance strategies are. However, some of the advantages that employers have gained from P4P include:
- Increased productivity: Whether or not workers reach targets and receive bonus compensation, P4P can motivate workers to try, and this can help them produce more.
- Improved morale: When workers believe they can gain extra rewards, they can perceive their employer in a positive light and feel more in control of their earnings. Teams can build cohesiveness and collaborate more effectively when provided with achievable incentives.
- Increased loyalty: P4P programs can help attract and retain talent by offering employees a fair opportunity to earn more.
- Lower costs: Adding another team member to increase overall productivity can be expensive when the costs of recruiting them, paying their salary, providing them with benefits, and taking on more administrative work are added up. Offering a small bonus to your existing employees can be a more affordable way to obtain an equal increase in overall productivity.
Disadvantages of Pay for Performance
There are also possible downsides to consider when implementing a P4P system, including:
- Demotivation: If pay for performance is portrayed as a threat rather than a reward, it can stress workers out and ultimately demotivate them if they think they can’t realistically achieve their goals.
- Competition: Employees may feel more inclined to compete rather than collaborate, especially if rewards are not equally available or fairly shared.
- Quantity not quality: If the wrong metric is selected to measure performance, employees can take advantage of this and try to maximize the quantity of their work without actually making any increase in its quality or value.
Pay-for-Performance Systems Summarized
Employers can offer their employees the opportunity to increase their compensation by achieving set performance and/or production goals. Using carefully selected metrics to assess their performance, they can set up automatic or discretionary rewards for their employees that can include cash and non-cash bonuses and incentives.
Used correctly, P4P plans can navigate around employee competition and increased stress and produce greater motivation, productivity, and loyalty in the workplace.
Frequently Asked Questions
If used correctly, it certainly can be. Employers have to carefully weigh how much they can and should afford to reward their employees, but they also need to ensure that the performance levels or goals they set are achievable. If not, a P4P compensation system can backfire and actually demotivate workers who feel overly pressured to perform.
With a P4P system, employees are incentivized to increase their performance levels to obtain additional compensation. Normally, if they reach set goals, they’ll be rewarded.
Profit-sharing either allocates shares to employees or gives them a cash payment as a percentage of their organization’s profits over a set period. While this system may also motivate employees, gaining rewards is not guaranteed in the same way. An employee may work very hard, but other factors could make the company’s profits stay the same or even decrease, so that the employee wouldn’t automatically be rewarded.
Charlotte is an Human Resources Information Systems and Martech expect, Charlotte has worked for major brands in the industry including FactorialHR and Tooltester. Originally from Manchester, UK, with a Bachelor's degree from the Manchester Metropolitan University, Charlotte currently lives in Barcelona, Spain.