What Is Merit Pay?

Merit pay is a compensation process that rewards employees based on their individual contributions. Merit pay is a tool employers can utilize to recognize and reward top-performing employees.

Should Companies Implement Merit Pay?

Merit pay is an excellent way to reward top performers; however, implementing merit pay increases throughout an organization requires strategic planning and execution.

The Benefits of Merit Pay

Financial incentives are a core motivator for many employees. Introducing a merit pay process into the organization can prove rewarding to both the organization and the ambitious employee in the following ways.

  • Identify individual performance. A merit-pay program includes setting clear expectations and goals for each employee, which more objectively evaluates individual performance during the review process.
  • Increase productivity and efficiency. When employees know that the quality of the work they are producing is tied to compensation, thay are highly motivated and self-directed.
  • Attract top talent. Employees who believe they are the best in their field and know their self-worth are eager to have their performance directly impact their pay. Employers can differentiate high- and low-performing employees and concentrate on retaining the most valuable employees.

The Downsides of Merit Pay

Merit pay is based on individual performance and results rather than tenure with the organization or number of hours spent working. While they do improve performance, merit-pay systems can lead to additional problems.

  • Evaluations. For the employee to receive a merit pay increase, a performance review must be completed. In some work environments, there is no exact measurement of rating employees’ performance. With the lack of quantifiable data, results in evaluations differ from manager to manager.
  • Favoritism. Any time an employee is being evaluated, the rating is subjectively determined by the direct manager. When completing evaluations to determine the merit pay increase, it is imperative that competencies and goals are measurable. Even when evaluations are measurable, employees may argue that they are at a disadvantage compared to others.
  • Competition. When compensation is tied to competition, employees may go against company policies and organizational values to ensure success. This type of competition can challenge employees’ ethical alignment within the organization.

How Does a Merit-Pay System Work?

There are several ways to structure a merit-pay system; we’ll look at the three most common.

Merit Grid

A merit grid instructs the manager to allocate an annual percentage of increase determined by the employee’s salary or hourly rate, hire date, and the employees’ performance review rating.

The sample grid below depicts the merit budget approved in collaboration with the finance department and C-Suite executives of 3%. The budget allows each department manager to understand the total amount of funds available to allocate to the merit increase.

Based on the rating score in column two, the department manager can recommend what percentage to award the employee. The salary increase column calculates the annual increase the employee will see with the recommended percentage (%) versus the approved 3% increase. The grid allows the department manager to allocate more or less of a percentage (%) to employees based on their specific performance rating without going outside of the approved overall budget ($29,331.43) .

Name Rating Pay Hire % Salary Increase 3% Merit Budget
A 4 20.00 6/11/02 8 3,199.87 1,199.95
B 3 18.00 5/17/19 5 3,276.00 1,1965.60
C 2 17.00 4/3/21 3 856.44 1,230.53
Budget $29,331.43


Management-by-objective, or MOB, is a collaborative effort between the employee and manager to define yearly objectives—typically three—that relate to department goals. The manager and employee meet for periodic check-ins to review the status of each objective. At the time of review, the manager reviews with the employee their overall performance in meeting the pre-established objectives. The manager then assigns a performance rating that correlates to a merit increase for the employee.

A potential downside of MOB is that the manager identifies the performance review as the time to address all concerns with the employee instead of focusing on the pre-established objectives and the employees ability to complete those objectives within the review period.

Group Incentive Plans

Group incentive plans reward a group of employees for collaborative work. Clear goals that can be measured quantitatively must be set to ensure all employees are rewarded for their performance. In a group incentive plan, the goal is to establish an area where the employees build upon each other’s skills to influence change.

For example, in a call center, a group-incentive goal might focus on customer satisfaction. Customer service satisfaction scores are heavily evaluated in a call center setting, as every employee who interacts with a customer can influence the ratings customers give at the end of their call. With this measurable data, it’s easy to tell when the group meets the goal and has earned the previously defined merit pay.

How to Implement Merit Pay

When tying compensation to performance, it can be difficult to know how and when to award the increase to the employee’s base salary. With careful planning and due diligence, an organization-wide approach best supports the strategic implementation of merit pay.

Step 1: Determine Compensation

To establish a merit budget, the organization must first agree on the strategic merit plan. Human Resources must work in partnership with senior managers and finance to determine the merit increase percentage and budget per department.

Step 2: Set Goals

Human resources, in partnership with department managers, devises accurate, credible ways to measure employee performance in regard to established goals. For example, when looking at a sales position, HR and the sales manager may establish goals that focus on the difficulty of the sale and scope of the job the sales representative is pitching to the customer, not just the total sales number for a set timeframe.

Step 3: Communicate

An essential part of managing a merit pay program is clear communication. Merit pay is most successful when all levels of the organization understand the plan. The reward structure, method of calculating merit increase, assigning merit increase, and timeline of the merit-plan implementation must be communicated effectively.