Merit-based pay is all about rewarding employees based on the quality of their performance rather than their tenure or job title. This can motivate them to go above and beyond and boost retention across your organization. Merit-based pay is a tried-and-tested method that connects rewards directly to business outcomes instead of generic market benchmarks.

If you want to know more about the specific advantages and disadvantages of the system, as well as how you can best calculate merit pay for your teams, you've come to the right place.

Read on for the pros and cons of this compensation strategy, more on calculations, and how the right compensation software can help you achieve your business’s goals.

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The Advantages and Disadvantages of Merit-Based Pay

As with any approach to compensation, there are several factors to consider before embarking on a merit-based pay strategy.

Merit-based pay can help you:

Attract, Retain, and Motivate High Performers

In a global survey of 45,000 employees, “pay and bonuses” were considered the top benefits for workers looking to leave their current employment for greener pastures. Recognition is clearly a top factor for today's talent. Merit-based rewards can help you attract, retain, and motivate the people who will help you drive business goals forward.

Get Ahead of Performance Issues

Because review cycles are part and parcel of merit-based pay, you’ll be able to identify development needs early. This helps you spot underperformance quickly and initiate coaching or improvement efforts.

Set Clear Day-to-Day Expectations and Business Objectives

Clear expectations are a foundational aspect of employee engagement and performance. According to Gallup, only 44% of employees fully know what’s expected of them at work. Merit-based pay can help you combat the confusion. With pay increases directly linked to meeting or exceeding expectations, employees and employers have an agreed-on standard for success. Add regular review cycles to the equation, and staff should have a clear understanding of what their day-to-day tasks should look like and how these need to align with business goals.

Encourage Healthy Competition

When employees are keenly aware of performance expectations, they're more likely to work hard to outperform the rest. A healthy sense of competition among colleagues can inspire employees to work productively and do their utmost to contribute to business targets.

As with any compensation strategy, there are a number of potential challenges too:

• There is a risk of subjectivity. Even with robust performance criteria, manager bias can influence review scores and lead to unfair outcomes.
• Even when managers are as unbiased as possible—and when their decisions are vetted by other colleagues—employees may perceive decisions as relationship-based rather than results-based and feel demotivated by what they think of as favoritism.
• Merit-based compensation is quite resource-intensive. Building and maintaining a fair and accurate system can take a lot of time and effort.
• Because employee morale is very strongly linked to salary, failure to achieve merit-based increases can severely damage morale—especially if expectations are not carefully managed.

Communicating performance standards and other expectations regularly and clearly can help you avoid these kinds of challenges and ensure staff stay motivated and working hard towards their increase.

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How Merit-Based Pay Works: Performance Standards and Review Cycles

To ensure that merit-based pay works effectively in your organization, you need clear and measurable performance standards. These standards can include KPIs like sales figures, customer satisfaction rates, or production targets hit. They can also include competency development milestones, especially for roles that rely on soft skills more than tangible outcomes.

It's crucial that you have a reliable and bias-free strategy for collecting this kind of performance data. Choosing compensation software that integrates with your HRIS can help. It removes the manual burden of transferring employee data from one program to another and reduces the risk of biased, error-prone data aggregation processes, such as those inherent in using spreadsheets. PeopleFluent Compensation is the perfect choice since it is platform agnostic, meaning it can consume information from any HRIS on the market, making it easy to keep track of your performance data.

Apart from performance standards, you will also need to develop a schedule for evaluating employee performance against the criteria you set. Collaborate with stakeholders across teams to decide on scheduling one-on-ones or check-ins at monthly or quarterly intervals. Whichever cadence you and your colleagues decide on, it's important that there is a degree of regularity leading up to the final review date. That way, employees can keep the end target in sight and ensure they align their performance with their targets. This is a win-win for both employers and employees. Staff will have the motivation to steadily work towards a target, and employers will benefit from steady, consistent focus on business targets.

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How to Calculate Merit-Based Pay in a Complex Enterprise

Most businesses construct a merit pay system based on a percentage scale. Taking wider market data into account is always a good idea, as this will help you keep your compensation competitive to attract top talent.

Employees are usually offered a percentage of their current income or pay. Typically, this varies between 1% and 5% of their base salary. Some organizations will reward exceptionally high performers more generously than other, more modest high performers.

Once performance data is in and the increase has been approved, calculating the new salary simply involves applying the merit increase percentage to the current salary and adding those two figures up to determine the new salary.

But for today's enterprise organizations, strategic planning goes far beyond basic calculations. Making a single change for one employee can result in a wide range of consequences for your entire organization. Pay equity can be disrupted, which may result in demoralization or non-compliance. Your budget can be impacted, which will have wide-ranging consequences for every team in your business. Salary compression is also a potential challenge, and with three in five organizations citing salary compression as a worsening issue in the post-Great Resignation years, it makes sense to plan strategically to avoid this outcome.

This is why using compensation software is always a good idea. With PeopleFluent, you can understand how merit increases will impact your wider organization before applying any changes. Comprehensive scenario modeling capabilities will help you analyze a wide range of outcomes, such as your organization's budget and pay equity across departments and regions. This empowers you to test any adjustments to your merit strategy in advance so you can plan for likely outcomes.

Using PeopleFluent's scenario modeling tools means you get a clear view of the percentage increase your organization can afford, which helps you align rewards with performance standards before rolling these standards out across your business.

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