Incentive pay is compensation paid to an employee when they meet certain objectives such as sales or profit targets or key performance indicators (KPIs). Based on the theory that rewards drive behavior, incentive pay is used to motivate employees to achieve individual or team goals.
Incentive pay—also referred to as performance pay—is a type of additional pay, offered to employees on top of their base salary. It’s often given in the form of monetary rewards such as bonuses or commissions. But incentive pay can also include other benefits such as gift vouchers, prizes, or extra paid time off.
A performance pay plan or program forms part of an organization’s compensation strategy and can be offered to employees at any level of an organization.
Merit pay vs incentive pay
Merit and incentive pay are often used interchangeably. While both relate to employee performance and motivation, there are important differences between the two.
Merit pay is a permanent increase in an individual employee’s base pay. It is essentially a pay rise as a result of their performance against set, measurable criteria.
Incentive pay involves one-off payments or other non-monetary gifts to an individual employee or team.
Structured Incentive Pay vs Casual Incentive Pay
Structured incentive pay involves making regular payments to employees when they meet specific, predetermined objectives. Examples include commissions or bonuses. The eligibility for and calculation of structured incentive compensation is typically set out in writing. This way, employees know exactly what incentive pay they can expect to receive.
Casual incentive pay involves one-off smaller incentives or gifts tied to a specific project or time period. There is a surprise element to casual incentive pay as it can be given at any time. Examples of casual incentive pay include gift cards or a team dinner at the end of a project.
Types of Incentive Pay
In addition to structured vs casual, incentive pay can also be monetary or non-monetary.
Here are some examples of types of monetary incentives.
- Commissions. Often used for sales positions, commissions are calculated according to the number of sales an employee or team makes.
- Cash bonuses. A one-off additional cash bonus payment for instances such as signing with an organization, holidays, retention, referral, or a general annual bonus at the end of the year.
- Profit-sharing. This is where an organization agrees to share end-of-year profits with employees—either via cash payment or stocks.
The following are examples of non-monetary incentives.
- Stock options. These allow employees to buy shares in the company at a discount. This can help build a sense of ownership among employees.
- Gift cards or vouchers.
- Extra paid leave.
- Other gifts such as chocolates or a bottle of wine.
- A team meal.
Why You Should Consider Offering Incentive Pay
Performance pay can be a useful tool for recognizing and rewarding employee performance, which is a key factor in creating higher levels of employee job satisfaction, organizational commitment, and trust in management.
In turn, this increases employee retention—employees who feel valued by an organization are more likely to remain with it in the longer term.
Incentive pay builds on this by motivating employees to achieve certain objectives that support an organization’s broader business goals. It can be used to increase sales, reduce costs, or encourage more efficient performance—resulting in better profits.
On top of this, organizations often compete to attract top talent, and an incentive pay program can help you stand out from the crowd of potential employers. Team-based incentive pay can also be useful in encouraging teamwork and collaboration.
Disadvantages of Incentive Pay
Incentive programs need to be carefully structured and managed to avoid certain pitfalls.
Not all employees are motivated by incentives. For some, while they might boost their productivity, it also intensifies their work experience. This increases their stress, impacting their overall job satisfaction.
Incentive pay can also bring out the worst in some employees. In the extreme, it may encourage them to take risks or behave dishonestly. A well-known example of this was the Wells Fargo fake account scandal, where employees opened additional customer accounts without the customer’s permission to receive related performance pay.
Perceived or actual inequities can arise in these programs—for example, where an employee feels they have unfairly missed out on a bonus. These can cause feelings of resentment which affect overall employee morale and company culture.
It’s also important to calculate the cost of an incentive pay program. It can be a significant expense and organizations must have the ability to provide it once it’s offered to employees. Retracting promised incentive pay can also seriously impact employee morale.
Tips for Designing an Incentive Pay Plan
- Ensure your incentive pay plan aligns with your business strategy. It should help your organization achieve its business goals. If it doesn’t, you risk spending money without increasing profits.
- Identify what you want to achieve with your incentive program. Do you want to attract top talent, increase sales, or ensure a large project is completed on time? Identifying these goals helps you to measure the effectiveness of your incentive plan and review it if necessary.
- Carefully consider how to structure your incentive pay program. Will it be structured, casual, or a mix of both? What types of incentives will you offer and which employees will you offer them to?
- Review your proposed incentive pay plan to confirm whether it may create any inequities or other unfair outcomes. If there is potential for this, your plan may have the opposite of its intended effect and you should review it accordingly.
- Check any legal requirements to ensure your incentive pay plan complies with any relevant employment laws, especially regarding discrimination. It’s also essential to understand the tax consequences of your plan for both the organization and its employees. It’s worth seeking professional legal and tax advice on this.
- Communicate it to your employees. Employees can’t be motivated by something they don’t know about. Make sure you explain your incentive pay plan to them and make it accessible. You can do this via a company-wide email, posting the plan on your intranet, and asking managers to discuss it with their team. Setting out your incentive plan also ensures transparency around the process.
Conclusion
Incentive pay is performance pay that employees receive for reaching a certain goal or target. It is in addition to their base pay. Incentive pay can be structured or casual, monetary—such as commissions and bonuses—or non-monetary—such as gift cards or team lunches.
An incentive pay plan is useful for motivating employees and increasing productivity. It’s also an effective way to recognize and reward top-performing employees. To design and implement an incentive plan, it’s essential to identify its objectives and review it for any legal, tax, or fairness issues, as well as communicate it to your employees.
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