Using Your Pay System to Improve Employees' Performance: How You Pay Makes a Difference

Abstract

One goal of many pay plans is to improve employees' performance. This investigation of pay policy assesses the effects on performance of base-pay levels, merit increases, and lump-sum bonuses. The study shows that both "how much" is paid (the amount of the reward) and "how" the money is paid (the relationship that exists between performance and pay) influence employees' future performance levels. As expected, the results show that how much you pay is important. Both raises and bonuses increase future performance, but merit raises had a greater effect than that of bonuses. In this study, the benefit of a 1-percent increase in base pay was comparable to the benefit from a 3-percent bonus. Even though the absolute level of one's salary was not related to future performance, relative pay levels made a considerable difference. Perhaps most important, the study also showed that how an employee is paid can also influence performance. For merit raises, the link between pay and performance was unrelated to future performance. However, the extent of the pay-for-performance relationship with bonuses was significantly related to future performance-provided the link between pay and performance is clearly established. Based on these findings, pay structure can be designed to achieve greater employee performance. To begin with, simply spending more on employee pay would yield minimal results. Improving the merit-increase pool by one percentage point but otherwise not making any allocation changes, for example, would be projected to increase performance only by roughly 2 percent. However, if the same money was applied to pay-for-performance bonuses, the analysis suggests a performance increase of better than 15 percent. Indeed, the results suggest that providing a strong pay-for-performance link for bonuses rather than raises had the greatest potential benefit, predicted to improve employee performance by nearly 20 percent.

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