Performance-Based Pay: Definition, Benefits, Challenges & Tips

Performance-based pay is a compensation system where employees receive extra cash for the results they deliver.

This can be based on team or individual performance and is a great way to motivate and retain staff.

But before you implement these financial incentives, you need to understand what they are, what they entail, and the advantages and drawbacks associated with them to make an informed decision.

In this guide, we'll explore all of the above so you can be more informed—including the five different types of pay-based-on-performance structures.

What Is Performance-Based Pay?

As mentioned, performance-based pay (PBP)—or pay-for-performance systems—is a compensation strategy that rewards employees based on individual or team performance.

Employee performance is tied to measurable, predetermined benchmarks you set within your company, such as sales/performance targets or project outcomes.

Performance-based rewards are designed to:

• Motivate employees
• Improve productivity
• Align your workforce with organizational goals.

In fact, according to a 2022 Lever study, salary or potential bonuses are the biggest motivators for employees to stay at a company, with 46% of employees preferring them over flexible work arrangements.

You can use different performance bonuses in the workplace to motivate and retain staff, such as:

• Merit pay increases
• Commission structures
• Profit-sharing plans

Each performance-based compensation system has its own unique characteristics, which we'll cover in the next section.

Types Of Performance-Based Compensation

Let's look at five types of pay-for-performance compensation strategies in more detail:

1. Merit-based pay raises
2. Bonuses
3. Commission-based pay
4. Profit-sharing
5. Gainsharing

1. Merit-based pay raises

Merit-based pay raises are commonly used to reward employees for individual performance.

Raises are determined through performance evaluations, during which managers assess an employee's skills and contributions to the company.

Merit-based pay raises are permanent. They increase an employee's base pay, unlike a once-off bonus. Employers can decide what merit increase is suitable for the employee/s, but according to recent research by Mercer, the average merit-based raise for 2024 sits at 3.5%.

Here's an example:

• Employee base salary = $3,000/month
• Merit raise = 3.5%
• New employee wage = $3,105/month [3,000 x 3.5%]

2. Bonuses

Bonus plans are once-off financial rewards offered to employees over and above their regular wages for a job well done—usually given when they achieve specific pre-defined goals.

These kinds of performance-based compensation systems are an excellent way to motivate your workforce based on individual, team, or organizational performance.

Here are a few examples:

• Individual performance: A salesperson team might earn a 5% bonus for surpassing Black Friday sales targets.
• Team performance: A manufacturing team may earn an extra $500 each for the collective effort to increase productivity, improve quality, or reduce waste.
• Organizational performance: An insurance company might reward its workforce with a $250 Christmas bonus when consistently exceeding targets throughout the year.
• Spot (or discretionary) bonuses: These rewards are given at the business owner/manager's discretion for exceptional performance, like an events company rewarding their staff after a successful New Year's party.

3. Commission-based pay

Commission-based pay is a performance-based compensation structure that allows workers to earn extra money based on their sales performance. This is commonly used in sales roles and is directly linked to an individual's achievements and the amount of money they bring in.

Here, we look at three types of commission-based pay models you can use:

1. Straight commission

Employees receive a fixed percentage of the sales they generate. With this commission structure, employees generally do not have a base salary.

For instance, sales reps earn 15% on the monthly sales they bring in. If they generate $25,000, they'll take home $3,750 [25,000 x 15%] that month.

2. Salary plus commission

This pay-for-performance model offers the best of both worlds; employees have a base salary and can earn additional compensation in commission.

For instance, an employee receives a base salary of $3,500 monthly and earns 5% on every sale thereafter.

3. Tiered commission

This commission model allows employees to earn more when they reach specific targets.

For instance:

• 5% commission on sales up to $50,000
• 7% commission on sales between $51,000 and $80,000
• 10% commission on sales $80,000+

4. Profit-sharing

Profit-sharing bonuses are compensation systems where employees receive a share of the company's profits. It's a powerful tool for fostering a sense of ownership and improving employee morale, as their efforts directly determine their potential earnings.

This performance-based pay model gives employees a portion of your business's annual or quarterly profits.

The business pays these earnings to a profit-sharing plan (PSP), which is divided among eligible employees and stakeholders. If no profits are generated for that year, you won't need to make any contributions to PSPs.

Determining how profits will be allocated to each employee can be done in several ways:

• Deferred (DPSP): Profit contributions form part of employees' retirement (401k) funds.
• Cash plan: Profits are paid to employees and taxed as normal income.
• Pro-rata plan: Each employee receives the same amount, either as a fixed dollar ($) or percentage (%) amount.
• Age-weighted plan: Larger profit splits are allocated to older employees.
• New comparability plan: Employees are divided into two or more groups using an Internal Revenue Service (IRS)-approved formula to calculate 401(k) contributions.
• Comp-to-comp plan: The total profit-sharing contribution for all employees is first calculated, and then each employee's portion is divided by the total contributions.

5. Gainsharing

Gainsharing is a type of performance-based compensation used to motivate employees and foster collaborative involvement within an organization.

Employees are given a share of company profits based on and measured against predetermined key performance indicators (KPIs). These metrics serve as a reference point from which future improvements are calculated.

A gainsharing pay-for-performance model is usually tied to specific, measurable, achievable, and time-bound (SMART) goals—and paid either monthly, quarterly, or annually.

At the end of the timeframe, KPIs are collected and compared to previous benchmarks. A positive change is considered a "gain", which translates to financial rewards for employees.

Let's explain:

A carpet manufacturing company notices $500 wastage for every carpet produced. They want to use a gainsharing compensation plan to encourage employees to reduce waste costs over six months.

After six months, waste costs per carpet have reduced to $285. And within that time, 1,500 carpets were produced. This means the company saved $322,500, and this "gain" amount is split amongst eligible employees.

• Original benchmark = $500
• Total savings per carpet within the timeframe = $215 [$500 - $285]
• Total "gain" in six months = $322,500 [$215 x 1,500 carpets produced in timeframe]

For more employee incentive ideas, check out ShareWillow's website.

Benefits Of Performance-Based Pay

Now that you have a good understanding of the various types of performance-based compensation, let's look at why they are advantageous to your company:

Enhanced motivation

• Goal alignment: PBP aligns employee goals with organizational objectives, creating a sense of purpose, accountability, and direction.
• Self-motivation: Recognizing and rewarding employee performance can boost intrinsic motivation, meaning workers do something because they enjoy it. This can lead to increased job satisfaction and retention.
• External motivation: Performance-based pay plans provide tangible rewards for employees to strive for high performance. They become more motivated to work harder to reach these targets due to external factors like financial gain.

Attraction and retention of talent

• Competitive compensation: Attracting top talent involves more than offering competitive salaries. PBPs can attract top talent from the market, as high performance is rewarded over and above salaries.
• Reduced turnover: PBPs help reduce employee turnover and retention costs (including reduced absenteeism). In fact, according to a recent Gallop study, well-recognized employees are 45% less likely to leave a company after two years.
• Employee value proposition: PSPs show your company's commitment to rewarding high performance, making you an attractive employer to job seekers.

Increased productivity

• Performance-driven culture: Offering PBPs fosters a results-driven work culture where employees are encouraged (and rewarded) for exceeding performance expectations.
• Improved efficiency: Pay-for-performance plans help drive operational success as workers are more inclined to give their best when project bonuses/financial incentives are linked to their efforts.

Challenges Of Performance-Based Pay

Next, we look at a few drawbacks of pay-for-performance plans:

Increased stress and burnout

Setting high-pressure performance targets for employees can lead to:

• Stress
• Burnout
• Increased risk of depression/anxiety symptoms

This is particularly common when employees feel overwhelmed or unsupported.

To avoid this, businesses must:

• Establish clear, achievable goals
• Provide ongoing support, training, and resources
• Regularly monitor workloads
• Adjust organizational goals if and when needed

Unhealthy competition

Performance-based pay might inadvertently foster competition over collaboration among your workforce, especially if individual performance rewards overshadow team-based goals.

Here are a few suggestions to counteract this:

• Avoid favoritism
• Recognize both individual and team achievements
• Encourage collaboration by fostering a culture of teamwork
• Emphasize the importance of collective success

Complex administration

Designing and managing any performance-based pay model can be complicated, requiring:

• Careful planning
• Clear communication
• A robust system to effectively track and measure performance KPIs

As a solution, use ShareWillow's incentive management software to streamline and simplify this process.

Best Practices For Implementing Performance-Based Pay

To ensure the success of your performance-based compensation system, it's crucial to follow these steps:

• Set clear performance metrics: Define SMART goals that align with organizational and employee goals. Identify KPIs that accurately measure employee and team performances.
• Regular performance evaluations: Conduct consistent assessments to provide feedback and monitor progress. Encourage open dialogue between managers and employees during performance reviews.
• Transparent communication: Clearly communicate performance metrics, rules, and eligibility criteria of the PBP model/s to all employees. This ensures everyone knows what is expected of them and how their efforts impact financial rewards.
• Balance individual and team incentives: Recognize and reward individuals and teams to motivate all employees to strive for excellence. Avoid favoritism to encourage collaboration and teamwork.

FAQs

Do employees pay tax on performance-based compensation?

Yes, employees pay tax on any pay-for-performance model as the additional cash is considered taxable income.

What are discretionary bonuses?

Discretionary bonuses are additional compensation given to employees at the discretion of the employer/manager. These are often once-off incentives that recognize exceptional performance or loyalty. A few examples include:

• Holiday bonuses—payments given at year-end as a token of gratitude and appreciation
• Project bonuses—awarded to employees for completing a specific task or project
• Spot bonuses—given "on the spot" for achievements worthy of recognition

Simplify Performance-Based Pay For Your Employees With ShareWillow Today

As you can see, there's a lot that goes into a company's performance pay philosophy. From determining KPI benchmarks to calculating commission structures, the entire process can seem overwhelming.

The good news? Pay-for-performance compensation plans are a brilliant way for you to motivate, attract, and retain staff.

Whether you opt for merit-based increases, profit sharing, or gainsharing programs, you can use ShareWillow's world-class incentive software to simplify the process.

We're on a mission to help millions of small businesses motivate employees to think and act like owners. Sign up for a free demo today.