Merit Pay as an Incentive

Merit pay or a merit raise is a salary increase the firm awards to an individual employee based on individual performance. It is different from a bonus in that it usually becomes part of the employee’s base salary, whereas bonuses are generally one-time payments. Merit pay has pros and cons.
Advocates say granting pay raises across the board (without regard to merit) reduces performance by rewarding employees regardless of how they perform.
Detractors argue, most notably, that since most appraisals are unfair, so too are the merit decisions based on them. A recent survey found that only 20% of employers in North America said merit pay drives higher levels of performance. This survey also concluded that awarding raises for demonstrating job-critical knowledge and skills was the better option.
If a merit pay plan isn’t working, one sensible reaction is to improve it. This starts with establishing effective appraisal procedures, to ensure that managers actually do tie merit awards to performance. Two merit pay adaptations are popular. One awards merit raises in a lump sum once a year. Traditional merit increases become part of the employee’s salary, but these lump-sum merit raises do not.
This has two benefits. First, the merit raise is not baked into the employee’s salary, so you need not pay it year after year. Another adaptation ties merit awards to both individual and organizational performance.