Performance Related Pay | Factsheets

Introduction

Performance-related pay (PRP) is a way of managing pay by linking salary progression to an assessment of individual performance, usually measured against pre-agreed objectives.

This factsheet explores the justification for linking pay and performance as well as the potential issues around implementing PRP schemes. It provides an overview of key issues including the role of line managers, measuring performance, distribution of awards and the impact on employee behaviours. It also highlights the latest research.

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What is performance-related pay?

Performance-related pay (PRP) is a way of managing pay by linking salary progression to an assessment of individual performance, usually measured against pre-agreed objectives. It is also known as individual PRP or merit pay. Wage increases awarded through PRP are normally consolidated into basic pay, although sometimes they involve the payment of non-consolidated cash lump sums - see more in our factsheet on pay progression.

PRP has grown since the 1980s as employers sought ways of improving performance by linking employee earnings to achieving business objectives. However, in some circumstances, PRP has proved a rather crude instrument and the 1990s and beyond witnessed a number of challenges to the theory and practice.

As some of the earlier schemes failed to deliver the promised results, a number of employers brought in new or revised PRP schemes or moved to new approaches altogether (for example, skills-based pay), while others developed hybrid schemes. The notion of linking pay to a wider definition of employees’ ‘contribution’ rather than simple ‘performance’ has gained ground. This emphasises not only performance in the sense of the output (the end result) but also the input (what the employee has contributed).

Recently, whether to link reward to employee performance has attracted media coverage as a result of some well-known firms breaking this practice. However, one of the findings from our Reward management survey is that performance-based reward is, despite the hype, still widespread in the private sector.

Not only that, but the measures used in performance appraisals are still quite traditional. Nearly all organisations surveyed assess performance against individual goals, with most using it to inform a salary and/or a non-salary reward decision. The next most common approaches are to assess achievement against: team goals; an absolute view of an individual’s performance; and an employee’s own self-assessment.

By contrast, recent innovations in assessing employee achievement such as peer assessment, 360 degree appraisal or external assessment are used rarely by our survey respondents. Even when such approaches are part of the appraisal process, there is a reluctance to use them for making pay and reward decisions.

The rationale for performance-related pay

PRP objectives may be grouped under three main headings.

1. Encouraging high performance levels by linking performance to pay

While money can influence staff behaviour, it isn’t always in the ways that the organisation intended. Where PRP appears to have worked, critics claim it’s often the underlying improvements in performance management and development that have the greatest impact on bringing about positive changes, rather than the increased pay. And in an era of tight pay budgets, it can be difficult to give those judged as high performers significantly more than those whose performance is seen as being good - see our performance management factsheet. Our report, Show me the money, highlights other issues with the operation of PRP, for instance, there's the danger it can: ‘crowd out’ intrinsic motivation, undermine teamwork, and encourage individuals to focus on certain measures at the expense of others

2. Embedding an entrepreneurial or high-performance culture across an organisation

PRP can send a message to workers about what achievements the organisation wants and is prepared to reward, although there are other (non-monetary) ways of communicating the need for high performance. Communication can also suffer as employees may feel constrained about having open conversations with their line managers in case this influences the size of their pay rise.

3. The notion of equity or fairness

There is more widespread acceptance of the effectiveness of PRP in this respect, that people consider it right that higher performing employees should get more money, but there are some notable differences by sector. Our survey on employee attitudes to pay finds private sector workers are more likely than their public sector counterparts to want their rewards to reflect performance. However, if pay for some individuals is not perceived as reflecting their performance, other employees may see this as unfair.

Measuring performance

PRP typically uses a system based on consolidated pay progression within pay brackets attached to each grade, level or zone.

However, for performance to be rewarded, an effective means of measuring that performance is needed. Historically, this has been via performance appraisal, though some employers are now using less formal approaches to appraise success.

Linking pay with performance

In traditional performance reviews, each employee’s performance is typically ranked on a scale ranging, for example, from ‘unsatisfactory’ to ‘superior’ (sometimes using ‘forced’ distributions, as detailed below). Some systems allow for managers' discretion in translating these scores into levels of pay rise, while others determine increases through a formula or a matrix system linking each grade, level or zone to each of the performance categories. This method may involve the use of a comparison ratio, or ‘compa ratio’, the term given to the relationship between each employee’s current salary and the mid-point of their grade. Thus, for a worker at the mid-point of their pay range, the compa ratio is 100%.

It’s often felt appropriate for pay rises associated with each performance category to be higher for employees at lower points within the pay brackets, given the presumed existence of a learning curve for new entrants to a grade. However, more senior employees who’re performing very highly may resent the award of comparatively low percentage pay rises.

Incentives and recognition: an evidence review shows that where ratings are used to gauge performance and allocate incentives, the rating method used makes a difference. If a greater number of categories is used in the rating segmentation (for example, five), employees are more likely to feel that it’s fair.

When it comes to the use of objective and subjective measures of employee performance the picture is more nuanced. Although subjective measures are generally seen as potentially prone to bias because they involve an element of judgement, research suggests that not including them may be detrimental and cause employees to perceive the rating process as unfair. However, performance evaluation that puts a lot of weight on subjective measures is also considered by staff to be unfair. Overall, this suggests a balance between objective and subjective assessments will be more effective than an overreliance on one or the other.

Coverage and trends in performance-related pay

Who gets performance-related pay?

While various estimates exist of the coverage of PRP, partly as a result of differing definitions of PRP adopted by researchers, we’ve identified the following broad themes and trends:

Individual PRP is prevalent in the private sector, and indeed is virtually ‘the norm’ in some parts of the sector, such as financial services.
In the public sector, most employers provide for a basic percentage increase, with a small proportion including a performance-related element, typically for senior staff.
Merit pay most commonly covers managerial and other white-collar staff, with fewer extending coverage to manual or lower-grade workers.
The coverage of PRP varies internationally, for example, employers in France make greater use of merit pay than occurs in Great Britain. Ironically, this is partly attributable to the much more highly regulated employment background in France that leaves individual managers keen to exert some control over performance improvement via pay.

Measuring trends in merit awards

Under PRP arrangements, the pay review process may provide for either:

pay progression entirely based on individual performance appraisal ratings (known as ‘all-merit’ awards), or
a general pay rise for employees in addition to an element that is linked to individual performance (‘basic-plus-merit’ awards).

Trends in performance pay are commonly measured via the pay review budget (or pay bill budget) allocated for the merit element of awards. However, the scope for any merit element of pay tends to be reduced during times of low pay award levels, with some employers finding it simpler to award a modest across-the-board increase rather than attempting distribution based on merit.

Implementing PRP schemes

For PRP to succeed, effective arrangements must be in place to define, measure, appraise and manage performance. The focus should be on encouraging high performance first, underpinned by effective performance management systems, and only then on pay as a reward to help achieve that goal. To create a sustainable high-performing workplace, the whole range of financial and non-financial rewards must be carefully designed to ensure that they support and are supported by PRP.

The key issues for employers implementing PRP include:

Line managers' objectivity and consistency

Line managers are key to effective implementation of PRP. They should be involved at an early stage in designing systems to ensure consistency and transparency when assessing achievement. Some schemes try to eliminate marking differences between ‘hard’ and ‘soft’ managers using ‘forced distribution’ arrangements, that is insisting that all managers band a certain proportion of staff in each performance pay grouping (for example, 10% ‘poor’ and 10% ‘superior’).

Research evidence reported in Incentives and recognition: an evidence review suggests there is no difference between competitive schemes, in which only the highest performers are rewarded, and non-competitive schemes, where all employees whose performance increased receive an incentive. However, given the importance of perceived fairness, highly competitive schemes that are seen as ‘winner takes all’ may well demotivate people. In a similar way, our evidence review on performance management found that the use of competitive ‘forced ranking’ in staff appraisal tends to backfire, due to perceived unfairness. On balance, it seems forced distribution can be used to an extent, but there may be little point in condensing rewards in highly competitive systems, as this approach is no more effective than more equitable rewards and risks backlash.

Ensuring objectivity is also important to avoid rewarding favourites. The potential for unlawful discrimination is particularly serious. It’s important that managers are made aware the impact that unconscious bias can have through training and for monitoring of merit pay awards by gender, ethnicity, age and so on).

See more in our line managers' role factsheet.

Distributing pay awards

As some HR commentators note, pay isn’t the only motivating factor, and sometimes might not even be the most important one. And the performance element of pay is often relatively small, particularly for those relatively middling performers who will form the bulk of the workforce. The problem is accentuated in times of low inflation when the pay bill increase is usually limited to relatively small percentage figures. Even where PRP may have a motivational impact for high achievers, the corollary can be the demotivation of the lower or middle level performers. So it’s important to consider the issue of pay award distribution carefully.

Identifying development needs

A major concern is that linking pay awards to the performance review process may inhibit an open and honest discussion of an individual’s training and development needs in case this influences the size of their pay rise. One solution is to separate the pay review aspect of performance assessment from the broader performance/development review, for instance by holding separate meetings some weeks or months apart.

Communication can also suffer as employees may feel constrained about having open conversations with their line managers in case this influences the size of their pay rise.

Time-consuming nature

The processes associated with PRP, such as performance reviews, can be administratively very time-consuming. In general, it's important to allow enough time away from day-to-day duties for managers and employees to be able to engage in the PRP process effectively.

Undesired impacts on employee behaviour

Behavioural science shows that while financial incentives can increase worker performance, if they are leveraged too strongly, they may create excessive risk. As a result, they may either distort people’s motivations by incentivising unintended or excessive behaviour, or weaken the motivating effect if people feel averse to the added risk. Rather, the size of incentives should be commensurate with what employees can reasonably do to increase their performance. Research (Incentives and recognition: an evidence review) indicates that linking pay to both individual and team achievements may be better than just focusing on one or the other. For more on what behavioural science says about how employees might respond to financial rewards and incentives, see our report Show me the money!

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