HR Management & Compliance

Compensation: How Do We Set Up a Pay-for-Performance System?

How do we go about setting up a pay-for-performance incentive system? We are in the very early stages and just don’t know where to start. Thanks.Anonymous in Alameda



In our experience, most organizations that want to establish a pay-for-performance system believe that financial incentives will motivate employees to improve their productivity. Establishing an effective pay-for-performance plan requires significant effort. Here are some key steps we recommend for doing it right:

  1. Clarify the objectives your organization has in mind. Answer the questions, “Why do we want such a plan?” and “What do we want the plan to accomplish for us?” Work with the management team to sort this out so that all voices are heard. Some of the most typical pay-for-performance objectives include:
    • improved productivity and/or efficiency
    • alignment of corporate/organizational business goals with employees’ priorities
    • creation of a management tool to focus on and communicate important outcomes
    • improved collaboration and teamwork
    • attraction of new employees accustomed to variable pay
    • response to employees’ requests for performance related recognition and rewards
    • perceived internal total compensation fairness
  2. Identify which pay elements are intended to reflect performance differences. These elements may be base pay, cash bonuses, commissions, stock options, and/or a combination of several of these.
  3. Make sure base pay levels are structured and equitable. A common mistake is to attempt to use an incentive plan to correct existing internal inequities and/or market misalignment relative to base pay. If some employees’ salaries are below market while others’ are not, for example, the addition of cash or other incentives can perpetuate and call attention to such disparities. If you don’t have a job classification system that considers both market and internal relative values of jobs, it would be best to develop one before attempting a pay-for-performance plan.
  4. Review labor market data. Although the variable cash compensation data reported in salary surveys are typically not as reliable as the base pay data are, they give a general sense of the competitive incentive pay levels that should be associated with comparable jobs in the market you compete for employees in. The variable pay levels reported in surveys can be translated into different target incentive levels for different jobs, usually by salary grade. Generally, the higher paid the job, the higher the target incentives are as a percentage of the job value. (This is because of the assumption that the higher the job level, the more opportunity the person has to impact the organization’s success.)
  5. Define the term “performance” as it relates to the new plan. The subjective ratings that appear on the typical annual performance appraisal form are not likely to be the best measures of performance for an incentive plan’s purposes. Rather, the results produced are more effective measures because of their relevance and objectivity. Keep in mind that performance may refer to one or both of the following:
    • Means of performance: individual competencies and behaviors
    • Ends of performance: results and outcomes produced
  6. Assess the measurability of performance, as you have defined it, for this plan’s purposes. For example, if you want to link goal achievement to pay, determine to what extent significant individual and/or team goals can be measured and objectively quantified.
  7. Establish the timing of the plan. Decide on measurement periods and how they relate to performance measurability. For example, if your fiscal year is a calendar year and you produce financial reports for calendar quarters, it may make sense to measure quarterly in a way that reflects these statistics. Remember, you can measure quarterly and pay out annually. More frequent measures make the plan more current and relevant.

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    Also, think through whether performance will be measured proactively or retroactively. To be truly motivational, desired performance outcomes need to be established before the measurement period so that employees know what they need to accomplish during that period. Paying for performance without having set performance outcomes to strive for beforehand is not particularly motivational and tends to serve more as a reward.

  8. Engage employees in the process. Beyond the obvious need to communicate the plan, encourage employees to work with their managers and co-workers to establish goals and measures. This will help them take ownership of the plan.
  9. Tailor the plan to fit. Every organization has its own history, culture, and issues. A pay-for-performance plan can reinforce what is desired—or can be a disaster if it isn’t well thought out.
  10. Do your homework. Review the organization’s records relative to incentive pay. Have other plans been tried in the past and, if so, with what results? If you may replace existing incentive plans with a new plan, review the actual compensation paid to individual employees over the past several years as guidance when establishing target pay levels under the new plan.


Shari Dunn is managing principal of CompAnalysis, a compensation and performance management consulting firm in Oakland.