Compensation 104: Pay for Performance

Continuing our series of compensation topics, this week’s Astronology will review the basics of Pay for Performance programs. About 71% of organizations have a formal employee performance appraisal system. Linking pay to performance through that appraisal system raises questions: How flexible can an employee performance appraisal system be? How can HR ensure that the performance appraisal system is fair? Does compensation link with performance appraisal score? Should it?

A pay for performance program is used to reward employees based on measurements of their performance through an appraisal system. These programs are heavily used in many industries, including healthcare. Pilot studies in some hospitals found using a pay for performance program led to an increase in efficiency.  Major concerns with pay for performance in the healthcare industry, however, are system validity, patient and physician autonomy / privacy, and the increase of administrative responsibility. Concerns regarding validity and workload can apply in other industries as well.  In addition, one must determine if the reward for high performance is an adjustment to an employee’s base pay, or an incentive or bonus reward.  While salary adjustments may have limited flexibility, in many industries, these “incentive-based compensation” or “bonus plans” are easily adaptable to meet a variety of needs.

Many organizations find pay for performance programs an answer to the complex problem of keeping up with a competitive market. Here are a few of the advantages of using pay for performance:

• Pay for performance makes it clear to the employee what areas should receive priority attention.

• Employees motivated by financial rewards are driven to achieve high levels of performance.

• The organization enjoys high performance from its staff and rewards such performers appropriately.

Given that the performance appraisal is linked to an employee’s pay, it is essential that the performance appraisal is fair.  The following are some aspects to consider when designing or updating a performance appraisal system used in a pay for performance program:

-The relative balance between the base salary and performance based pay: Many employees are willing to accept a below-market base salary if the incentive could add up to above market pay.

-How will the criteria be weighted?:  To over-reward employees for short-term accomplishments can be quite costly to an organization. It is important to clearly define what would be considered short-term versus long-term actions.

-How will the organization guard against score inflation or other manipulation?:  Manipulation of performance appraisal scores by raters and managers undermines the fairness of the employee appraisal and pay for performance systems.  Employees will perceive management as “gaming the system,” and the rewards become meaningless.  To guard against this demoralizing effect, Human Resources must continually review score results across departments and managers to identify scoring trends, and address score inflation or manipulation sooner rather than later.

-Will there be a partial incentive or reward if goals are partially achieved?: To have an “all or nothing” incentive or other reward can work for some industries, but not all. Establish at what rate rewards will be provided and what constitutes a “partial reward.”

-How will the criteria be established? How are the accomplishments measured?: Tapping into the expertise of an HR consulting firm is recommended when it comes to answering these questions. Utilizing an external third party enables the organization to explore the types of systems the competition uses, performance management trends, best practices, and pitfalls to avoid.  For example, Astron Solutions’ Web-Based Talent Management program, Flare™, combined with supportive consulting, has helped many organizations efficiently manage the challenges of creating and implementing a pay for performance program. Why not request a demonstration to learn more?

-Can we establish any of the rewards to be paid out on a discretionary basis?: Perhaps an employee may handle an unforeseen task so masterfully that those responsible for handling bonus awards or merit increase awards may deem it necessary to reward the employee outside the scope of the formal pay for performance program. Keep in mind, however, that it can be demotivating to have compensation based on unknown criteria. When using this type of discretionary plan, be discreet and make payout decisions wisely.

Pay for performance programs run contrary to the thought that performance should not be linked to compensation. This is especially so when one questions the structure of a pay for performance program. One person writing for the Harvard Business Review recently said, “When you try to institutionalize pay for performance you actually ruin the concept.” Others even question whether board members or HR professionals in an organization would know enough about what it takes – skill and difficulty – to perform at current levels.  As such, it is important to make sure when creating the pay for performance program design team that all sides or concerns are represented and considered. Examining the experience each team member has in areas such as compensation and management is critical.

When structured appropriately for the organization’s jobs and industry, pay for performance can provide multiple benefits to the employer.  Without careful development and on-going monitoring, however, the program may run contrary to the organization’s Human Resource goals.  Pay for performance is an important part of the compensation world that must be considered carefully by all organizations.