What is Merit Pay? A Comprehensive Guide for HR Professionals

Rewarding employees is a proven strategy that effectively enhances productivity, boosts motivation, and improves employee retention. When employees feel valued and get their money’s worth for their hard work, good things happen for both the organization and its workforce.

A recent study established that merit pay, or pay-for-performance, is one of the most potent tools in HRM to boost employee productivity—with 93% of private companies claiming to at least offer any form of short-term incentive. But as an employer, how exactly do you utilize merit pay and maximize its benefits?

In this article, we’ll dive deeper into the concept of pay-for-performance. What is merit pay? How does it work? Are there pros and cons? And how do you calculate it? Read on to learn more.

What is merit pay in HRM?

Merit pay, as defined by the US Department of Labor, is a raise in an employee’s pay based on a set of criteria established by the employer. Also known as merit incentive or pay-for-performance, merit pay is usually given to employees to reward their exemplary work performance.

Pay-for-performance can be a salary increase, commission, bonus, or incentive. It’s primarily an internal agreement between an employer and an employee. Moreover, a merit increase isn’t legally required according to the Fair Labor Standards Act (FLSA).

Making your employees feel valued through financial rewards through an effective merit pay system promotes a great workplace culture that brings a lot of positive effects to the company. Compensation Planning Software offers a comprehensive and adaptable module for merit planning that’s designed to seamlessly integrate with your existing payroll system.

How does merit pay work?

A merit increase heavily relies on the quality of an employee’s performance. An organization typically establishes a set of performance standards along with well-defined goals and milestones. Then, the company measures employee performance based on these organizational standards.

These evaluations are often executed in the following intervals:

• weekly

• bi-weekly

• monthly

• quarterly

• semi-annually

• yearly

As an employer, you must ensure that the evaluation procedures of the merit pay process are clear and transparent to promote fairness and equality among the workforces. This also prevents sensitive issues such as bias and discrimination.

Streamline your company’s collaboration efforts using the Compensation Planning Software, it enables teamwork within a single comprehensive system while allowing you to manage all your compensation plans in one solution—including merit, bonus, equity, and total rewards.

Pros and cons of merit increase

Although merit pay aims to provide an overall positive effect to your company, it could also become a double-edged sword if not handled properly by HR. To give you a better understanding, here are the pros and cons of merit increase:

Advantages:

• Enhances motivation and productivity: Pay-for-performance motivates employees to work harder and improve the quality of their work since there’s a guarantee that their efforts will be rewarded.

• Alignment with organizational goals: Merit increase is proven to be a win-win solution for companies since it encourages employees to be more focused on achieving the business goals of an organization.

• Attracts and retains top talent: When top talents understand that their value and efforts are well-appreciated by a company, it increases their chances for a long-term stay.

• Promotes accountability: Merit increases drive more employees to become responsible and accountable for their work performance since it's directly related to their salary.

• Cost-effective: Merit increases are actually cost-effective for companies. For example, a brokerage company only gives out commission when sales are made, this improves the cost management practices and reduces fixed costs at the same time.

Disadvantages:

• Unhealthy competition: Pay-for-performance could also disrupt the collaborative culture in the workplace. Rather than working with each other to achieve successful results, employees could focus on individual success and just strive to outperform one another.

• Burnout: Being assigned a quota or performance targets can induce a lot of stress, pressure, and anxiety in employees.

• Short-term solution: With the merit increase in mind, employees would rather prioritize tasks that directly impact their performance targets. This neglects other essential aspects of their jobs in the long run.

• Friction in team chemistry: When handled poorly, merit increases could destroy the workplace’s positive culture.

• Not suitable for all industries: Although the concept of a merit pay strategy is encouraged by a lot of successful businesses, it’s not always applicable to any industry such as the government and other unionized sectors.

Having a strong and reliable talent management system is crucial to ensure an effective merit system. With the help of Compensation Planning Software, you can now incentivize without compromise, allowing you to handle even the most complex incentive programs of any organization.

Merit increase: Calculation and examples

To help you grasp the concept of merit increase better, here are a few examples and calculations on determining merit pay:

Example 1: Employee A is a private school teacher with a current salary of $120,000. If he meets the school's teacher performance goals, what would his new salary be if the merit pay for teachers follows the average raise percentage in 2024?

New salary = 120,000 x 3.6%

New salary = 120,000 + 4,320 (merit raise)

New salary = $124,320

Example 2: Employee B is a Sales Agent earning an annual salary of $55,000. What would be his new salary considering that he’s entitled to receive a merit increase of 7.5% plus a commission bonus of $200 per car if he sold 50 cars last year?

New salary = 55,000 + (55,000 x 7.5%) + (200x50)

New salary = 55,000 + 4,125 (merit raise) + 10,000 (total commission)

New salary = $59,125 + $10,000 (total commission)

FAQs

Below are common questions about the merit pay system:

How much is the typical merit increase?

The 2024 and 2025 average raise percentages are 3.6% and 3.5%, respectively. Most companies typically follow these figures or give merit raises in the vicinity of 4% to 5%, depending on company and employee performance.

What are the criteria for a merit increase?

Companies implement merit pay policies on their own terms and therefore follow unique criteria depending on their preference. Here are some factors affecting merit increases:

• Performance evaluations

• Achievement of goals and targets

• Company standards

• Merit pay budget

• In-demand skills

• Length of service

Is a merit increase the same as a salary raise?

No, a merit increase isn’t necessarily the same as a salary raise. Merit pay is generally tied to employee performance while salary raises are affected by other factors such as cost of living, inflation, minimum wage, etc.

What jobs use merit pay?

The concept of merit pay increases is usually implemented by businesses with easily measurable performance metrics such as the following:

• Sales

• Marketing

• Customer service

• Technology

• Consulting