Guidelines for Awarding Merit Pay Increases

When you’re a small business owner, it can be hard to know how and when to award pay increases, particularly ones that are tied to performance. While most companies provide at least an annual wage increase to maintain competitiveness, how and why you give a pay increase can greatly affect the impact of both the salary boost and performance evaluation.

Our advice: strategically plan pay increases to ensure you’re using the best system possible to link pay to performance while also encouraging the achievement of specific company goals and rewarding top performers. Use the following three-step system as a guide to help you get started.

Step 1: Consider company budget and develop performance-based metrics

Annual merit-based increases, which are pay increases that an employee earns based on performance, typically begin with the company setting a proposed budget. This is followed by managers’ assessments of their employees’ performance, which should be based on specific performance metrics.

Metrics used in merit-based pay raises may vary between jobs, roles and teams, or they may be company-wide, but they should tie into company and team goals. It’s also a good idea to make employees aware of the evaluation metrics at the start of the period being reviewed so they fully understand expectations. Some companies take this a step further and have employees set their own goals (usually in consultation with management), which they are then evaluated against.

Work with your certified HR expert to provide guidance on performance metrics, help structure performance evaluations and merit pay increases, and create a meaningful performance review program custom-tailored to your company.

Step 2: Determine how performance will relate to an increase in salary

Merit pay increases should be structured to fairly reward high-performing employees similarly across the company to reduce the risk of salary-increase inequality. Since pay increases are most frequently made as a percent of salary, that would mean a high-performing web developer would receive the same percent increase as a high-performing line worker.

Also consider the employee’s performance scorecard, current pay rate (whether they’re above or below the company’s pay midpoint), and the proposed budget for merit increases -- each of these may affect the percentage your company can award an individual team member.

Step 3. Create an employee’s performance scorecard

How did the employee perform through the year? Determining whether an employee was a high performer (i.e. excellent vs. a satisfactory) requires creating a scorecard. Your management team will determine how well each employee completed performance metrics. Note that some companies start this process with the employee conducting a self evaluation, which is then forwarded to his or her manager for approval or modifications.

Your scorecard may weigh some of the evaluation criteria more heavily so that more important goals are given greater value and ultimately impact the employee’s overall performance “score” more. In the following example, the total of all goal scores should add up to 4 points or fewer to align with the ratings. You may also choose to use a 100 point scale or another scale entirely.

Since the employee’s score was between a 3 (good) and a 4 (excellent), a manager may opt to give either a modified percentage increase (ex: 5%) or put the employee into either of the “good” or “excellent” categories.

How to know if your performance review system needs work

In the event your company only has “top performers” after performance reviews, it may be time to revamp your performance scorecard. To encourage managers to truly highlight the top performers over the satisfactory and low ones, you may want to shift your performance management system to a bell curve where only 20-25% can be considered top performers, 60-65% are midrange, and 10-20% are under performers.

Other modifications may include:

• Company performance goals. In addition to individual performance, all employees may be rated on the company’s overall achievement of a key metric. For example, 60% of an employee’s pay increase may be based on company financial metrics, whereas 40% of the merit increase may be based on the employee’s performance review.
• Cash recognition outside of merit increases. Pay increases may go beyond a bump in base pay. Cash recognitions may also be given throughout the year in the form of spot bonuses or other variable pay options awarded to high performers. These can be a great way to extend the impact of merit-based pay for a company with budget limitations and allow rewards to flow throughout the year. This may also help prevent the creation of a culture of expectation, where employees have stopped seeing a performance-related pay increase as merit-based.

When should you give employees a pay increase?

Unlike annual cost-of-living pay raises, which tend to happen at the same time each year, merit increases aren’t always tied to a calendar. That means you can choose to conduct these as your company sees fit -- either on a set date or time period, on an employee’s anniversary date, or as needed. Also understand there is no law regulating how or when you should increase an employee’s pay, outside of minimum wage and other FLSA regulations, although pay increases are frequently considered a valuable tool in building employee retention and loyalty.

Advice regarding compensation plans, performance reviews and merit increases

Compensation strategies should never be decided on a whim, particularly when pay is used as a motivation for employee performance. 

When structuring your program’s performance review/merit increase plan and timing, keep the following guidelines in mind:

1. Pay increases that are used to motivate employees are most effective when they are tied to performance, in contrast to cost-of-living increases.
2. Performance-based increases should be awarded shortly after a performance review to emphasize the connection between performance and pay.

The following example shows how pay increases may be structured (see Step 2):