The essence of a pay for performance strategy is simple: when your employees perform well, you reward them with extra pay.
It sounds like a good idea, right? And it is—most of the time. If you don’t have a pay for performance policy with clear metrics and achievable goals, you’re in trouble. The key is to avoid impulsively doling out rewards.
Instead, pick from the many strategies that fall into the pay for performance category. Consider them case by case and decide which one is best for you.
Do you have clear metrics that your company wants people to hit? We have a long list of pay for performance options, including methods that work when employees can’t easily tie their work to specific outcomes.
Pay for Performance With Clear Metrics
The most obvious case to use pay for performance (PFP) is when you have clear metrics and outcomes to increase. For instance, you might have specific projects for each employee to complete. Leads for them to generate. Sales quotas for them to meet.
So what makes a good metric?
Something objective and quantifiable. In other words, if you can’t measure it in a concrete way, don’t use it.
It’s usually easier to find room in the budget for PFP systems with clear metrics. If a salesperson makes 10 more sales than you expected, you have more money coming into your business. It’s easy to give some of that back to the employee to reward them for a job well done.
Pay for performance systems with clear metrics can look like multiple things, from commissions to gainsharing to piece rates.
Let’s take a look.
A commission is a pay for performance model in which employees get to take home a cut of a sale. Commission-based pay is common in industries like real estate, auto sales, and finance.
Some employers pay employees solely based on commission, which means the entire salary is made up of an employee’s commissions. This is generally fine as long as the commission is equivalent to paying the local, state, or federal minimum wage.
But it doesn’t work well for workers who live in areas without a state or local minimum wage. That’s because the federal minimum wage is only $7.25 per hour. Most employees would struggle to pay rent with that salary.
So we only recommend doing it if you’re in an industry that makes enough sales to pay employees at least $15 an hour, if not more.
Some real estate companies can pull this off. If a real estate agent sells a house for $400,000, they typically get a 5-6% cut of that sale. Say they get a 6% cut. That means they get to take home $24,000. After that, they have to deduct the brokerage fee for the broker they work under. We’ll say the broker requires a 50-50 split.
This leaves the real estate agent with $12,000 before taxes and other expenses.
Not bad, but considering it takes several months to close on a sale, agents have to push themselves if they want to earn above minimum wage. That’s why some real estate agencies, like Redfin, pay a base wage plus commissions.
A base salary + commissions model is a win-win for both the employee and the employer. The base salary helps keep your employees from working hard for zero pay. We all know, after all, that even the most carefully crafted sales can fall through.
But when an employee’s hard work does pay off, they get to bring home a chunk of change. The more they sell, the more they earn. And the employer reaps the benefits of having a high-earning worker that brings them lots of revenue.
Setting Up a Commission Model
A base salary + commissions model is also our favorite commission structure because it’s so easy to set up.
First, use compensation benchmarking to determine the average salary of a salesperson in your industry. We’ll say you’re a small car insurance company in an area where car salespeople make $70,000 per year on average.
Now you’ll decide how much of that salary should be covered by a base wage versus how much a motivated employee should be able to make from commissions. Common ratios are 60:40 and 50:50.
Since you’re a small agency, you go with 50:50—so 50% of the $70,000, or $35,000, will be your employees’ base wage. They’ll need to earn the other 50% through commissions.
Commissions are simple to bake into payroll because you don’t really have to budget for them. You can just write a commission policy that states that your employees will earn X percent of each sale in commissions, and leave it at that.
If you want to encourage a team-based approach to working hard, consider gainsharing. In this method, employees work together toward a goal that will bring your company an increase in profits.
When they meet the goal, each employee gets a share of the profit gained.
You can use all sorts of different metrics for gainsharing. Common ones include:
- An increase in sales revenue
- Heightened customer satisfaction
- Completion of a complex, lucrative project
- Tightened processes/early completion of projects
As long as you can find a way to measure it, you can use gainsharing for all sorts of things.
Let’s say that a small ad agency lands a dream gig—an ad for the country’s biggest televised football event. The client—a niche soft drink company—has an 8 million dollar budget for this ad.
They have to pay 7 million of that to the football event itself. But the other $500,000 of it will be paid to your ad agency. The company has offered a bonus of $100,000 if you get it done 7 days before it’s due.
You can only pull this project off if everyone puts in a ton of work. So you decide to turn it into a gainsharing project. Your team of 15—which includes you, the agency owner—will not only nail the ad but turn it in a week early, earning the small ad agency a huge sum of $600,000.
Working together, your whole team decides that $300,000 of this sum will need to go into the operating budget. The other $300,000 can be split among all 15 team members.
That’s a bonus of $20,000 apiece before taxes.
Obviously, your gainsharing doesn’t have to yield a giant bonus to be worth it. But if your team is only going to earn an extra $10, it’s probably not going to motivate anyone. So make sure it’s a goal worth working toward.
Setting Up a Gainsharing Model
At its core, gainsharing is a collaborative model. That means your employees should have a say in what is measured, how it’s measured, and how the gains are split.
The first task is to identify areas that could use improvement. Do the loan officers in your mortgage agency make small mistakes that add up to a pretty big cost? A gainsharing program to reduce those mistakes—and therefore save money—could help.
Or do you want your table manufacturing company to increase its output without sacrificing quality? A gainsharing program could be a game-changer.
You could even identify more than one potential area and ask your employees to vote for the one they’re most excited about.
Next, you’ll bring everyone together to discuss how much the gainsharing program could save the company—and how much the employees stand to gain from it. Then you and your team can put your heads together to figure out how you’ll achieve your goal and earn that extra cash.
If you’ve ever paid an independent contractor a certain price for a product or service, you’re familiar with piece rate. This pay for performance method simply means paying a worker according to their output.
But you can apply it to your employees, too. Especially if you’re in the home services, manufacturing, or agriculture industries.
It works like this: a worker is paid X dollars for Y units they produce or services they provide.
Let’s say you own a small landscaping and yard care business. Your basic yard care package costs $150. It includes lawn mowing, shrub trimming, and flower bed weeding.
You pay your lawn technicians a piece rate of $75 per package. That means if they can care for three yards per day, or about 15 per week, they can earn $1,125 per week.
This is equal to a pay rate of $28.13 per hour. Since that’s above the federal minimum wage—and most state and local ones, too—you’d be okay.
But what if business gets slow and you can only offer employees five yards per week?
You’d be in trouble. That’s the drawback of piece rate pay. You must make sure you pay your employees fairly.
As with the commission model, you could pay a base rate plus a piece rate on top of that. This could get complicated to figure out, but it might suit your business. The U.S. Department of Labor has a piece rate calculator you can use to run your numbers.
Setting Up a Piece Rate Model
A piece rate model is simple enough to set up. We suggest going with a base salary + piece rate wage to eliminate the extra stress you’d feel about meeting the minimum wage requirements in your area. (Or federally, if you don’t have a local or state minimum wage.)
Next, take a look at the average salary for the role you’re building a compensation package for. Decide how much you can afford to pay in base wages and how much will be made up with a piece rate.
For example, let’s say you live in California, where the minimum wage is $15.50 per hour. This is equal to $32,240 per year. Understanding that lawn and yard care is a physically demanding job, you want to pay on the higher end of the average. You decide the ideal yearly pay would be $60,000.
You decide to pay $15.50 per hour as the base wage. That way you don’t have to worry about meeting California’s minimum wage requirements. That leaves $27,760 to be made up in piece rate work.
Your company, which currently has one employee—you!—averages about 25-30 yards per week. It’s way too much for you to do alone, which is why you’re hiring your first employee.
With the savings you’ve been able to put away from your first year of business, you can comfortably pay the $15.50-an-hour rate even if business is slow.
Let’s say your employee works eight hours per day caring for 15 lawns a week. As the business owner, you earn $150 per lawn from that employee’s work alone, or $2,250 per week. For each lawn cared for, you give a piece rate of $40. This means your $2,250 turns into:
- $620 per week to cover the employee’s weekly minimum wage without dipping into savings
- $620 per week toward the employee’s benefits, gas, mileage, and tools
- $600 in piece rates per lawn for your employee
- $410 toward business expenses like taxes and worker’s comp
You, the business owner, are left to mow the other 15 lawns per week—and you can pay yourself using that revenue.
With a combined minimum wage and piece rate, your employee should earn around $60,000 per year as long as business is decent.
Unlike a spontaneous bonus, a discretionary bonus is carefully planned. You, the employer, outline specific metrics or goals you want your team to achieve. When the team meets them, they all get a one-time bonus.
Discretionary bonuses can be for individuals, teams, or the whole company. The important thing, as always, is to set it up correctly.
Setting Up Discretionary Bonuses
First, check your budget.
Do you have room to pay one or more employees a discretionary bonus? Will the bonus be enough to motivate your workers?
Second, check your goals at the company-wide, team-wide, and individual levels. Is there an area that could use extra TLC? Dig into that area and unearth the metrics that could help meet your most pressing goals.
Finally, collaborate and communicate with your team.
We’ll use an imaginary stamp and card shop as an example. Last holiday season, the shop floundered. It ran out of stock on the most popular cards, gifts, and stamps. This resulted in disappointed customers—and fewer sales than the owner would have liked.
So she decides to change things this holiday season. She chats with her team of five employees, and together they come up with a plan.
She’ll give each one of them a $2,000 bonus if they work together to increase sales by 15% over last year. They will:
- Update their website with SEO keywords that will draw locals and pump up online sales
- Implement a new point-of-sale system that keeps track of their inventory
- Organize the stockroom (and keep it that way!) to make it quick and easy for employees to grab a variant of an item for an interested customer
- Add a new step to the closing duties wherein one team member checks the stockroom, makes note of any low-stock items, and puts in a note for the owner to order more of those products
The team works together seamlessly, with just a few hiccups here and there. Despite inflation, a rising cost of living, and shoppers less driven to spend, the card shop sees a 25% increase in sales due to the team stockroom effort.
The shop owner doles out the hard-won discretionary bonuses and adds an extra $1,000 to each one to boot.
Pay for Performance Without Clear Metrics
Even though using clear metrics is the fairest and cleanest way to offer a pay for performance program, it’s not always doable.
But it’s still a good idea to offer employees the opportunity to earn more compensation if they’re willing to improve and grow.
A merit increase is like a pay raise. But pay raises typically happen at the beginning of a fiscal year. Everyone gets a raise based on their job title and the number of years they’ve worked for a company.
A merit increase is based solely on performance.
This doesn’t mean you should hand out raises every time you notice an employee going above and beyond.
Let’s pretend you have two very competitive employees, Jack and Lila. You’ve never said anything about merit increases before, but you’re known for giving random raises. Your employees aren’t quite sure how to get one of these random merit raises, but they want one.
So Jack and Lila, who are both salaried workers, start coming to work early. They both stay late. Lila even comes in on the weekend to wrap up an important project a few days early.
Of course, you don’t know that because, well, it’s the weekend. You’re at home catching up on your sleep.
You’ve been busy with other tasks and haven’t really noticed Jack and Lila’s increased fervor. But one day, a third employee named Mayra turns in a project early. You happen to walk by right as the client is calling her to say thank you.
Delighted, you decide to give Mayra a spontaneous merit increase.
When Jack and Lila find out, they’re secretly furious. They wonder if you appreciate their hard work at all. The client seemed to like their work, but she didn’t give them a call to say thank you. Maybe they didn’t work hard enough. Maybe, Jack and Lila think, you’re secretly angry with them. The two are exhausted and cranky, and because of this, their performance dips.
Now you know how not to do a merit increase.
When done well, a merit increase can boost employee productivity, help you analyze the health of your business, and reduce your turnover rates.
Here’s how to set up this pay for performance model the right way.
Setting Up a Merit Increase Model
Sit down with your leadership team and hash out these details:
- Does your budget have room for merit increases?
- What percent increase per person, hypothetically, can you fit into the budget?
- How many can you afford to provide per employee each quarter or year?
- Where could your company improve its output?
- How can each employee contribute to your company’s overall improvement?
Once you’ve answered these questions, you can move forward with your performance review cycle. Some companies do a yearly review cycle. Others do quarterly or even monthly cycles. Do whatever works for your budget.
We recommend putting up guardrails like salary caps and bands to make sure you don’t overspend on merit raises.
Now it’s time to sit down with each employee to discuss how their work can support those larger goals you identified earlier.
Collaborate on steps to achieve those goals. As the year progresses, check in with each team member to see if they need guidance or help fielding obstacles. Toward the end of the performance review cycle, measure each employee’s performance.
If they’ve met their performance goals, reward them with that well-earned merit raise.
Just make sure you pick realistic goals that won’t cause employees to overwork themselves or burn out. The goal here is motivation, not extra stress.
Profit sharing is a lot like gainsharing. But instead of trying to save money or cut costs, you’re trying to motivate your whole team to drive up those profits. And when the extra money comes in as a result of the collaborative push, everyone gets a cut of the profit.
These shares are usually paid out at the end of each year after a company’s accounting department takes stock of year-end profit. You can do quarterly profits too, though, to keep the profit sharing plan at the top of everyone’s mind.
Profit sharing is a way to make the company’s overall financial well-being relevant to everyone who works there. It can be an excellent motivator for small to medium businesses with little debt. Even better if they have a record of decent quarterly or year-end profits.
If you don’t have these things—and you don’t have a backup fund for the slow times, either—then you should hold off on using this pay for performance plan for now.
Setting Up a Profit Sharing Plan
The most important rule to remember with profit sharing plans is that you must:
- Outline the eligibility requirements for the profit sharing plan
- Establish a formula for splitting the profits across eligible employees
- Avoid giving a disproportionate share of the profits to your top-paid employees
- Follow the IRS’s contribution limits per person
The last three on this list are the IRS’s rules, not ours.
Profit sharing can be a rewarding form of variable pay for your employees. Some employers even use it as their retirement plan.
We don’t necessarily recommend using it as your only form of retirement benefits for your employees, though, since it’s a pay for performance model. You can either use profit sharing to boost retirement benefits or hand out bigger paychecks every quarter or year-end.