Pay-for-performance (incentive) programs can improve productivity, but managers need to consider several challenges in their design and implementation. Employees may be tempted to do only what they get paid for, ignoring those intangible aspects of the job that are not explicitly rewarded. Cooperation and teamwork may be damaged if individual merit pay is too strongly emphasized. Individual merit systems assume that the employee is in control of the primary factors affecting his or her work output, an assumption that may not be true. Individual performance is difficult to measure, and tying pay to inaccurate performance measures is likely to create problems. Pay incentive systems can be perceived as an employee right and can be difficult to adapt to the organization’s changing needs. Many employees do not believe that good performance is rewarded (the credibility gap). Emphasizing merit pay can place employees under a great deal of stress and lead to job dissatisfaction. Finally, merit pay may decrease employees’ intrinsic motivation.

To avoid the problems sometimes associated with pay-for-performance systems, managers should (1) link pay and performance appropriately, (2) use pay for performance as part of a broader HRM system, (3) build employee trust, (4) promote the belief that performance makes a difference, (5) use multiple layers of rewards, (6) increase employee involvement, and (7) consider using nonfinancial incentives. Employee participation in the design of the plan can enhance its credibility and long-term success.

There are four types of incentive programs. At the level of individual employees, merit pay (which becomes part of base salary) and bonuses and awards (given on a one-time basis) determined via supervisory appraisals are most common. At the next level, team-based plans reward the performance of groups of employees who work together on joint projects or tasks, usually with bonuses and noncash awards. At the level of the plant or business unit, gainsharing is the program of choice. Gainsharing rewards workers based on cost savings, usually in the form of a lump-sum bonus. At the fourth and highest level of the organization—the entire corporation—profit sharing and employee stock option plans (ESOPs) are used to link the firm’s performance with employees’ financial rewards. Both plans are commonly used to fund retirement programs.

Two employee groups, top executives and sales personnel, are normally treated very differently than most other workers in pay-for-performance plans. Short-term annual bonuses, long-term incentives, and perks may be used to motivate executives to make decisions that help the firm meet its long-term strategic goals. Sales employees are revenue generators, and their compensation system is normally used to reinforce productive behavior. A reliance on straight salary for salespeople is most appropriate where maintaining customer relations and servicing existing accounts are the key objectives. A heavy reliance on straight commission is most appropriate if the firm is trying to increase sales. Most firms use a combination of the two plans. In today’s globally competitive marketplace, many firms are also using incentive programs to reward customer service.

Small firms face some special challenges when designing pay-for-performance systems because they are less likely to have the necessary professional support to develop and administer these plans. Real or perceived mistakes in allocating incentives can have a large impact on these firms. Because information travels quickly, because there is often a fine line between personal and work life, and because people are supposed to cooperate closely with each other, pay-for-performance plans in these firms are more likely to be successful if there is active employee participation in the development of the plan, incentives are linked to the achievement of organizational goals, and frequent informal feedback is provided to employees. In designing these plans, most small firms find it beneficial to offer generous profit sharing and equity-based pay for employees.