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One of the key roles of a CHRO/CPO or HR business partner (HRBP) is to understand and address the business and talent challenges that their organization faces. This includes developing timely, responsive, effective solutions, particularly in compensation design and plan development. The ability to apply and guide the development of incentive pay plans is a critical value-add, underscoring the importance of your role in the organization's success.
The effectiveness of incentive pay plans is evident in the 84% of companies that use targeted strategies to further incentivize their top-performing workers. Adding incentive pay to employees’ base wages addresses the gap in standard performance management and merit pay processes. This motivates employees to exceed performance expectations and provides the recognition they deserve for their hard work, contributing to a positive work environment.
For example, Gallup has shown that pay and benefit levels are the most common reasons for turnover in the prior year. This relates to employee dissatisfaction with the lack of recognition at work, with 10% of workers reporting that they do not feel valued. Worse yet, that group includes 49% of females and 49% of people of color.
The opportunity for HR teams lies in deploying incentive pay plans. This is a crucial role, as 85% of workers believe managers should praise quality work whenever they observe or hear about it. Furthermore, 52% of employees say an annual bonus makes them feel more appreciated, and 88% express a “strong preference” for cash bonuses. The HR leader's role in deploying these plans is integral to the organization's success and employee satisfaction.
Defining “incentive pay”
Incentive pay is a form of variable employee compensation, meaning that the payment and amount are not guaranteed, are performance-based, and are made available in addition to the eligible employee’s hourly or salary wages. Eligibility is directly tied to achieving defined performance goals, objectives, or milestones. They are typically designed as supplements to the organization’s job architecture and pay structures, often to address short-term issues or opportunities related to the need to drive enhanced employee performance, productivity, focus, and attention
They are related to rewards and recognition programs in that the awarding of a cash incentive is simultaneously a recognition event, which amplifies its power to affect and drive employee performance and behavior. Their value lies in their ability to communicate what is most important (at that moment) to an organization, as employees perceive that the company is “putting its money where its mouth is” or taking action that supports its stated priorities and position relative to what is most valued.
The value of deploying incentive pay plans
Developing and offering incentive pay plans or programs creates a tangible reason for employees to exert extra effort and shift their everyday priorities toward what the organization has determined is an immediate concern. It grabs employees’ attention in ways that can drive substantial advantages, including:
- Separate the company from its competitors with the same jobs. Using creative opportunities for workers to earn extra cash can help attract and retain high performers who might be swayed by small increases available elsewhere or need a second job, given existing market-based pay levels.
- Incentivize employee production above expected levels. These can drive employees to put forth more effort, work more efficiently, and work longer hours to achieve the elevated goals.
- Drive performance in otherwise challenging circumstances. Incentive pay can be used to maintain employee performance and productivity levels during business slowdowns, rumored closings or acquisitions, or market downturns.
- Fund higher levels of compensation than might otherwise be affordable. As incentive pay is not guaranteed, higher revenue or profitability can offset its use. Given the lower rates of pay offered to low- or unskilled labor, increased productivity can be used as a basis for paying the best performers higher effective rates of pay.
- Prioritize employee targets for focus. These pay schemes provide the company with a clear, well-defined direction for shaping employee work behaviors. They communicate what is most important to employees and can help guide their discretionary time and effort toward specific organizational goals.
- Communicate the value of high performance. Using these supplemental pay plans reinforces the company's appreciation for overachievement in individual (or team) work objectives. They send the message that working diligently to exceed job requirements is so crucial to organizational success that it will share the proceeds of those efforts and results.
Of equal importance, incentive pay plans can reinforce the company’s culture and corporate values. For example, organizations can develop plans aligned with and promote objectives such as a culture of performance, customer success, teamwork, etc.
Incentive pay is linked to higher talent and business outcomes
Data supporting the positive outcomes of incentive pay is abundant. Given its essential role in recognition, research found that 65% of employees reported a willingness to work harder when they felt their managers noticed their contributions. Another study found that 37% of surveyed employees reported that greater appreciation from their managers would motivate them to produce higher-quality work more frequently.
Recognition is also highly correlated with improved employee outcomes, with 14% higher engagement, productivity, and performance in organizations with recognition programs than in those without. Interestingly, those organizations also generated a 12% higher customer satisfaction rate. Turnover rates are unsurprisingly lower in organizations that prioritize employee recognition and rewards, with their workers 56% less likely to be looking for a new role elsewhere. Another study found that incentive pay is significantly and positively associated with enhanced employee satisfaction, organizational commitment, and trust in management.
Types of incentive pay plans
It is essential to understand that incentive pay plans are supplemental pay-for-performance programs. They differ from other programs labeled “alternative rewards,” which generally refer to non-monetary plans that provide cash-value awards, such as “reward marketplaces” that grant points to purchase travel, or gifts. They are also separate and distinct from pure recognition programs or processes, stock, or other equity-related programs. Common examples of incentive pay plans include:
| Type | Purpose/Use | Details |
| Profit-sharing plans | To incentivize employees to focus on organizational goals and priorities. | Pre-determined opportunity based upon a defined percentage of profits achieved. |
| Sales or service SPIFs (sales performance incentive fund) | Increase short-term sales volume by targeting a product or service sales goal. It is also helpful in handling market or public relations issues by focusing employees on customer engagement. | Funding is determined by the financial value of customer acquisition or retention during slow or difficult market conditions. |
| Signing or stay bonuses | Incentives include job offer acceptance, employee retention, and a focus on mission and goals. | Targeted at critical role new hires who will lose bonus or commission opportunities Typical for retaining critical employees with upcoming mergers, acquisitions, and divestitures. |
| Targeted bonus opportunities | To enhance the financial position of lower- or mid-level roles and motivate targeted contributions. | Line workers and support staff, or for employee referrals, projects needing to meet tight deadlines. |
| Spot bonuses | For unique, unplanned, but significant contributions or achievements. | Most often awarded at managers’ discretion. It may include gift cards. |
| Gainsharing | Rewards financial improvements by teams to boost efforts and rally the troops around a shared objective. | Incentives for team efforts to drive revenue growth, cost reduction, process or product/service improvements, etc. |
| Profit-sharing bonus | Awarded for exceptionally high-profit performance vs. plan or expectations. | Individual, group, or all-employee, based on the discretion of top leadership/BOD. Awards tied to employee salary/wage levels. |
| Health and Wellness Incentives | For employees who improve key health metrics (BP, cholesterol, BMI). It helps drive lower health care costs, illness, and injuries. | Awards can be cash or payouts for free or discounted spa days, gym memberships, and other perks. |
Designing and developing incentive pay plans
As previously noted, many non-compensation professionals may lack the skill to identify opportunities and create a specialized incentive plan. Yet it often represents a potent response to specific talent and business challenges, adding significant heft to the CHRO/CPO or HRBP tool chest. The following process can be used to define and develop a plan, most commonly in conjunction with the compensation and Finance teams, who bring crucial modeling and affordability analysis skillsets.
1. Recognize a targeted need and opportunity
The first step is recognizing the opportunity to address a business challenge through an incentive pay plan. This comes from participating in leadership discussions about specific challenges or goals that need special attention. Frequently, such opportunities arise from leadership staff meetings, strategic plan review sessions, or sales, service, production, or project performance status reviews. They are often short-term needs requiring a boost to get the planned performance back on track or longer-term needs to improve talent or business outcomes.
2. Identify the objective of the incentive
Articulate the desired employee behaviors or performance to be targeted in clear, straightforward language, with metrics and objectives that are easy to understand and act on. Consider the extent to which those behaviors are a) possible - within targeted employees’ skills and capabilities to change and improve, and b) within their discretion—not requiring managerial approvals or blessings. The behaviors and performance targeted for increases must be considered achievable by the employees to avoid the backlash that the company is asking too much. In that spirit, it is critical to validate the assumptions of achievability with line managers and leaders, and to refine the concept based on their feedback.
3. Assess the compensation opportunity
Next, consider how much additional pay should be offered to employees. Start by projecting/modeling (with Finance and Sales) the revenue or profit opportunity level that a particular percentage improvement in employee effort, productivity, or production could achieve. For example, if employees were 5-10% more productive in their sales, service, or production output, how much revenue or profit would that generate? Knowing that such an increase might not be sustainable for more than 30, 60, or 90 days with the existing staff, what would the financial boost look like?
Next, the market pay data for each job family, level, and role proposed for eligibility is reviewed. How much compensation would it take to move the average worker to 102-105% of the market rate for each job? 105-110%? What would the total bill be for that additional pay cost (daily, weekly, or monthly)? How does that compare to the projected revenue or profit gains? That comparison should drive a calculation of how much to share with employees. A model of those costs/payouts then helps generate a per-head budget, balanced with the impact of potential wage increases on their market rates.
4. Develop performance criteria and rules
Clarifying the rules for participation is essential at this point. Determine and document eligibility (who is covered), a timeframe for the program, payout frequency (accumulation vs. pay-as-earned), any performance or participation minimums that must be met, and whether payouts will be based on team vs. individual performance.
Additional considerations to be documented include guidelines for individuals, such as:
Criteria for participation
- Attendance, days worked, individual minimums
- Minimum tenure addressing new hires
- Payout eligibility in cases of transfer, merit increase, promotion, resignation, or termination for cause.
Performance standards that must be met, maintained
- Clarifying what is being incentivized—teamwork and team performance vs. individual contributions to team goals, etc.
- Minimum production and contribution goals by the team and the individual
- Payout levels/targets for different roles and pay grades/levels
Governance/oversight structure
- Program sponsors, owners, and administrators
- Key measures/KPIs and reporting requirements
- Monitoring plans with schedules for meetings, attendees, report distribution, and decision-makers
5. Present the concept or model
Once the plan is designed, it should be presented to leadership for review, discussion, and approval. The presentation should communicate the plan’s purpose and rationale, timeframe, financial impact analyses, criteria, administrative guardrails, measurement and reporting, and governance structure. The goal is to provide clarity and a business case for leadership for awareness, understanding, and buy-in. After approval is achieved, communications with the impacted employees can proceed, during which the plan’s purpose and rationale are presented, transparency is provided around their roles, program criteria, requirements, performance standards, and expectations, and payout schedules are reviewed.
6. Track and report
For incentives that affect broader groups of employees, such as profit- or gain-sharing programs, and Sales Performance Incentive Funds (SPIFFs), public sharing of progress and results with all stakeholders is essential to successful implementation. Others that involve individuals (spot, health and wellness, sign-on, retention bonuses) should be communicated by their manager with congratulations or a thank-you.
For all of these, however, creating online dashboards and communicating with key stakeholders should be done formally and regularly. Keeping them engaged and aware of progress (and utilization rates) is critical to sustainability. Of particular importance is tracking and reporting desired/planned outcomes to demonstrate the extent to which the incentive pay plan is achieving its purpose and goals.
Issues and considerations with incentive pay
While incentive pay plans are popular, they should be chosen, designed, and implemented with awareness of several downsides that can erode their advantages and perceived value. Care should be taken to prepare leaders and sponsors for these so they are seen as flawless panaceas for the issues they are designed to address.
They can lose their luster and opportunity to excite
Some types of cash incentives, such as annual performance bonuses, are often viewed as guaranteed for the average-to-high performers who earn them every year. While the amount earned might vary, when payouts are consistent, they can quickly become viewed as a part of the guaranteed salary. For example, when payouts are high due to an exceptional stretch of years with above-target payouts, a return to the norm can leave many dissatisfied. One expert pointed out that “a reward can lose its motivational power when considered a sure thing.” As a result, focusing on the short-term and targeted nature of an incentive pay plan can help avoid these issues.
They are taxable and more costly than the award amount
Cash incentives are subject to IRS taxation and must be reported as additional income as payouts are made. Between federal, state, and local taxes, actual employee payouts can be 20-30% lower than communicated, and the company has to contribute another 10-12% in its share of the taxes. Consideration of post-tax employee payout amounts is required to ensure the amounts paid are meaningful to individuals at different compensation levels.
They can inadvertently create competition for the awards
When individual incentive pay plans are created, they can harm collaborative behavior if employees perceive them as a “win-lose” proposition. It is essential to carefully consider and craft the participation and earning criteria to entice people to work together for the common good and towards shared goals and objectives. Having robust reporting and controls in place to avoid unethical, fraudulent, or otherwise harmful behaviors is critical. Payout monitoring should identify overachievers and review results to ensure adherence to the plan and company standards. Similarly, managers should watch for over- (or anti-) competitive behaviors that might reduce the intended motivational effect on all eligible employees.
They can limit the motivation of top performers
Classic research in behavioral psychology informs us that incentivizing what is otherwise a self-rewarding behavior limits the impact of the extrinsic (cash) required. When designing the incentive pay plan, avoid any design intended to get the bottom 80% of performers to do what the top 20% already do on the job. An example is the heightened focus on customer satisfaction, which may be a top priority, and the self-rewarding behavior of top performers who deliver excellent customer service because it brings them pride and satisfaction. The key is to create incentives that will appeal to most employees performing the work or output that needs to be boosted.
Relevant Practices & Tools
Core Performance Management Practices to Set Expectations and Provide Effective Feedback. >
Performance management engages employees and their managers in the annual process of planning critical work efforts and developmental activities, evaluating the extent... more »
Leveraging Multiple HR Systems and Sources When Producing Integrated Metrics. >
As manager requests grow in sophistication, an appetite for more complex data will rise. This will most typically include data from numerous HR processes and systems... more »
Matching Clear Criteria to Modern Rewards and Recognition to Drive Targeted Behaviors. >
While the processes remain separate in emerging Performance Management, compensation and career development remain integrated with and enabled by it... more »
Making Compensation Decisions that Align with Observed Performance. >
Compensation or pay issues generally flow from the performance evaluation – the better the evaluation, the higher the potential rewards... more »
The Change Impact Analysis Template: Identify and Assess how Initiatives Impact the Company. >
This template provides a structure to document how specific stakeholder groups will be impacted by an initiative and measure the degree of change... more »
FAQs
When is an incentive plan the right tool instead of just raising base pay?
Use incentives when you need behavior to shift quickly toward a specific outcome, such as with work volume throughput, sales mix, backlog reduction, quality improvement, or on-time delivery. Base pay buys individual capability and market competitiveness; incentives buy focus, urgency, and persistence on the few things that move the needle for the business now. Because they are variable by nature, incentives can be self-funded through incremental revenue or savings and dialed back when priorities change. If the job requirement is enduring and role-defining, consider adjusting base pay; if it is targeted and time-bound, design an incentive.
What plan mechanics keep payouts motivating and predictable?
Set a clear threshold (e.g., no pay below minimum performance levels), a target (a competitive payout for on-plan or expected results), a cap (the maximum payout available), and decelerators to protect budgets and affordability. Use simple performance payout curves so people can estimate earnings in their head, and consider accelerators above target to reward true stretch performance. Avoid cliffs that pay nothing at 99% goal achievement and everything at 100%, as those invite end-of-period gaming. Publish examples with real numbers so employees can see how their effort can translate into potential pay.
How should we model affordability and funding?
Build a pro-forma model that links each 1% performance gain to incremental margin growth, then earmark a fixed share of that value to employee payout potential. Accrue incentive pay expenses monthly based on actual performance, so management and the finance team can see costs and benefits in lockstep. Create a formal governance process and “trigger” to alert management to pause or re-scope the incentive plan if market economics or company financials change. Run best-, base-, and worst-case scenarios and pressure-test them against recent financial volatility. If the plan cannot be validated for self-funding within realistic ranges, redesign it.
How do we demonstrate impact and iterate on incentive plans without creating confusion?
Define success up front, such as primary KPI movement, payout-to-profit ratio, retention of target roles, and compare those against a pre-plan baseline. Test the effects by comparing pilot and control groups, or phased go-lives, to isolate the effectiveness of the proposed plan, and set a formal “sunset or scale” review after one or two performance cycles. Publish the results, including what worked, what changed, and what is next, so that executives and employees see structured and planned learning instead of management flip-flopping. Small, frequent adjustments beat large, annual plan rewrites that both test and reset trust in the plan.
