Introduces the basics of pay and reward, including staff benefits. Outlines the UK legal position on aspects such as equal pay and the national minimum wage
Performance-related pay (PRP) is a way of managing pay by linking salary progression to an assessment of individual performance, usually measured against pre-agreed objectives. But despite the common use of PRP schemes, questions still remain around the its effectiveness.
This factsheet explores the rationale for linking pay and performance as well as the potential issues around implementing PRP schemes, both generally and with a specific focus on PRP schemes in the public sector. It also provides an overview of key issues including the role of line managers, measuring performance, distribution of awards and the impact on employee behaviours.
For performance-related pay to succeed, effective arrangements must be in place to define, measure, appraise and manage performance. The focus should be on encouraging high performance first, underpinned by effective performance management, development and appraisal systems, and only then on pay as a reward to help achieve that goal. To create a sustainable high-performing workplace, the whole range of financial and non-financial rewards must be carefully designed to ensure that they support and are supported by PRP.
What is performance-related pay?
Performance-related pay (PRP) is a way of managing pay by linking salary progression to an assessment of individual performance, usually measured against pre-agreed objectives. It is also known as individual PRP or merit pay. Wage increases awarded through PRP are normally consolidated into basic pay, although sometimes they involve the payment of non-consolidated cash lump sums - see more in our pay progression factsheet.
PRP has grown since the 1980s as employers sought ways of improving performance by linking employee earnings to achieving business objectives. However, in some circumstances, PRP has proved a rather crude instrument and the 1990s and beyond witnessed a number of challenges to the theory and practice. As some of the earlier schemes failed to deliver the promised results, a number of employers brought in new or revised PRP schemes or moved to new approaches altogether (for example, skills-based pay), while others have developed hybrid schemes.
Recently, the notion of linking pay to a wider definition of employees’ ‘contribution’ rather than simple ‘performance’ has gained ground. This emphasises not only performance in the sense of the output (the end result) but also the input (what the employee has contributed).
The rationale for performance-related pay
PRP objectives may be grouped under three main headings.
1. Encouraging high performance levels by linking performance to pay
While money can influence employee behaviour, it isn’t always in the ways that the organisation intended. Where PRP appears to have worked, critics claim it’s often the underlying improvements in performance management and development that have the greatest impact on bringing about positive changes, rather than the increased pay. And in an era of tight pay budgets, it can be difficult to give those judged as high performers significantly more than those whose performance is seen as being good - see our performance management factsheet. Our report, Show me the money, highlights other issues with the operation of PRP, for instance, there is the danger it can: ‘crowd out’ intrinsic motivation, undermine teamwork, and encourage individuals to focus on certain measures at the expense of others
2. Embedding an entrepreneurial or high-performance culture across an organisation
PRP can send a message to employees about what achievements the organisation wants and is prepared to reward, although there are other (non-monetary) ways of communicating the need for high performance. Communication can also suffer as employees feel constrained about having open conversations with their line managers in case this influences the size of their pay rise.
3. The notion of equity or fairness
There is more widespread acceptance of the effectiveness of PRP in this respect, that people consider it right that higher performing employees should get more money, but there are some notable differences by sector. Our survey on employee attitudes to pay finds private sector workers are more likely than their public sector counterparts to want their rewards to reflect performance. However, if pay for some individuals is not perceived as reflecting their performance, other employees may see this as unfair.
PRP typically uses a system based on consolidated pay progression within pay brackets attached to each grade, level or zone.
However, for performance to be rewarded, it’s necessary to have an effective means of measuring that performance. Historically, this has been via performance appraisal, though more recently some employers have used less formal approaches to appraise performance, such as using rating-less approaches
In traditional performance appraisal, each employee’s performance is typically ranked on a scale, incorporating three to six categories, ranging, for example, from ‘unsatisfactory’ to ‘superior’ (sometimes using ‘forced’ distributions, as detailed below). Some systems allow for management discretion in translating these scores into levels of pay rise, while others determine increases through a formula or a matrix system linking each grade, level or zone to each of the performance categories. This method may involve the use of a comparison ratio, or ‘compa ratio’, the term given to the relationship between each employee’s current salary and the mid-point of their grade. Thus for a worker at the mid-point of their pay range, the compa ratio is 100%.
It’s often felt appropriate for the pay rises associated with each performance category to be higher for employees at lower points within the pay brackets, given the presumed existence of a learning curve for new entrants to a grade. However, more senior employees who’re performing very highly may resent the award of comparatively low percentage pay rises.
Coverage and trends in performance-related pay
Who gets performance-related pay?
While various estimates exist of the coverage of PRP, partly as a result of differing definitions of PRP adopted by researchers, we’ve identified the following broad themes and trends:
Individual PRP is prevalent in the private sector, and indeed is virtually ‘the norm’ in some parts of the sector, such as financial services.
In the public sector, the majority of employers provide for a basic percentage increase, with a small proportion including a performance-related element, typically for senior staff.
Merit pay most commonly covers managerial and other white-collar staff, with fewer extending coverage to manual or lower-grade workers.
The coverage of PRP varies internationally, for example, employers in France make greater use of merit pay than occurs in Great Britain. Ironically, this is partly attributable to the much more highly regulated employment background in France that leaves individual managers keen to exert some control over performance improvement via pay.
PRP in the UK public sector
Despite considerable interest in PRP in the public sector dating back many years, this has proved harder to translate into practice. Where performance pay does occur, it often takes the form of non-consolidated bonuses and/or team-based incentives, an approach recommended by the Makinson report on performance pay in central government, rather than individual merit pay.
Nevertheless, in recent years there have been a number of high-profile initiatives such as the introduction of a PRP scheme for teachers, which some researchers argue has resulted in some discernible performance improvements.
A number of distinct issues arise when introducing PRP into a public sector setting, including the potential difficulty of measuring individual effort in certain roles. Moreover, certain public sector workers are arguably more motivated by non-financial rewards that could actually be undermined by some forms of PRP. One theory is that PRP in this type of public service setting can help employees to work more effectively, by encouraging them to focus on key objectives, rather than the money alone.
The impact of government PRP policy in the public sector is unclear, given the government’s over-riding policy of restraining pay rises for most workers in the sector, although it seems likely that further attempts may be made in the future to increase links between pay and performance.
The Hutton review examining senior public pay includes a section devoted to the perceived need to ensure that pay reflects performance in the sector, focusing on the use of earn back, whereby senior staff have an element of their basic pay ‘at risk’, which then has to be earned back through meeting agreed objectives. However, this recommendation hasn’t been widely adopted.
Since September 2013, all decisions on pay progression for teachers in England and Wales are based on the outcome of a performance appraisal linked to their individual performance, rather than the length of their service.
Measuring trends in merit awards
Under PRP arrangements, the pay review process may provide for either:
- pay progression entirely on the basis of individual performance appraisal ratings (known as ‘all-merit’ awards), or
- a general pay rise for employees in addition to an element that is linked to individual performance (‘basic-plus-merit’ awards).
Trends in performance pay are commonly measured via the pay review budget (or pay bill budget) allocated for the merit element of awards. However, the scope for any merit element of pay tends to be reduced during times of low pay award levels, with some employers finding it simpler to award a modest across-the-board increase rather than attempting distribution based on merit.
Implementing PRP schemes
For PRP to be effective, employees need to perceive a clear and prompt link between the effort expended and the reward that will be obtained, and also to feel that the level of reward on offer is worth the effort.
The key issues for employers implementing PRP include the following:
Objectivity/consistency of line managers
The role of the line manager is key to the effective implementation of PRP, and this group should be involved at an early stage in designing systems to ensure consistency and transparency when assessing performance. Some schemes try to eliminate marking differences between ‘hard’ and ‘soft’ managers by the use of ‘forced distribution’ arrangements, that is insisting that all managers band a certain proportion of staff in each performance pay grouping (for example, 10% ‘poor’ and 10% ‘superior’).
Ensuring objectivity is also important to avoid rewarding favourites. Particularly serious is the potential for unlawful discrimination. It’s important for appraising managers to be aware of the impact that unconscious bias can have through training/awareness and for monitoring of merit pay awards to take place (for example by gender, ethnicity, age and so on).
Distribution of pay awards
As some HR commentators have noted, pay is not the only motivating factor, or even the most important one, for some employees. And the performance element of pay is often relatively small, particularly for those relatively middling performers who will by definition form the bulk of the workforce. The problem is accentuated during times of low inflation when the pay bill increase is usually limited to relatively small percentage figures. Even where PRP may have a motivational impact for high performers, the corollary can be the demotivation of the lower or middle level performers. Therefore it’s important to carefully consider the issue of pay award distribution.
Identification of development needs
A major concern is that linking pay awards to the performance review process may inhibit an open and honest discussion of an individual’s training and development needs. One solution is to separate the pay review aspect of performance measurement from the broader performance/development review, for instance by holding separate meetings some weeks or months apart.
The processes associated with PRP, such as performance appraisal, can be administratively very time-consuming. In general, it's important to allow sufficient time away from day-to-day duties for managers and employees to be able to engage in the PRP process effectively.
Undesired impacts on employee behaviour
Behavioural science finds that while financial incentives can increase worker performance, they may also drive out intrinsic motivations, such as the desire to do a good job. Or they may incentivise people to focus on some targets (such as customer service) at the expense of others (such as sales). Research indicates that linking pay to both individual and team performance may be better than just focusing on one or the other.For more information about what behavioural science says about reward, see our report Show me the money!.
ARMSTRONG, M. (2014) Armstrong's handbook of performance management: an evidence-based guide to delivering high performance. 5th ed. London: Kogan Page.
BOERI, T. (2013) Executive remuneration and employee performance-related pay: a transatlantic perspective. Oxford: Oxford University Press.
HIGH PAY CENTRE. (2015) No routine riches: reforms to performance-related pay. London: HPC.
MARSDEN, D. (2009) The paradox of performance related pay systems: why do we keep adopting them in the face of evidence that they fail to motivate? CEP Discussion Paper, 946. London: London School of Economics, Centre for Economic Performance.
Performance-related pay and employment relations in European companies (2013) Luxembourg: Publications Office of the European Union.
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BAJOREK, Z. and BEVAN, S. (2015) Performance-related-pay in the UK public sector: a review of the recent evidence on effectiveness and value for money. Journal of Organizational Effectiveness: People and Performance. Vol 2, No 2, pp94-109.
Merit or demerit: how might we reform performance pay? (2013) IDS Pay Report. No 1112, May. pp20-21.
PARK, S. and STURMAN, M.C. (2012) How and what you pay matters: the relative effectiveness of merit pay, bonuses and long-term incentives on future job performance. Compensation and Benefits Review. Vol 44, No 2, March/April. pp80-85.
SHAW, J.D. and GUPTA, N. (2015) Let the evidence speak again! Financial incentives are more effective than we thought. Human Resource Management Journal. Vol 25, No 3, July. pp281-293
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This factsheet was last updated by Charles Cotton.
Charles Cotton: Performance and Reward Adviser
Charles directs the CIPD's performance and reward research agenda. He has recently led research into: how employers can help improve their employees’ understanding of their personal finances; how front line managers make and communicate reward decisions to their employees; how employers manage the risks around reward; how private sector employers can build the business case for workplace pensions; how employees form their attitudes to pay; and how the annual pay review process can become more strategic.
He is also responsible for the CIPD’s public policy reward work and has given evidence to select committees on banking pay, redundancy awards as well as responding to various consultations, such as on pensions, retirement and MPs’ expenses.