Bonuses and financial incentives are a type of variable pay based on lump-sum payments linked to:

• individual,
• collective,
• organisational performance, or
• some combination of these.

They are not consolidated into base pay, though in certain situations (such as budget constraints) they are given as part of a pay rise, or instead of one. They are often paid in cash, but senior staff usually get some of these rewards in company shares.

It is important to tell apart incentives and bonuses, although they are interlinked and often used interchangeably.

• Incentives try to influence future employee behaviour or performance. If the employee meets a specific target then they get a payment.
• Bonuses can either be discretionary or non-discretionary. Like incentives, they can encourage employee performance or behaviour to meet pre-set objectives. However, they can also be used to reward past achievements.

It's also helpful to differentiate between:

• Non-cash incentives, which aim to influence employees’ future performance by awarding prizes or ‘gifts’ linked with some performance measure.
• Employee recognition schemes are backward looking as they recognise previous performance rather than incentivising future efforts. They may be informal and discretionary. Such schemes may be linked with non-cash incentives.

Our report Show me the money! The behavioural science of reward examines how people respond to various incentives.

The desire to incorporate bonus and incentive plans into reward packages is driven by the ‘new pay’ philosophy. This recommends that ‘guaranteed’ remuneration (basic pay and benefits) comprise a smaller proportion of the overall reward package, with a shift towards strategic reward linking employee performance and pay to the wider business strategy.

In some sectors, there's also been a move towards market-based pay, whereby an employee might only get a pay rise if the market rate for that role has increased. In this situation, a person’s contribution could be recognised via a bonus instead of a pay rise.

For the employee, the main benefits of a bonus or incentive over consolidated salary increase are:

• You have greater control over the amount of your pay.
• Potentially, you can earn more money.
• You can receive the bonus in one go.

But the downside for employees includes:

• You need to re-earn these non-consolidated payments.
• They may not count towards your variable pay (such as overtime rates) or your benefits (such as occupational sick pay).
• Your payments may be unpredictable or lower than expected if you cannot hit your targets.

For the employer, the advantages include:

• Ongoing motivation as bonuses must be re-earned.
• Smaller impact on those employment costs that are linked to basic salary levels, such as pension contributions.
• Ability to maintain market pay competitiveness without having to increase the annual pay bill.
• Flexibility, for example, the ability to cut or even stop payments during economic downturns.

To be effective, financial-based bonus or incentive schemes should align with an organisation’s:

• business objectives,
• corporate governance, and 
• ethical standards.

They should also align with the views of its stakeholders.

Yet this can lead to a proliferation of checks and balances, such as malus or clawback, which can reduce their motivational impact.

The success of these schemes also depends on how performance is:

• defined,
• managed,
• developed, and
• ascribed.

This requires effective communication and support for both line managers and employees.

Payment of a bonus or incentive is linked to a mixture of work quantity and quality. They are also linked to a mixture of individual, team, and company performance.

You can divide schemes into the following broad categories, though definitions vary, may overlap, or be linked:

• Individual-based - individual performance determines the size of the bonus or incentive.
• Schemes driven by business results - bonuses are set according to such company targets as profit level or customer satisfaction.
• Team-based – these link the bonus with some measure of collective performance.
• Project-based – are often used when a deadline is important.
• Department/site-based – can be used to reward workers who meet productivity improvements.
• Gainsharing – people share in the financial gains achieved through improved productivity or performance.
• Combination – two or more of the above. For example, a scheme based on a combination of both individual and team performance.

Many employers use a cash-based bonus or incentive plan, our 2019 Reward management survey finds. However, these are more common in the private sector. The most common arrangements include:

• individually-based plans (for example, personal performance or commission);
• plans driven by business results (such as profit); and
• combination schemes.

CEO bonuses and incentives

Most FTSE 100 executives’ bonus and long-term incentive plans are weighted towards financial measures of company success. Non-financial measures, such as workforce ones, play a small, albeit growing, role. See our CEO pay and the workforce report for more.

Levels of payments

Bonuses or incentives need to be ‘worth having’ if they are going to influence employee behaviour or performance. They must be set high enough to have an effect, and reflect (though not be driven by) market practice. However, setting bonuses too high can encourage undesired behaviours or outcomes. Such as taking on more risk or mis-selling. So, caution must be exercised.

Incentive calculation must be kept simple. Ideally, employees should be able to measure progress against targets. And carry out the calculation themselves.

Employers must decide how they'll set bonus payments. Including:

• whether to use a formula (typically for incentives) and 
• how to express payments (for example, as a salary percentage or a flat-rate payment).

Information tracking specific breakdowns of UK bonus payments over time (by gender, for instance) can be found in the Office for National Statistics' Annual Survey of Hours and Earnings.

Concern around bonuses

Following the 2008 recession, bonuses in the UK became a concern. The Financial Services Authority (FSA) considered that remuneration practices were a ‘contributory factor to the market crisis’. A range of measures were introduced to regulate remuneration in the finance sector, particularly for senior pay.  Though these measures are now under review.

For incentives to work as intended and avoid distorted outcomes, employers should have an open and ethical culture in which staff:

• are encouraged to do the right thing and
• feel able to challenge management decisions or targets they think are unethical.

See more in our factsheet on ethical practice and the role of HR.

Cash is not always the best way of motivating employees. So, many workplaces use non-financial incentive schemes. These incentivise employees by offering gifts and prizes.

Non-financial incentives are often found in customer-facing industries. They might be a single prize won by the highest-performing employee or team. Or a range of awards recognising different levels of achievement.

The benefits include:

• Affordability – They may be more cost-effective than cash bonuses.
• Simplicity – It's easy for a sales employee to understand what they need to do to win the latest prize.
• Psychological impact – Employees can find it easier to talk with colleagues about winning a gift than about getting a cash bonus.

Drawbacks can include:

• Lack of credibility – Such prizes may not be taken as seriously as cash.
• Lack of employee awareness – Employees may be less conscious of the value of non-financial incentives over ‘hard cash’.
• Lack of value – People value the same non-financial reward, such as a trip to a sporting event, differently, so what might be an incentive to one person might not to another.

The incentivisation industry is more highly developed in the USA than in the UK where, according to our 2019 Reward management survey, only a minority of employers have non-financial incentive schemes.

Types of non-financial incentives

Non-financial incentives may be broadly divided into:

• Merchandise
• Activities/special events
• Travel
• Retail vouchers
• Awarding points that may be converted into a range of awards.

Incentive suppliers

Suppliers of non-cash incentives often provide other initiatives, such as recognition and team-building activities. There is more information in the journal Incentive and motivation.

Tax implications

Employers implementing a non-financial incentive scheme can be subject to income tax over a certain level. UK employers can pay any tax or national insurance owing on behalf of employees. Information on the UK tax implications of non-financial awards can be found in HM Revenue and Customs guidance.

The purpose of recognition

Recognition (non-monetary rewards) is given to acknowledge and reinforce employees' efforts, behaviour, or achievements. Employers can measure the climate of recognition in the workplace by asking its employees how well they feel it is recognising their efforts. For more information, see our report Incentives and Recognition: An evidence review. 

Do recognition schemes work?

The 2019 Reward management survey finds widespread use of individual or team-based non-financial recognition, while Incentives and Recognition: An evidence review, shows how they can be effective.

CIPD blog

One-off bonuses: are they the best way to support people through the cost-of-living crisis?

Books and reports

ARMSTRONG, M. (2023) Armstrong's handbook of reward management practice: improving performance though reward. 7th ed. London: Kogan Page.

COTTON, C., GIFFORD, J. and YOUNG, J. (2022) Incentives and recognition: an evidence review. Practice summary and recommendations. London: Chartered Institute of Personnel and Development.

PERKINS, S.J. and WHITE, G. (2020) Reward management: alternatives, consequences and context. 4th ed. London: Chartered Institute of Personnel and Development.

Visit the CIPD and Kogan Page Bookshop to see all our priced publications currently in print.

Journal articles

COTTON, C. (2020) CEO pay: complex solutions for complex problems. CIPD Voice. Issue 26. 16 November.

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. 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.

TAYLOR, T. (2010) The challenge of project team incentives. Compensation and Benefits Review. Vol 42, No 5, September/October. pp411-419.

CIPD members can use our online journals to find articles from over 300 journal titles relevant to HR.

Members and People Management subscribers can see articles on the People Management website.