Managing Employee Reward Systems Merit Pay What Is Merit Pay? Pay for Individual Performance Based on Performance Appraisal - Supervisory Judgments of an Employee’s Performance One Year is the Typical Review Period Increase Folded into Base Salary (in most cases) Used in Most US Firms and US Multinationals

Managing Employee Reward Systems Merit Pay (Cont’d) Many Problems with Merit Pay Performance Appraisal is Subjective and is Subject to Errors & Biases: –Leniency, Stringency, Central Tendency Bias –Halo, Recency, Contrast Effect Errors Difficulty Measuring Employees’ Work Outcomes in Many Jobs - What gets measured is behavior or traits in some cases. May place too much Emphasis on Individual Goals and lead to goal conflict with others in unit/group.

Managing Employee Reward Systems Merit Pay (Cont’d) Employee likely to focus on short-term goals and neglect long term goals. Employee likely to be judged on outcomes he or she cannot control such as system factors. –Ex. Sales Rep receives a poor sales territory compared to other sales reps. Sales are more difficult in this one. Timing is poor - only given on annual basis. Size of Marginal Increase for Excellent Performance may not justify additional effort (difference between ave. & excellent on scale)

Managing Employee Reward Systems Merit Pay (Cont’d) Non-Performance Factors (Seniority and Cost of living) may Dilute Merit, reducing the Credibility of the Pay for Performance Relationship. Limited Budgets for Merit Pay - May result in zero sum game, in which some “good” performers are labeled “average” or “poor” in a ranking or forced distribution scheme to ration pay raises. Merit pay increases may be viewed as an entitlement - or an annuity earned only once, but received in salary in perpetuity.

Managing Employee Reward Systems Merit Pay (Cont’d) Best Practices for Merit Pay Use Valid Performance Appraisal System –Accepted by Employees/Free of Politics –Valid Measures of Individual Performance Have a Large Enough Merit Pay Budget (at least 5 percent of payroll) to Recognize Different Performance Levels with Pay Meaningfully. Works Best in Private Sector firms where high performance is an important cultural value.

Managing Employee Reward Systems Merit Pay (Cont’d) Consider Alternatives to Merit Pay if conditions are not favorable for it. –Individual Lump Sum Bonuses –Skill-based Pay –Team Bonuses –Annual Market Adjustments (Seniority increases) Employees should be Able to Challenge their Merit Increase –Appeal Mechanism such as Open Door Policy which lets another manager or committee review the pay decision and make an independent judgement.