Does Performance-Based Pay Increase Productivity?

What is performance-based pay?

Performance-based pay refers to compensation that is earned when employees drive sales or meet other targets. This pay, such as a commission or a bonus, is usually offered in addition to some level of base compensation and is intended as an incentive for employees. 

Performance-based pay can be difficult for employers to track, as employee performance may ebb and flow. Companies that want to keep better tabs on their payroll should consider using one of the best online payroll software solutions, especially when transitioning to a structure such as performance-based pay.

Research examines performance-based pay models

Research shows that performance-based pay seems to encourage employees to work harder and drive better results for the company. However, the trade-off is that employees are more likely to overwork themselves, leading to low job satisfaction and, potentially, high employee turnover (which can become expensive for the company.)

A study published in IZA World of Labor found that “performance-related pay is a relevant policy to improve firm performance and competitiveness, although the adverse effects on work intensification and employees’ physical strain and psychological stress should not be overlooked.”

Therefore, when an employer implements a policy of performance-based pay, it is essential to hold regular meetings to gauge team members’ overall morale and assess whether they are at risk of occupational burnout, which can seriously hamper their productivity. 

A study published in the Human Resource Management Journal similarly revealed that workers who receive performance-based pay work harder but end up with higher stress levels and lower levels of job satisfaction. The research found that employees who receive performance-based pay or know how well their employer performs financially are more likely to feel overworked. That pressure offsets the gains in productivity that the pay structure is designed to produce, the study’s authors said.

The study revealed the flaws with performance-based pay models, said Chidiebere Ogbonnaya, the study’s lead author and a research fellow at the University of East Anglia at the time of the study. He added that many employees who receive performance-based pay feel immense pressure or do not have enough hours to complete work tasks.

“By tying employees’ performance to financial incentives, employers send signals to employees about their intention to reward extra work effort with more pay,” Ogbonnaya said in a statement. “Employees, in turn, receive these signals and feel obliged to work harder in exchange for more pay.”

Although employees may value these earnings and see the pay structure as positive, the ultimate beneficiary of their extra effort is the company.

“As a consequence, performance-related pay may be considered exploitative, or a management strategy that increases both earnings and work intensification,” Ogbonnaya said.

What about organizational performance-based pay?

When the researchers looked specifically at pay tied to company profits, they found that performance-based pay increased job satisfaction, employee commitment and trust in management if the profit-related pay was distributed equitably across the organization. When profit-related pay was given only to a small portion of the workforce, by contrast, there were lower levels of job satisfaction, employee commitment and trust in management, the study found.

Does pay increase performance?

Many studies have shown that the amount of pay someone receives does not directly contribute to their level of performance. No matter how much you pay employees, they’ll eventually cycle through their normal routines. If those routines include slacking off and underperforming, then that’s what will happen.

Moreover, a study in Harvard Business Review found that not all employees respond well to incentive-based pay. For example, accounting or human resources professionals may want a steady salary instead of a commission for each report they complete. Still, pay increases and bonuses for bulk work, even in operational environments, can be beneficial.

There’s also a chance of corruption: If employees get in desperate financial situations outside of work, they may cheat the system to get more pay. This issue caused Wells Fargo retail bank employees to fraudulently open customer accounts to meet aggressive sales quotas, resulting in a $575 million lawsuit at the end of 2018.

Pros and cons of performance-based compensation

There are advantages and disadvantages to adopting a performance-based pay model.

Pros

• It improves the recruitment and retention of high-performing talent. For top performers, understanding what’s expected of them, achieving those expectations and reaping the rewards are incentives to stay. In turn, your HR team can analyze the qualities of these top performers to identify those traits in prospective candidates and build the ideal workforce.
• It reveals areas for improvement. Performance-based pay affords business leaders the insight to find the “weak links” by assigning quantifiable values to team members’ contributions. By first identifying the low performers and then analyzing why they’re performing below expectations, you can discover areas in your business that need improvement, such as training processes, supervision and communication.
• It can increase productivity. By nature of this compensation structure, employees who contribute more to the company are paid more, thus encouraging higher productivity. Companies with pay-for-performance compensation usually use a calendar or schedule to track deadlines, and team members can use those expectations to complete work more efficiently.
• It sets clear expectations. A performance-based model puts compensation largely within employees’ control, enabling them to increase their own pay. This also establishes clear expectations for raises, thereby reducing miscommunication and fostering transparency around the subject of pay.

Cons

• It risks valuing quantity over quality. Businesses that decide performance-based pay is right for them should be aware of the adage “quality over quantity.” Because quantifying accomplishments is the natural rubric for this pay structure, you should emphasize the importance of high-quality work when giving assignments to avoid rushed, subpar work.
• It can hurt your company culture. Not everyone is built to flourish with performance-based compensation. Team members who aren’t comfortable in a competitive environment may not appreciate the structure. It can break down collaboration and teamwork, as performance-based pay tends to favor an individual’s achievements over a team’s accomplishments. As the study above mentioned, it can also lead to higher stress and lower employee morale, both of which hurt company culture
• It’s hard to change. Once a team has adjusted to performance-based pay and the benefits it affords — especially for go-getting team members who thrive on the challenge of surpassing a goal — it’s very hard to change it. Even if you find that another pay structure would work better for the business as a whole, attempting to change it may cost your company its top performers.

Alternatives to performance-based pay

Performance-based pay is expected in the investment industry, such as for hedge fund and portfolio managers, but comprehensive pay structures are more common in most other industries. Generally, employees experience performance-based pay only in the context of bonuses and extra rewards, not as their full compensation.

You should consider several other compensation structures before deciding if performance-based pay is right for your workforce. Hourly wages and salaries are the most common forms of compensation for employees and often include “indirect compensation” in employee benefits, such as insurance and yearly raises.

Commission is a type of compensation that’s more closely related to performance-based pay. It can be offered in conjunction with a salary and usually reflects a percentage of an individual’s or team’s contributions to the company.

Is performance-based pay right for your team?

Performance-based pay isn’t for everybody. While some employees thrive on it, others need a steady, predictable paycheck. With a properly executed incentive plan, performance-based pay can work for companies of any size, but be sure to consider your employees’ needs and the alternatives first.

Jacob Bierer-Nielsen contributed to this article.