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What is incentive pay?

By Ian Floyd|10 min read|Updated Oct 26, 2022

What is incentive pay?

When done well, incentive pay can inspire hard work, increase sales and create competition that’s both fun and productive.

But what is incentive pay, and how do you best use it to maximize employee performance and output?

Let’s get started.

Table of contents

‌What is incentive pay?

Incentive pay is merit-based compensation — outside of a guaranteed salary or hourly wages — that’s generally tied to achieving performance goals, milestones or objectives. It provides wage flexibility and extra motivation during fair times and foul.

Rewards can be distributed to:

  • Individuals — based on personal job performance

  • Larger groups and departments when they meet shared goals

  • Vendors, channel partners and affiliates as an investment in the relationship

These bonuses are often financial, but they don’t have to be. Companies can offer a variety of benefits, including:

  • Promotions

  • Working on preferred projects

  • Fun prizes

  • Workplace improvements

  • More paid time off

There are two types of incentive pay.

1. Structured incentive compensation

Incentive-based compensation can be a structured part of an employee’s pay.

These incentives are established in writing and occur with regularity if the employee, department, or company meets certain business objectives.

These could include:

  • Yearly bonuses

  • Sales commissions

  • Temporary wage increases

  • Stock options

  • Annual performance-based salary increases

2. Casual (or one-off) incentives

Alternatively, companies might offer casual incentives: one-time or occasional offerings created to reward and encourage staff.

Casual incentives might include:

Pro tip: Build a mixture of structured and one-off incentives into your incentive pay plan. Give employees something to work toward (structured incentives) and something to be delighted and surprised by (casual incentives).

What types of incentive payment are there?

If you already have an incentive program in place, consider updating the rewards you offer. Employee needs and desires change over time. It’s smart to update your offerings every few months. Incentive pay can take several forms:

1. Cash bonuses

A cash bonus is a sum earned in addition to guaranteed wages or salary. It allows companies to adopt a system of variable compensation. Instead of committing to a steady pay increase for the future, a company can offer employees one-time, additional payments.

According to Glassdoor, these are the most common types of cash-based incentive pay examples:

  • Annual bonus: Defined as an annual payment that’s generally based on a worker’s annual salary. Not guaranteed, an annual bonus depends on both the organization’s profitability and the individual’s performance.

  • Signing bonus: A one-time reward given when a candidate commits to working for a company.

  • Discretionary or spot bonus: A one-time cash payout that rewards past work. Managers often have a certain amount of discretionary funds and can use them when an individual exceeds job requirements.

  • Holiday bonus: A reward given by organizations during the holidays to celebrate the accomplishments of the past calendar year.

  • Retention bonus: A one-time payment to encourage loyalty and keep employees from leaving.

  • Referral bonus: A reward for an employee who helps recruit a qualified applicant for an open position.

  • Profit-sharing bonus: A percentage of the business’s profits that’s distributed to employees and usually divided up by title and salary.

Several of the above can take forms other than cash. An organization might distribute gift cards during the holiday season, offer stock as a profit-sharing bonus, or reward employees with an extra paid day off.

That said, employees indicate a strong preference for cash bonuses. In an Incentive Research Foundation survey, 88% of respondents ranked them in their top three preferred incentives. However, some types of cash incentives — namely, annual bonuses — are often treated similarly to a guaranteed salary. When a reward is considered a sure thing, it can lose its motivational power.

2. Commissions

Commissions frequently complement the base salary of a salesperson. Companies can pay:

  • A percentage of each sale

  • A set amount per customer or transaction

  • A quarterly or annual commission based on the percentage of quota met

  • An amount to be divided among a certain group based on that group’s total sales performance

Some companies offer tiered commission structures as well. For example, a salesperson might make $X in commission for the first $50,000 of sales and $1.25X for all sales over that quota.

3. Non-monetary rewards

Not all rewards are cash-based. Consider providing direct benefits (like a more flexible schedule or time off) and workplace improvements (such as better equipment or catered food during late nights). Non-financial incentives further allow bosses to personalize rewards in a way that cash doesn’t. Why not give that chocoholic who just netted you a huge deal a year-long membership to a chocolate-of-the-month club?

Gift cards are an increasingly popular reward in incentive programs. When you can afford only a small amount — or when you want to reward a smaller accomplishment — it may be more effective to give employees a $5 gift card to the coffee cart downstairs than to dole out cash.

Can’t afford anything? Consider penning a personal, handwritten note that thanks someone for their hard work, or sending a company-wide email that recognizes their accomplishments.  

What incentive pay programs should you offer?

Incentive pay can be used in nearly any part of your business.

Think of structured incentives as an investment in a specific business outcome. Create incentives that focus your employees’ time and brain power on achieving important goals, whether they’re long-term or short-term. Casual incentives are a flexible tool for rewarding exceptional performance, ideas, leadership, or any other attribute you’d like to reinforce.

Here are five examples of incentive pay programs you can implement today:

1. Employee rewards and recognition

While the two terms are often used interchangeably, employee reward programs are not the same thing as employee recognition programs. Both can offer either casual or structured incentives.

Reward programs provide financial benefits. Employee rewards programs motivate employees by giving them the chance to earn money or perks outside of their regular salary and merit pay increases. For instance, annual cash bonuses supplement guaranteed salaries, allowing employers to increase compensation based on yearly performance.

Recognition programs provide psychological benefits. Recognition programs motivate staff by acknowledging and celebrating superior work. For example, an employee-of-the-month program commends an individual for excellent work but may not have any financial reward tied to it.

A well-rounded employee reward and recognition program combines the two. They add a game-like element to the workday while reminding staff that they’re valued, contributing to workplace morale.

2. A sales incentive programs and SPIFF programs

An incentive pay plan rewards salespeople or sales teams that reach or exceed established targets. On top of their regular wage or salary, they have opportunities to gain additional cash or other rewards.

Sales incentives are most often structured systems of commissions or cash bonuses, but you can also provide spontaneous privileges and perks.

SPIFF programs are a short-term sales incentive program that many companies utilize to sell hard-to-move products or increase sales over a short period of time.‌

3. Health and wellness incentive programs

‌Companies are increasingly adopting employee health and wellness incentive programs. For instance, employers could offer to pay a higher percentage of health care costs for all employees who show year over year improvements in key health metrics, like blood pressure, cholesterol levels, or BMI.

Another example: If the team signs 10 high-value customers by the end of the quarter, then everyone gets a $500 prepaid card to use on whatever helps them relax — a massage, a spa day, a yoga class, etc.

Why would an employer want to run this type of program?

Health insurance premiums are often one of the costliest business expenditures. By promoting healthy lifestyles, you can:

  • Contain annual health care cost increases

  • Minimize workers’ compensation claims

  • Mitigate employee absenteeism due to illness or injury

Pro tip: Avoid health and wellness programs where people are forced to publicly share their health information. This could violate medical privacy laws and alienate employees who aren’t comfortable sharing those details.

4. A channel incentive program

Channel incentive plans apply the concept of incentive pay to business partners such as distributors, retailers, and other affiliates. They're rewarded when they achieve established goals. For example, you might offer:

  • Bonuses for new customers

  • Volume rebates

  • Development funds

  • Sales incentives paid to sellers who move a certain amount of product

5. Environmental, social and governance (ESG) programs

‌There’s a growing movement to incorporate environmental, social, and governance goals into incentive programs. ESG programs aim to make a positive impact on the world at large. Some top ESG priorities include:

  • Slowing and mitigating the impacts of climate change

  • Improving access to medicine

  • Reducing plastic waste

These intangible factors may be harder to measure, but incentives reinforce company values and strengthen culture. For instance, employers might offer paid time off to employees who volunteer in their community.

How do you design an incentive pay plan?

Design an incentive pay plan tailored to your specific:

  • Work culture

  • Employees

  • Organization-wide goals  

No single approach will work for every company. Take the time to identify exactly what you want to accomplish and the best way to do so.

Keep in mind:

  • Align the target of your incentive pay program with company goals

  • Define success at the outset.

  • Determine the best way to motivate employees to achieve their goals.

  • Refine these objectives and break them down into individual targets for employees.

Remember that not all goals have to be tied to company profits and losses. Values-based programs are increasingly popular. ‌For incentive pay to be an effective motivational tool, you need to follow certain organizational, motivational, and behavioral principles.

Organizational principles

What are you going to measure, and how will you measure it? What qualifies as success for an employee?

For example, when designing an incentive pay plan for a sales team, you’d likely establish individual or group quotas. But how can you quantify other types of success and the goals of other departments?

And how can you ensure that your targets and incentives truly promote behavior in keeping with company values and goals? Sometimes rewards systems can backfire, inspiring behavior that threatens the business and encouraging problematic competition or unethical practices.‌

One of the most common problems that plagues goal-setters of all stripes: nebulous or overly idealistic objectives or metrics. Make sure the targets you establish are SMART:

  • Specific

  • Measurable

  • Achievable

  • Realistic

  • Time-based

Your employees need to know exactly what success looks like, when the deadline is, and how to measure their progress. ‌Make sure workers are in control of their outcomes, too. If you confuse areas of responsibilities, you’ll frustrate all involved.

Motivational principles

What will drive your employees? Do they want more recognition, more flexibility, or more cold hard cash?

Again, ask people what they want — even if you already know. People are more likely to invest themselves in plans they feel they’ve contributed to. When surveying employees, be clear about what is and isn’t on the table — and for whom. Your incentive pay design should account for different:

  • Levels

  • Access

  • Experience

  • Departments

Be both fair and transparent as you differentiate between the incentives available to different positions.

Behavioral principles

The Society for Human Resource Management and consultant Aubrey Daniels present a number of different behavioral principles to apply when designing your pay plan and rewards. Their wisdom can be distilled into the following rules:

  1. Be objective: Or, rather, accept that humans are unable to be perfectly objective. As much as possible, avoid subjective measures, such as performance reviews, in favor of quantifiable results.

  2. Be transparent: Make sure the entire staff understands their goals and incentives. Transparency also helps you guard against accidental discrimination or other unfair practices.

  3. Be comprehensible: Convoluted incentive schemes just confuse people. The compensation structure should be simple enough that a seventh-grader can grasp it.

  4. Be proactive: Replace after-the-fact bonuses with “pay for performance.” While bonuses do boost morale and encourage employees to work hard, they can’t motivate employees in the same way that a known benefit can. Give employees a target they can aim at and a good reason to hit it.

  5. Be comprehensive: Account for potential consequences and refine your targets accordingly. Avoid overly simplistic goals, which can backfire by inspiring the wrong practices.

  6. Be regular: Shorten the periods over which you measure performance. Instead of evaluating employees yearly, break up goals into smaller chunks. For one thing, regular quotas — or other targets — give employees meaningful feedback that they can incorporate immediately.

  7. Be consistent: Establish the rules and stick to them. Nothing erodes employee confidence faster than continually changing policies and compensation systems.

  8. Be aware: While you don’t want to change your goals and methods midstream, you need to be alert to metrics and changing industry conditions. Depending on the numbers, you may have no choice but to revise or discontinue your program.

Does incentive pay really work?

Yes, incentive pay works — particularly when there’s a perceived scarcity of rewards. If incentive pay is always available, then people are more likely to consider it guaranteed pay.

To best understand why, consider the benefits of incentive pay.

Benefits of incentive pay

A well-designed incentive pay system should push your employees and business forward. Incentive pay:

  1. Aligns employee, partner and vendor interests with company goals

  2. Defines what’s important for your business

  3. Empowers your people to improve processes and systems to achieve your goals

  4. Rewards high achievers

  5. Builds a culture around teamwork and performance

  6. Pushes employes to continue developing their skills in order to achieve their goals

  7. Professionally and intellectually stimulates employees, which can reduce turnover

All of the above contribute to a better product or service and improved customer experience. Ultimately, these efficiencies and improvements result in tangible top-line and bottom-line growth.

Incentive pay risks to consider

All strategies come with risks. But, when built and monitored thoughtfully, all of these risks can be mitigated.

  1. If your program is a competition, it can lead to tension between employees. Unhealthy competition and jealousy can compromise morale, engagement, and productivity. To combat this, build programs that unite teams, not divide them.

  2. ‌Employees might neglect responsibilities that aren’t tied to incentives. In this scenario, help employees understand why their responsibilities are important and indirectly impact their overall progress toward incentivized goals.

  3. Incentives can encourage employees to adopt overly aggressive sales styles or unethical practices. This can be mitigated by defining acceptable behavior or processes for an incentive program.

  4. Incentive pay programs that don’t define success criteria could be susceptible to wage descrimination. For instance, if bonuses are based on performance reviews, then the reward can be affected by supervisors’ personal biases and relationships.

Key takeaways

Incentive pay is merit-based compensation. It’s generally tied to performance or meeting established objectives, and it can come in the form of monetary and non-monetary rewards.

Common incentive pay programs include:

  • Employee rewards and recognition programs

  • Sales incentive programs

  • Health and wellness incentive programs

  • Channel partner programs

  • Environmental, social and governance programs

Build a unique program that fits your business needs as well as the interests and motivations of recipients: employees, clients, partners.

Published July 15, 2021

Updated October 26, 2022

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