Pay for performance is a hot topic in the compensation space. As companies tighten budgets, compensation leaders have to pull whatever levers they can to be able to hire top talent and retain their best performers. But implementing a new compensation philosophy is no small task.

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Here, we’ll cover what is pay for performance, why it matters, and some key considerations to think through if you want to create a performance-based pay strategy for your business.

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The Background on Pay for Performance

When it comes to salary raises and equity refreshes, it used to be common for companies to take the “peanut butter approach” and spread the budget around equally to all their employees. This approach is appealing: it’s easy, satisfying, and feels fair. And a lot of companies could afford to do it.

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Cut to today, and the macroeconomic landscape has changed. Companies are dealing with factors like inflation and economic uncertainty, and many are struggling to grow. That means budgets for raises are tighter, and equity burn is a bigger concern. Taking the peanut butter approach is harder to do in the current business climate.

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These factors and the pressure they create has led to a growing trend in pay for performance.

What is pay for performance?

Compared to the peanut butter approach, pay for performance is more targeted. It involves incorporating your merit cycle and performance ratings into your compensation strategy in order to reward high performers with higher compensation than lower performers. This could come in the form of salary increases or raises, bonuses, or employee equity.

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Pave Data shows that many companies use some type of scale to rate employee performance during the merit cycle, the most popular of which is a five-point scale.

When companies use a performance rating, the scale will typically include rankings like “below expectations”,  “meets expectations”, and “exceeds expectations”. Within companies in Pave’s sample, the majority of employees received a rating of “meets expectations” or above—only about 8% were rated below expectations. 

In a pay-for-performance model, these merit cycle ratings would be mapped to the raises, bonuses, or equity grants outlined in the compensation strategy.

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For more insights on merit cycles, download Pave's free Merit Cycle State of the Union report.

Why Pay for Performance Matters

Pay for performance matters for compensation leaders because it helps them allocate smaller budgets more efficiently. If there’s less money to go around when it’s time to give raises, allocating that budget to the highest performing employees is smart spending. 

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Pay for performance also builds a culture that rewards employees for great work, which can be a motivator for your team. At Pave’s Total Rewards Live event, Michael Ng, VP of Total Rewards at Stitch Fix, spoke about the importance of understanding the difference between equity and fairness. 

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“The words ‘equal’, ‘equitable’, and ‘fair’ are often used interchangeably, when we all know that there are nuanced but important differences,” Michael said. ‘Equal’ quite literally means ‘the same.’ To pay fairly, people who go over and above should receive more, while those who lack motivation and miss goals should receive less. To pay fairly, we must differentiate pay. This is the essence of pay for performance.”

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When employees perceive your compensation practices as fair, they’re more likely to stick around. 

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“Pay for performance can also be a powerful tool for retaining critical roles,” said Katie Aldred, Consulting Partnerships Lead at Pave. “Rewarding your top performers in positions that are most impactful for the business helps you keep your superstars in-seat for the long run.”

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If you’re considering a performance-based pay strategy, as stated above, it’s not just about cash raises and bonuses. Employee equity is another lever comp leaders can pull within a pay for performance model, which can have the added benefit of helping to manage equity burn.

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Pave Founder & CEO Matt Schulman posted about pay-for-performance culture on LinkedIn—see what the community had to say.

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Benchmarking Pay for Performance

Despite the growing emphasis on pay transparency and equity, many organizations struggle to implement true pay for performance cultures. According to Pave’s benchmarks, the market medians Q1 of 2024 showed that:

• The vast majority (87%) of eligible employees received a raise
• The difference in raise percentage between promoted and non-promoted employees is only 5.2% (9.2% vs. 4.0%)

This raises questions about whether current compensation practices truly reward high performers. In many organizations, top performers might be 2x, 3x, or even 10x more impactful than the bottom quartile of employees. Yet, the compensation treatment shows only a 5.2% preference for top performers rather than 100%, 200%, or 1000%.

Implementing a Pay-for-performance Culture

To create a genuine pay-for-performance culture without increasing the overall merit cycle budget, companies may want to consider more drastic measures:

1. Limit raises to fewer employees, allowing for larger increases for top performers.
2. Increase the average raise for promoted or top-performing employees beyond 9.2%.
3. Implement minimal or no raises for low performers.

For example:

• Reduce the percentage of employees receiving raises from 87% to a lower figure.
• Increase the average raise for promoted or top-performing employees to significantly more than 9.2%.
• Set the average raise for low performers at or close to 0%.

However, these approaches come with their own set of challenges and cultural implications. Organizations must carefully weigh the trade-offs between strict pay-for-performance models and broader pay equity goals.

When implementing these changes, consider the following steps:

1. Analyze your current merit cycle data
2. Compare your figures to industry benchmarks
3. Determine how much you want to shift towards a pay-for-performance model
4. Develop a strategy for reallocating your merit cycle budget
5. Communicate changes clearly to managers and employees
6. Monitor the impact on employee satisfaction and performance

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Support Your Comp Strategy with Pave

Pay for performance is gaining traction in the current market landscape. If you’re interested in implementing a pay-for-performance model, or evolving the version you already have, Pave can help. 

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Pave Market Pricing can help you improve your compensation strategy by putting benchmarks into action and updating comp bands. In addition, leverage Pave’s Compensation Planning tools to run your merit cycle and align it with your comp workflows, all in one tool.

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Ready to learn more? Request a demo today.

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