Merit increases are an important factor of a company’s compensation strategy that can be mutually beneficial for employers and employees. Even though monetary compensation per se may not be enough to retain top talent, it remains a core element of the employer-employee relationship.
Merit pay can help organizations retain top-performing employees. But it can also drive them away if it’s not managed carefully. It’s important to understand how merit increases compare to other monetary incentives that can be delivered via employee rewards programs, use cases, calculation, and implementation.
What is a Merit Increase?
A merit increase is a raise or increase in salary based on an employee’s performance. Unlike a bonus, which may occasionally be added to salary under certain conditions, a merit increase is a permanent uplift in monthly compensation.
Typically, merit increases are in the range of 2% to 3% of base pay. However, some organizations may go as high as 5% to 10% to reward deserving employees.
We asked Ali Saqib Husain, Senior Manager, Organization Effectiveness at TD Bank, Canada about merit pay. According to Husain, “Merit pay is an effective tool, especially for industries with high growth potential, such as e-commerce. A company like Amazon with double-digit growth for much of the last two decades, can afford to award large merit increases without hesitation. However, it may not be an ideal tactic for organizations where profit isn’t the prime motive, for example, NGOs or the Government sector.”
Organizations may use several methods to structure merit pay programs. In many cases, a merit pay pool is allocated for merit-based salary increases. This pool may be a percentage of total payroll or a fixed amount based on company performance.
The allocation of merit increases is a subsect of compensation planning and may be based on specific and measurable metrics or broad subjective categories. A high degree of managerial discretion is involved here, and the decision to award merit increases would usually happen during a performance review cycle so that there is also a benchmarking process to ensure fairness among employees.
Regardless of the methods used to review current salary and award merit increases, the company objectives of a merit increase program are ultimately to improve employee retention, motivate teams, and align employee interests with company goals.
Merit Increases vs. Other Types of Employee Reward
Merit increases serve a specific purpose in an organization’s rewards mix. To understand this function better, let’s compare and contrast merit pay with other types of rewards.
Merit Increase vs. Pay Raises
There is a subtle but essential difference between a pay raise and a merit increase. Even though both increase an employee’s base salary, only the latter is exclusively tied to job performance.
On the other hand, pay raises may be awarded as a result of contractual obligations, time spent in an organization, inflationary adjustments, and yes, job performance.
Like merit increases, pay raises are typically announced annually in light of performance reviews but the frequency can vary based on company policy.
While both of these employee incentive ideas are designed to motivate and reward employees, pay raises have a broader role and aren’t exclusively designed to reward employee performance.
Merit Increase vs. Bonuses
Bonuses are one-time financial rewards given to employees for achieving certain predefined goals or for exceptional individual or team performance. Unlike merit increases, bonuses are awarded in addition to the employee’s base salary and don’t lead to a permanent pay increase.
Performance bonuses can be awarded annually, semi-annually, quarterly, or at other times (such as ad-hoc spot bonuses) depending on the company and industry.
Another difference between the two is the perceived size of each reward. Merit raises may give employees an increase of 3% to 5% in annual salary, which may not seem much on a weekly or monthly basis.
On the other hand, because bonuses are one-time rewards, they usually come in the form of larger lump-sum payments, potentially holding a higher perceived value in the short term.
Merit Increase vs. Commissions
Commissions are financial rewards designed to motivate employees to meet predefined short-term business objectives. Examples of such business objectives are the number of closed sales, the number of new clients onboarded, or other quantifiable metrics.
Unlike merit pay increases, commissions do not increase an employee’s base salary and can vary every month. Furthermore, commissions are usually confined to sales, business development, or other roles that directly impact the bottom line, while merit pay is applicable across a wide range of jobs.
Merit Increase vs. Cost of Living Adjustments
Cost of living adjustments (COLA) are attempts by companies to maintain their workforce’s purchasing power in the face of constant inflationary pressures. Like merit pay increases, a cost of living adjustment increases an employee’s base salary on a permanent basis.
However, unlike merit pay, COLA is not contingent upon an employee’s hard work or achievements. Instead, it’s merely an effort to maintain the real value of an employee’s promised compensation.
Merit Increase vs. Promotions
Promotions are an employer’s way to reward and recognize high-performing employees. Just like merit increases, promotions are the result of exceptional individual performance.
However, promotions have a broader impact on an employee’s job than merit pay. While the latter only brings about a nominal increase in annual pay, the former moves an employee up in the company hierarchy. Annual raises in a promoted employee’s salary are also, generally speaking, substantial compared to an average merit increase.
Some other factors that affect promotion decisions include employee expertise, experience, and organizational needs.
Which Employees Should Be Offered a Merit Increase?
So far, we have established that merit increases are based on employee performance. But there is more nuance to this discussion than one might initially think. How do you define these top performers? If there are several top performers, how would you prioritize them for the merit pool?
Let’s review some of these considerations.
Rewarding Your Rockstars
Your best performers are the first in line for merit increases. In most organizations, they are easy to spot. Their work stands out from the rest.
However, organizations still need to find ways to quantifiably measure the performance of their top performers. To ensure fairness in the merit increase process, HR leaders need to work towards processes that eliminate or reduce subjectivity from performance reviews, for example by utilizing performance management software.
These employees aren’t topping the performance charts, but they’re showing constant improvement. If you have the right metrics in place to measure their performance, you’re in a good position to spot these trends and award merit pay to encourage them.
However, not all employees are motivated by financial rewards. Insight into non-monetary incentives is also important when you’re looking to optimize your merit pay program.
Prioritize by Role Impact
Inevitably, some roles at your organization are going to have a bigger impact on the bottom line than others. When you’re analyzing employee performance for merit pay, it makes business sense to prioritize the roles that have greater potential to shape your business.
Another way a role can be highly impactful for a business is when the set of skills required for that position is hard to find, making employees in such roles rare and costly to replace.
Managing Merit Increase Growth
While merit increases can motivate and reward top performers effectively, they can also lead to situations where employees rapidly exceed the salary range defined for their position.
To prevent this scenario, some organizations use a “merit increase matrix”. It takes an employee’s salary range into consideration in addition to their performance when making decisions about merit pay.
Regarding rapid merit pay growth, Husain said, “High merit increases should only be reserved for exceptional performers. A top performer who consistently earns merit pay rewards not only becomes more loyal to the organization but is also likely more productive than several employees combined. In other words, the replacement cost for such talent would be higher than what it costs to retain them.”
How to Calculate a Merit Increase
If you’re starting a merit increase program from scratch, use the following guidelines to get a head start:
1. Allocate a Merit Pool
Assign a budget for the year’s merit increases. This can be a percentage of the total payroll or a fixed amount based on company performance. The size of the merit pool dictates the potential level of merit increases that employees can expect for the year.
2. Measure Employee Performance
Since merit increases revolve around employee performance, measuring this performance correctly is a key aspect of a fair merit increase program. In its simplest form, a performance measurement mechanism may involve rating employees on a scale of 1 to 5 on various KPIs.
3. Define Employee Categories
A common method to help managers decide how to award merit increases is to define categories of employees based on their performance evaluation. There’s no fixed set of rules for how this categorization should be done, but a typical setup may be as follows:
- Top performers
- Average performers
- Below-average performers
The top performers earn the maximum merit increase, while the average performers get a lower bump in merit pay. Finally, the below-average performers either get a low merit increase or none at all.
4. Decide Merit Increase Percentages
The next step is to assign merit increase percentages to the defined categories. Considering the categories mentioned above, here’s an example of what these percentages can look like:
- Top performers: 5%
- Average performers: 2.5%
- Below-average performers: 0%
5. The Calculation
Finally, we can calculate the merit increase by applying the appropriate percentage to an employee’s salary:
Merit increase = Base salary x merit increase percentage
In this example, for a top performer whose base annual salary is $100,000, the calculation would be:
Merit Increase = 100000 x 5% = 5000
Consequently, we’re going to add $5000 to this employee’s annual base salary, making it $105,000 per year.
Tips for Implementing Effective Merit Increases
Here are some useful tips for implementing merit increase programs that deliver.
Align Your Merit Increase Programs with Company Goals
One of the first things to consider when working on your compensation strategy is to align it with the company’s goals. What behaviors add value and move your company forward, and which of your employees are making an effort to align their efforts accordingly?
Defining this will help you decide how to structure your merit pay program and which roles to recognize as more impactful for your organization.
Measure Performance in a Quantifiable Manner
It may not be possible to eliminate subjectivity from merit pay decisions. However, try to use only quantifiable metrics to measure employee performance to ensure fairness and avoid unnecessary conflict.
Train Your Evaluators
Equitable merit pay decisions require a deep understanding of individual and team performance metrics. Train your performance evaluators to understand the tools and nuances at play in merit pay decisions.
Another advantage of standardized training for your evaluators is that it helps to maintain consistency in your merit pay program across multiple departments and management layers. This reinforces the idea that everyone is being held to the same standards.
Ensure Transparency Through Communication
Make your merit pay process as transparent as possible to ensure every employee understands company expectations, the rewards for hard work, and the path to success. This is only achieved through a comprehensive internal communications strategy.
A lack of pay transparency is likely to result in frustration, demotivation, and conflict.
Have an Appeals System
Develop a process for employees to appeal and have their case reviewed should they feel the need to do so. This will increase transparency and may even improve the review process by minimizing potential errors.
This would be a time-consuming and resource-intensive exercise not every business might be willing to undertake. However, keep in mind that 63% of employees quit their jobs due to what they perceive as low pay or unfair pay. A platform in which employees may raise their concerns regarding remuneration is, therefore, necessary to preserve retention.
Collect Employee Feedback
The best merit pay programs are collaborative efforts where the management is open to employee suggestions on how to make improvements. After all, it’s about rewarding and motivating employees at the end of the day. Make them feel included in the process.
Maintain Market Competitiveness
One of the key purposes merit pay serves is to retain employees. However, if other companies in your industry are offering a better merit increase program, you might have an uphill task at hand.
Even though a merit increase program is only one piece of the puzzle in a broader compensation strategy, keeping up with market trends is going to ensure your program is set up for success.
Offer Non-monetary Rewards
A holistic rewards and recognition program maintains the balance between monetary and non-monetary rewards. Certificates, public recognition, growth opportunities, etc, cater to different employee motivations.
Some Final Thoughts on Merit Increases
Offering merit increases is a potent tool in an organization’s rewards mix. However, it needs to be used in ways that complement the organization’s compensation and benefits strategy. Rewarding certain people and leaving others out may potentially create discord between employees and management if the process is not transparent from the outset.
Well-defined expectations, clear communication, quantifiable metrics, and continuous feedback are some of the tools managers can use to optimize the merit increase process. When used with a variety of monetary and non-monetary rewards, merit increases can help organizations retain and promote their top performers.