How to Link Performance Appraisal and Compensation: Drive Growth and Performance
How effective is compensation management at your organization? Are compensation changes orderly, transparent, and perceived as fair?
If compensation at your organization isn't rewarding your people properly, you risk losing your top talent and falling behind your peers.
Compensation is a "living, breathing market force," says Jessica Zwaan, COO of Whereby.
By linking your people's compensation to their performance in a way that meets their expectations, you can drive behavior toward outcomes that matter for your organization.
This article will look at:
- how to effectively link performance appraisals and compensation for your people;
- the benefits and limitations of this approach;
- A few examples of organizations that are doing it well.
🆚 What's the difference between performance appraisals and compensation reviews?
It's easy to confuse performance appraisals with compensation reviews.
Still, they're not the same: compensation reviews address overall salary and benefit structures at organizations, whereas performance appraisals address the performances of individual employees.
Compensation reviews address company-wide compensation issues, such as how equitable compensation structures are across different groups of people. They help ensure that your organization's overall compensation management is competitive, aligned with company objectives, and designed to incentivize your people.
The findings of organization-wide compensation reviews ultimately translate to each employee's compensation plan.
On the other hand, performance appraisals relate to how each employee performs relative to their target outcomes.
🏆 The 5 benefits of linking performance appraisals and compensation
1. Motivate employees
Paying your people more when they perform well makes them feel valued and recognized for their efforts and motivates them to continue performing well.
The more motivated your people are, the more likely a high-performance culture can flourish at your organization. Companies with high-performing cultures create significantly higher returns for shareholders—up to 3 times, according to research by McKinsey.
Motivated employees are also more likely to experience job satisfaction, as motivation and satisfaction are "interrelated and mutually reinforcing," according to LinkedIn Personnel Management.
2. Boost engagement
When people feel rewarded for their efforts, they're more likely to feel engaged with their company and roles.
Nearly two-thirds of companies with a strong connection between performance and compensation have a more engaged workforce.
3. Increase competitive transparency
Give your people a clear understanding of how their pay increases as they improve their performance to demonstrate that your compensation structures are competitive.
Companies like Apple, Google, Netflix, and Dell have found that competitive compensation leads to happier and more productive employees, explains John Hall, co-founder of Calendar.
Transparency about how compensation links to performance also reduces stress for your people.
If they're performing well, they'll know what to expect (e.g., a pay increase) without needing a stressful conversation (e.g., asking for a raise). This transparent approach promotes equity for people who may feel uneasy about such discussions, such as those from minority backgrounds.
4. Improve compensation alignment with outcomes
Link your people's pay with performance to improve alignment between their compensation and outcomes. If your compensation structures also align with your organizational objectives, you'll improve the overall organizational alignment of your people.
Stronger organizational alignment helps your people feel more engaged and invested in your company's objectives.
5. Attract top talent
Research from Pew Research Center has shown that compensation is a key reason people leave their employers.
By aligning performance with pay, people are less likely to feel your company does not adequately compensate them for their efforts. This helps retain strong performers as they know their superior performance is being recognized and rewarded.
💸 How do you link employee performance with compensation?
There are several ways to link compensation with performance. They usually involve base salary adjustments or variable pay structures.
Whichever the method, you should be aware of:
- Budgeting—Pay structures have many components, including retirement contributions and health insurance, so your compensation budgets should consider all components affected by performance-related adjustments.
- Calculations—When calculating performance-related adjustments, reward the right people appropriately (i.e., the top performers).
With these in mind, here are the most common ways to link employee compensation with performance.
Merit increases
Most employees receive yearly increases to their base salary, usually to account for higher living costs. In contrast, merit increases are higher than average base salary increases.
Unlike increases to base salary, which usually reflect a standard rate (e.g., the rate of inflation or a rate agreed by a workers' union), merit increases reflect employee performance. Companies often track merit increases using a metric called the 'forced distribution rate' so that they can make relevant adjustments to budgets each year.
Commissions
Commissions are typically paid to employees involved in selling and are calculated on the sales value they generate.
Commissions are calculated differently depending on the type of work done.
For example, a salesperson earns a commission on the value of products sold.
In contrast, a recruiter earns a commission on the salaries of appointed employees.
Commissions are usually paid monthly or quarterly and take on different structures, e.g., base salary plus commission, commission-only structures, once-off commission bonuses, tiered commission structures, or percentage-based variable commissions.
Bonuses
Bonuses are cash compensations paid on top of base pay. They are often discretionary, i.e., not guaranteed, and may not relate to specific outcomes.
Bonuses come in many forms, including:
- Annual bonuses: typically tied to a company's overall performance.
- Spot bonuses: for performance outside the scope of an employee's role.
- Signing bonus: once-off when joining a new position.
- Retention bonus: to retain top performers, often during company mergers or acquisitions.
- Referral bonuses: for referring candidates that are successfully hired.
- Holiday bonus: for recognition of good work approaching a holiday season, e.g., Christmas bonuses.
Equity or stock option grants
Equity and stock options are compensation forms tied to a company's stock price.
Employees may know the amount of equity or options they've been granted. Still, the ultimate value of their grant will depend on the stock price when they sell their shares or exercise their options.
Companies with less cash but strong growth prospects typically use equity and stock options, such as startups or companies in high-growth industries (e.g., IT or technology firms).
The structures, tax treatment, and vesting timeframes of equity and stock options can be complex. Still, if circumstances play out favorably, this form of compensation can be lucrative.
Profit sharing
Through profit sharing, employees receive a proportion of a company's profits.
The amount of compensation received fluctuates with the company's profitability year-on-year.
Profit sharing is useful for incentivizing employees to focus on the net earnings of their company (i.e., after costs and expenses).
This approach contrasts commission-driven structures linked to sales that do not depend on a company's costs and expenses.
Profit-sharing plans come in various forms, including:
- Pro-rata—paid to employees in proportion to their base pay.
- Fixed percentage—the same (fixed) percentage paid to all employees.
- Age-weighted—e.g., older employees receive a larger percentage of profits than younger employees.
- Comparability plan—profit percentages vary by a range of factors, e.g., hours worked, contract terms, or tenure at a company.
On-the-spot recognition
On-the-spot bonuses are paid for exceptional performances that warrant immediate recognition. On-the-spot recognition can come in the form of cash or gifts, including physical gifts or experiences.
➡️ Looking for fun ways to recognize your people? Check out these great employee recognition ideas.
💡 5 Best practices for effectively linking performance appraisals and compensation
1. Focus on development
While compensation conversations can build trust with your people, they can leave employees feeling stressed or defensive if their compensation outcomes aren't strong.
Focus on development rather than poor performance during performance appraisals, highlighting the potential for more substantial compensation outcomes with better performance.
Identify strengths, development opportunities, and training gaps, for instance.
A development focus shifts the attention away from compensation outcomes for poorly performing employees. It shows them how to achieve better results in the future.
➡️ Check out these 7 tips for giving your people meaningful, clear, and constructive feedback.
2. Set clear performance goals
By setting a clear link between performance and pay, you're helping your people understand how they add value and how they can increase it.
Use objective performance measures that are evidence-based (i.e., linked to data) so that they're credible and understandable. Your people should see that their compensation is consistent with the value of their contribution.
Well-defined employee performance metrics are easy to track and draw insights from. Examples include:
- work efficiency—the quality and quantity of outcomes;
- success rate—e.g., the number of closed sales
- collaboration and teamwork—peer reviews, 360 evaluations, and survey-based team satisfaction scores
- skills and competencies—completing training programs to address skills gaps.
3. Promote fairness and transparency
Apply your performance and compensation management process fairly and consistently across different groups, e.g., gender, age, and ethnic groupings.
Employee appraisals inherently involve judgment, so it's easy for biases to set in even when differences aren't obvious. Contrasting personality types, belief systems, or even personal habits can lead to biased judgments.
Such biases may harm your people, particularly when appraisals are linked to financial compensation.
One way to minimize biases and promote equity in your performance and compensation management process is to keep it as transparent as possible. This helps your people understand the drivers of their performance-related pay.
Another way is to conduct regular compensation reviews to identify biases in your compensation framework, if they exist, and address them before they become entrenched.
Pay equity is an increasing priority in organizations—66% of organizations had pay equity initiatives in 2022, according to PayScale's recent Compensation Best Practices Report, compared with fewer than half in previous years.
4. Communicate regularly
When giving your employees feedback on their performance, perceptions matter. How you communicate employee performance will affect how your people feel about their compensation outcomes.
Help your people understand the basis of their performance appraisals by communicating regularly. Explain how their performance review fits in with your organization's compensation strategy and draw linkages between each employee's job-related performance and their compensation.
By building regular opportunities for conversations with your people as a part of their performance management process, they'll better appreciate how their performance and compensation are related.
➡️ Are your managers struggling to have effective compensation conversations with your people? Learn why compensation training for your managers is essential.
5. Separate performance and compensation discussions
Compensation can be a sensitive topic. When discussing an employee's performance, they may be distracted by their compensation outcomes when discussed in the same conversation.
But by separating performance and compensation discussions, your people can focus on their performance evaluation and development details.
And having separate discussions need not diminish the link between performance appraisals and compensation.
"Once performance reviews are complete," explains Dannie Lynn Fountain, a senior HR practitioner, "performance ratings can then be used to calculate compensation changes."
😟 3 Key challenges of linking performance appraisals to compensation
Despite the benefits of linking performance to compensation, there are some limitations to be aware of. Here are three key challenges to look out for.
Misdirected incentives
When an employee's performance is linked to financial compensation, they may be inappropriately incentivized depending on how their performance is evaluated.
Sales personnel, for instance, may be driven to achieve quotas so that they receive their commissions, even if that means pushing hard-sell tactics. This may lead to misselling or diminish the reputation of the company.
In the lead-up to the financial crisis of 2008–09, for example, there were numerous cases of financial misselling driven by commission structures. In one such case, RBS, a UK-based bank, was fined USD 5.5 billion for misselling toxic mortgage bonds by their US brokers.
Ensuring pay equity
Unconscious biases can be magnified when performance is linked to pay. Since performance evaluations can be subjective, inequities can worsen when subjective judgments drive unfair compensation outcomes.
For instance, groups of people who have historically been favored may entrench their positions when financial compensation is at stake. Managers may favor select groups or individuals if their decisions lead to better financial outcomes for those people.
Disingenuous self-evaluations
When people know that their performance appraisal impacts their direct compensation, they may not be honest in their self-evaluations.
This makes the evaluation process particularly delicate for managers, who must form an objective view of employee performance without appearing overly critical. It is a difficult balance to strike in the face of self-evaluations that have employees artificially boosted.
Performance-for-pay can also lead to an unhealthy environment of competition in your organization—teamwork, trust, and cooperation may suffer due to the excessive competition that it creates.
💰 3 Examples of companies successfully linking performance with compensation
So, what does successfully linking performance and compensation look like in practice? Here are three examples of companies doing it well:
Google—performance-based compensation with separate appraisal discussions
Google's compensation strategy adopts a pay-for-performance philosophy that rewards high performers. The compensation packages are broad-based—including base pay, bonuses, and equity—to motivate team and individual performance.
Google carefully aligns individual and organizational goals, promotes employee development, and maintains a transparent performance management process to encourage meritocracy.
When it comes to employee performance reviews, Google keeps them separate from compensation discussions.
Google believes separate discussions allow more effective performance appraisals as people focus on the appraisal process rather than financial outcomes.
Holding them together "kills learning," suggests Laszlo Bock, Google's former SVP of People Operations.
Zappos—compensation based on an egalitarian, self-evaluation process
Zappos replaced annual performance reviews with a more frequent, real-time 360-degree feedback approach. Plus, company culture is critical in Zappo's performance appraisal process, and its people are encouraged to adopt its core values.
For example, employee autonomy is a feature of Zappos' performance management framework, with managers playing a less dominant role than in other companies.
Zappos links compensation with employee performance through skill badges. Instead of job titles, employees collect skill badges as they grow in their roles. The more badges a person has, the more they level up and the higher their paycheck.
Zappos' process of evaluating employees doesn't depend on manager judgments. It is a transparent approach that builds trust and motivates Zappos' people to achieve more.
Starbucks—compensation based on partnership
Starbucks uses its Bean Stock program to share the company's financial success with its people—employees are granted stocks in Starbucks (annually) based on their time with the company over the previous year.
Bean Stock forms a part of most employees' compensation packages at Starbucks, directly tying company performance with individual compensation. It was a pioneering program when first introduced in 1991, encouraging their people—referred to as "partners"— to act like business owners by sharing in the company's success.
➡️ Drive growth and performance with Zavvy
At Zavvy, we know that compensation is important for your people. We also know how to motivate and build trust with your people through growth and development opportunities that go in hand with performance.
Zavvy helps you build a more effective performance review process for your people by linking their performance appraisal to their compensation based on their efforts and outcomes.
📅 Book a free 30-minute demo to see how you can reward your people more effectively with Zavvy.
❓ FAQs
What's the relationship between compensation and performance appraisal?
An employee's compensation refers to their salary and benefit arrangements. In contrast, their performance appraisal is a process of assessing how they're performing against their targets. Some organizations link these while others don't.
Should performance be linked with compensation?
By linking performance appraisals with compensation, organizations can motivate their people, boost engagement, increase compensation transparency, and attract top talent.