Linking Performance Appraisal and Compensation: A Comprehensive Guide

In today’s competitive business environment, effectively linking employee performance to compensation is critical for organizational success. Performance appraisals are the cornerstone of this approach, directly influencing salaries, bonuses, promotions, and other employee rewards. When done right, this connection motivates employees and fosters a culture of transparency and fairness within the organization.

This comprehensive guide explores the various ways to align performance appraisals with compensation, offering best practices and addressing common challenges to ensure your compensation strategy is fair and effective.

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 can take different structures, such as 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 depending on a company’s overall performance
• Spot bonuses are used for performance outside the scope of an employee’s role
• Signing bonuses are offered once-off when joining a new position
• Retention bonuses aim to retain top performers, often during company mergers or acquisitions
• Holiday bonuses are used for recognition of good work approaching a holiday season, e.g., Christmas bonuses

On-the-spot recognition

On-the-spot bonuses are paid for exceptional performances that warrant immediate recognition. On-the-spot recognition can come in cash or gifts, including physical gifts or experiences.

Find 30+ meaningful employee recognition ideas to boost employee morale in your organization.

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, such as startups or companies in high-growth industries (e.g., IT or technology firms), typically use equity and stock options.

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

The 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, motivating them to continue performing well. The more motivated your people are, the more likely a high-performance culture can flourish at your organization.

According to McKinsey research, companies with high-performing cultures create significantly higher returns for shareholders—up to three times.

2. Increase competitive transparency

To demonstrate that your compensation structures are competitive, explain clearly to your people how their pay increases as they improve their performance.

John Hall, co-founder of Calendar, explains that companies like Apple, Google, Netflix, and Dell have found that competitive compensation leads to happier and more productive employees.

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.

3. Retain talent

Compensation is one of the top reasons 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.

Best practices for effectively linking performance appraisals and compensation

Follow these practices to effectively link performance appraisals with compensation decisions.

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 attention away from compensation outcomes for poorly performing employees and shows them how to achieve better results in the future.

2. Set clear performance goals

By clearly linking 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.

4. Communicate regularly

Perceptions matter when giving your employees feedback on their performance. How you communicate employee performance will affect how your people feel about their compensation outcomes.

Communicating regularly can help your people understand the basis of their performance appraisals. Explain how their performance review relates to 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.

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.

However, by separating performance and compensation discussions, your people can focus on their performance evaluation and development details.

Separate discussions do not diminish the link between performance appraisals and compensation.

6. Conduct regular calibration sessions

Calibration sessions are critical for ensuring consistent and fair performance evaluations across departments. They ensure managers evaluate performance consistently across the organization and prevent situations where some managers might be lenient while others are strict, which can result in unfair compensation practices.

These sessions typically involve a cross-functional group including HR professionals, department heads, team managers, and, in some cases, senior leadership. HR leads the sessions to ensure alignment with the company’s evaluation criteria and compensation structures, while department heads provide insights into their teams’ specific context and contributions.

By bringing together multiple perspectives, calibration sessions reduce the risk of bias and ensure that performance appraisals and compensation decisions are consistent across the organization.

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 historically favored people 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 be dishonest 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. Excessive competition can cause teamwork, trust, and cooperation to suffer.

Drive performance and growth with Deel Engage

Compensation is a crucial factor influencing employee satisfaction and retention. Proper preparation, transparency, and effective communication are crucial for linking performance appraisals to compensation decisions.

Ensure productive compensation conversations with Deel Engage:

• Communicate your organization’s compensation and total rewards philosophy with a learning journey and share it from the onboarding stage
• Use our salary insights tool to benchmark compensation for various roles and regions
• Evaluate employee performance using our flexible review tool—collect qualitative and quantitative insights from multiple sources, including the employees themselves, with the self-evaluation function
• Train managers in communication, negotiation, and giving feedback skills for effective and empathetic appraisals and compensation conversations

Additionally, Deel HR, our truly global HRIS solution, is always included for free. It ensures compliance with local regulations concerning compensation.

Book a demo to see how our solutions will help you build a high-performance workforce.