Does Performance-Based Pay Really Work?

Small business owners who don’t want to give employees permanent pay increases may be using performance-based pay — such as bonuses or profit-sharing arrangements — to reward employees without putting too much stress on their business finances. But it turns out this type of pay arrangement may have unintended negative consequences for employees and the business as a whole, a new study reports.

Is Performance Based Pay Effective?

Trends in Performance-Based Pay

During and right after the Great Recession, many business owners couldn’t afford to give employees raises. Even if they could afford it, the downturn had lots of entrepreneurs shell-shocked and fearful of committing to additional monthly payroll expenses. So many businesses turned to pay arrangements based on either the employee’s performance (such as bonuses) or the company’s performance (such as profit-sharing or employee stock ownership).

While this arrangement does have many benefits, there are also some downsides, according to a study published in Human Resource Management Journal. The study looked at three different types of “contingent pay” — performance-related, profit-related and employee stock ownership — and how they affected employee attitudes such as job satisfaction, commitment to the company, and trust in management.

Here’s what they found:

Only performance-related pay (in other words, pay based solely on the individual employee’s performance) positively affected all three of these employee attitudes. Pay arrangements related to company profit, or employee stock ownership, either didn’t affect employee attitudes or affected them negatively.

But even performance-related pay isn’t all good. The study reports that although performance-related pay positively influenced workers’ attitudes, it also tended to stress them out to a degree that might negate the beneficial effects. Employees in this type of arrangement are more likely to feel they’re being encouraged to work too hard, which decreases their job satisfaction. Ultimately, the stress can lower their productivity — giving performance-based pay the exact opposite effect that was intended.

Making Performance-Based Pay Work

This doesn’t mean you should write off the idea of performance-based pay altogether — but you do need to take some precautions to make it work for your business. Try these tips:

• Strike a balance. Try setting “stretch goals” — performance goals that aren’t easy to achieve, yet aren’t so difficult that employees feel defeated before they even start. You could also set different bonus levels for different levels of performance so that not everyone feels they have to aim for the highest possible level.
• Make it proportionate. Don’t make employees work incredibly hard for a small reward. It’s important to ensure a balance between employee job demands and the reward, the study says.
• Pay attention. Regularly check in with employees and managers to see how your performance-based pay system is working. Do employees seem stressed and overloaded? Perhaps the bar is set too high.

If you do use a pay structure that is tied into company profits rather than individual effort, be sure that the opportunity to earn profit-related pay is distributed across the entire company. If only a small percentage of employees are eligible to receive this type of incentive, the study found that the business as a whole suffers from lower job satisfaction, decreased commitment to the company and less trust in company management.

As for employee share ownership, if you’re not already doing this, the study suggests it’s not worth trying: It negatively affected job satisfaction and had no effect on employee commitment or trust.

What has your experience with performance-based pay been? Does it work for your business?

Performance Review Photo via Shutterstock

This article, "Does Performance-Based Pay Really Work?" was first published on Small Business Trends