What is Incentive Pay, and Why is it Essential to Overall Compensation?

December 12, 2022

Wake up. Work. Get paid. Go to bed.

Okay. It’s not that simple – a lot happens between waking up, working, getting paid, and going to bed. However, for most people, work is an important part of life, and they want to feel like their work matters. 

In other words: when people work, they want to get paid! It’s a sense of accomplishment and validation to know that an employer appreciates the time and effort that’s put in.

Moreso, a healthy work environment means your employees know what to expect, how to expect it, and when they will receive it. Clear communication about pay plays an essential role in driving business performance and overall employee satisfaction.

... Cognitive satisfaction is derived from the evaluative appreciation of work-related aspects, such as payment, schedules and benefits (Eyupoglu et al., 2016).

“Payment,” or compensation, is quite a broad term – it takes many forms. Therefore, employees and employers must understand various types of compensation and how they apply it to their particular situations. 

In this blog post, we'll define incentive pay, discuss its importance, and look at some common types of incentive plans. But first, let’s start with some comparisons.

What is compensation? What is incentive pay?

Compensation generally refers to the payment received by an employee in the form of salary, benefits, wages, or variable pay. Compensation is typically given as monetary payment in exchange for time, labor, and expertise.

So, what is the definition of incentive pay?

Incentive pay is a variable form of compensation. It’s a merit-based compensation awarded outside guaranteed hourly or salary wages directly tied to achieving performance goals, objectives, or milestones.

Incentive pay is a type of compensation that provides employees extra motivation to meet or exceed specific goals. 

Incentive pay can be:

  • Casual or structured: Casual incentives are distributed irregularly, not within a fixed schedule. In contrast, structured incentives are part of an established incentive plan. 
  • Monetary or non-monetary: Monetary incentive pay examples include commissions, quarterly or yearly bonuses, stock shares, and sign-on bonuses. Non-monetary incentive examples are items or time such as recognition awards, special meals or events, travel rewards, gym memberships, tuition reimbursement, and employee referral bonuses.

It’s also worth noting that the type and size of the reward can depend on metrics like deals completed, units sold, customer acquisition cost, gross sales, and so on.

Pro tip: It's always worth checking what incentives are available in the compensation plan before you start working for a company!

The bottom line is that incentive pay is an essential part of overall compensation and can be used to encourage desired behaviors or results. There are many different types of incentive pay, each with its own benefits and drawbacks (more on this later). 

Generous and specific financial incentives can help drive and sustain a rapid performance improvement ... companies that implemented financial incentives tied directly to transformation outcomes achieved almost a fivefold increase in total shareholder returns (TSR) compared with compa­nies without similar programs. (Source)

What are the differences between incentive pay and a bonus?

Again, incentive pay is a merit-based compensation awarded outside guaranteed hourly or salary wages directly tied to achieving performance goals, objectives, or milestones.

It’s typically known ahead of time. Meet or exceed specific goals and receive incentive pay.  Incentive pay is something employees can work towards as it is payment clearly defined in a compensation plan based on specific performance objectives.

Bonus pay, or performance bonus, is a form of incentive pay consisting of a one-time lump sum payment typically awarded at year-end — it also can apply during the course of employment when employees reach certain milestones, such as hitting quarterly sales goals by specific dates. The latter would then be a part of the incentive plan. Bonuses are often based on a department or the company reaching a particular goal. 

Some common monetary incentive bonus examples include:

  • Spot bonus: Small cash prizes awarded in direct, immediate responses to positive performance.
  • Project bonus: Given after a project is completed.
  • Performance bonus: A cash bonus reflective of employee success.
  • Referral bonus: A financial bonus issued to employees who connect new businesses or bring new employees to the company.

What are some examples of incentive pay plans?

When it comes to incentive payment plans, there is no one way to implement them. The following examples can be used individually or combined – depending on what works best for your organization.

  1. Merit pay bonus: Employees receive a one-time $1,000 bonus payment based on their exceptional work ethic and contribution to company goals in the previous fiscal year. This can also come in the form of a group bonus, which would establish a set of criteria (including pre-established goals or objectives by a designated time) that employees must meet to qualify. The bonus could then be divided among all qualifying employees, regardless of their position within the company. This would incentivize employees to work together towards common goals and reward those who contribute the most to the company's success!
  2. Sales commission: A salesperson is paid a monthly commission of 3% on all sales generated over the period. Typically, the commission is earned after the salesperson meets or exceeds a certain sales target.
  3. Gainsharing: A sales rep gets financial shares (equity) based on business success tied directly to their performance. Profit-sharing is quite similar to gainsharing, but instead of individual performance driving the payout, it’s the company's overall profitability.
  4. Retention bonus: Awarded to an employee based on tenure with the organization – the amount is most often calculated as a percentage base pay.
  5. Spot awards or SPIFFs (aka, Sales Performance Incentive Fund): These are small incentives — money, event tickets, gift cards, etc. — given to sales reps for some short-term performance achieved.
  6. Employee of the month: An employee is awarded a $100 gift card every month. After three consecutive months, the employee is given an additional $500 bonus.
  7. Overtime pay rate: An employee works more than 40 hours in a week and earns 1.5x their regular rate for all hours worked over the threshold of 40.

Remember, this is a partial list. There are many different incentive plans out there depending on your business needs, so it’s critical to do your research before deciding which one is right for you and your team!

How is incentive pay calculated?

Incentive pay is calculated in various ways depending on the compensation structure. A straightforward way to do it is by awarding a percentage of the employee's base salary as incentive pay. For example, if an employee has a base salary of $50,000 and is awarded a 5% incentive pay bonus, they would receive an additional $2,500 in addition to their base salary. 

Some employers also offer incentive pay as a flat dollar amount or a number of days' pay. Another factor that may affect incentive payouts is how well the employee performs. For example, if an employee exceeds expectations or goals, they may be eligible for a higher payout than someone who meets expectations but does not exceed them. In this case, businesses might use a points system, where employees earn points for meeting or exceeding goals. Other companies may use a percentage-of-profits system, where employees are paid a percentage of the profits made from their work. 

What Charlie Munger taught us about the benefits of incentive pay

Charlie Munger is a billionaire American businessman, former real estate attorney, and billionaire investor. He is vice chairman of Berkshire Hathaway (you know, Warren Buffett’s company).

He knows a thing or two about the benefits of incentive pay and behavioral economics.

In The Psychology of Human Misjudgment, a 1995 speech he gave to an audience at Harvard University, Mr. Munger shared a powerful incentive story about the Xerox company.

Former Xerox CEO and President Joe Wilson needed help understanding why the far superior model Xerox copier was not selling well compared to their older model. He discovered the incentive agreement – commission for sales of the older model – was a much greater motivation for the sales team than the commission agreement for the newer model. As a result, the sales team was incentivized to sell the older model. 

The psychology of positive reinforcement (incentives) in practice – impacting sales directly.

As Charlie Munger shared, "Never, ever, think about something else when you should be thinking about the power of incentives.” 

The benefits of incentives for employees are undeniable. Employee incentive pay benefits include happier employees and better employee performance and retention. In addition, offering financial incentives boosts productivity and provides recognition for hard work.

The pros and cons of incentives

It’s worth reinforcing that psychology plays a role in the success or failure of an incentive program. It’s rooted in operant conditioning based on B.F. Skinner’s research showing rewarded behavior becomes repetitive behavior. People work harder and more effectively when knowing their extra efforts will result in a financial reward.

Financial reward is an obvious advantage for employees, but what are the benefits outside of monetary rewards? 

The advantages of incentives include the following: 

  • Competition and gamification: Fostering healthy competition among employees and leaning into the “gaming” concept of incentives.
  • Goal clarification: Incentive programs help companies more clearly define goals, empowering employees to earn more money and receive company recognition
  • Increased employee satisfaction and retention rates: More incentives mean happier employees who hang around longer.

A few disadvantages of incentive pay? Beware of employees gaming the system to make their performance appear to meet goals or objectives when they don’t. 

Here are some other disadvantages to keep in mind when putting together your incentive structure:

  • Creating a "zero-sum" mentality, where employees focus on taking money away from one another rather than working together for the common good.
  • Similarly, promoting competition over cooperation can lead to unhealthy rivalry and sabotage among coworkers.
  • Creating an atmosphere of fear and mistrust.
  • Creating a false sense of mistreatment: employees may feel they are not being paid fairly unless they receive incentive pay.

By now, you know the advantages of incentive programs far outweigh the disadvantages. When designing an effective program, consider benchmarks, test “early and often,” and have a communication plan. The incentive program should help drive a culture of high performance, not take away from it!

From incentive pay to Incentive Compensation Management (ICM)

Incentive pay can be an effective way to motivate employees and improve organizational performance. However, it is essential to carefully manage incentive compensation programs. Otherwise, they can become costly and lead to an atmosphere of distrust and conflict. 

Ready to take control over your incentive compensation management?

CaptivateIQ enables sales, finance, and operations teams to design, deploy, and adapt incentive compensation plans. Our ICM software can easily handle the complexities of crediting and compensation rules while quickly processing large amounts of data — the result: operational efficiencies. Spend more time on the big picture and less time on the minutia!

Note: This content is for informational purposes only and should not be construed as financial, accounting, tax, legal, or compliance advice or guidance. Please consult a professional adviser for guidance on your specific situation.