3 Things You Need To Determine Merit Pay Without Ratings

by Jamie Resker | Posted | Performance Management

3 Things You Need To Determine Merit Pay Without Ratings

Your organization wants to do away with ratings. But if you do that, how are you planning to determine pay increases?

I’ve got a model that’s just what the doctor (or finance department, or CHRO, or whoever) ordered.

Before you walk away from ratings, you need to establish an approach to understand, differentiate, and measure employee performance.

The three key factors to consider for compensation decisions are:

  1. Employee Performance Measurement Metrics: The ability to differentiate employee performance
  2. Merit Budget: Typically a fixed dollar amount that is set aside to recognize and reward employees.
  3. Pay Range Structuring: Market data or an internally developed salary scheme (which should correlate to market data) will determine the minimum, mid, and maximum pay ranges for the positions in your organization.

I’ve put together a brief five minute video outlining my process. A deeper dive into how everything works can be found in the rest of the blog post below.

Step 1: Establish Employee Performance Measurement Metrics

The 5-level rating scheme is too limited to meaningfully measure performance - it needs to go. But most see the only alternative as having no system to measure and track performance. Establishing a new, more robust measurement system is a must.

I use the employee performance continuum for a snapshot-in-time to identify an employee's coordinates in relation to the two performance dimensions:

  • Work Results
  • Observable Behaviors

This four-square model can be drawn on a napkin, but here's a downloadable form with instructions. In my previous article, I showed how the employee performance continuum, a visual model, can be used to evaluate an employee's performance.

employee-performance-continuum
I've had many debates on how this plotting is just "ratings in disguise". But this continuum goes much further than your typical five-point rating system: Meets Expectations, Exceeds Expectations, Needs Improvement, etc.

Using the employee performance continuum allows for a robust discussion about the individual's performance (not their rating). I advise doing this process twice yearly. Don't stop measuring employee performance, but do get rid of the categories that are too narrowly defined and will always fall short of accurately describing work performance.

Once you have your performance measurement approach in place, allocating limited merit and bonus dollars is straightforward. Of course, you'll be constrained by the budget - there's only so much money to go around.


Step 2: The Total Merit Budget (Dollar Amount Available) and Allocation

Just like any other budget line item, the finance department needs to forecast payroll expenses. The merit budget is usually established by multiplying total payroll dollars by a number (commonly 3%). The finance department will use this figure to help project payroll costs:

3% of a $20,000,000 payroll = $600,000

In this example, there is $600,000 dollars to allocate (this pot of money may cover merit, bonus and market-pay adjustments).

Allocations to Budget Holders

Next, the $600,000 will likely be allocated to the various budget holders: For example, the VP of engineering receives $48,000 (an amount equal to 3% of Engineering's payroll of $1,600,000). The $48,000 may even be allocated to individual directors or managers who will then recommend merit increases based on each employee's assessed performance contributions.

The practice in your organization probably works in a similar fashion. Now that the budget is known, let’s get back to the employee performance continuum. Once employee performance has been measured, the various performance levels which will inform how to allocate merit pay (and sometimes bonus and equity in the form of stock options).

The "ultimate" budget owner, the VP of engineering in this example, grants final approval for individual pay recommendations. At this point, adjustments to the recommendations are fine-tuned as the budget owner looks at the larger picture. This involves taking some dollars from one individual and rewarding someone whose performance impact is greater within the grand scheme.

Step 3: Determine your pay structure

Market data or an internally developed salary scheme, which should correlate to market data, will determine the minimum, mid, and maximum pay ranges for the positions in your organization.

When making your pay decisions without using any ratings, here are a few things to keep in mind:

Performance metrics

Recognize an employee’s total performance – a combination of work results and observable behaviors. Consider greatly reduced or no change-in-pay for off-target performance related to value detracting behaviors, low work output/results or a combination of the two. This way you have more money to spend on your most valuable people.

Salary ranges

It’s important to have a set salary range for any given position in an organization. These can be determined by market indicators like industry average pay levels. Ideally, you want to work their compensation toward the middle of that pay range.

The allocation and size of raises

Once you have performance data and salary ranges figured out, you’ll have a much easier time determining pay increases.

Consider larger increases for:

  • High-level performers paid in lower range.
  • Employees who have made a significant difference to the business.
  • Employees needing a market adjustment

Consider smaller increases for:

  • Employees already in the upper salary range dimension
  • Consider bonuses to supplement merit pay as a reward for top performers who are close to the salary cap or in danger of exceeding the limit

Reflect Pay Increases as Dollar Amounts

If you're really stepping away from ratings, one important gesture is to express pay increases as a dollar amount instead of a percentage. Part of your pay policy could read, "adjustments in pay are reflected in the March paychecks as a $ amount". This way, the manager gets to thank employees that get an increase their hard work and quote a specific dollar amount.

Why remove ratings?

Here’s what’s great about using this system. According to Harvard Business Review, companies that get rid of traditional performance ratings see a ton of benefits, including:

  • Increased frequency of manager-employee performance conversations
  • Reduced administrative costs
  • Performance conversations focus on goals, growth and development

Learn more about how you can make pay-for-performance work in your organization in our free eBook, linked below.

Your Turn: Is your organization thinking about getting rid of traditional performance ratings? Do you have a success story? Share it with us!

Why Pay-For-Performance Can Work At Last

Pay for performance is finally working thanks to more nuanced approaches and better software tools. This white paper explores the topic from each of these angles.


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Why Pay-For-Performance Can Work At Last

Pay for performance is finally working thanks to more nuanced approaches and better software tools. This white paper explores the topic from each of these angles.


Read Now


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