How effective is performance-related pay?

Written by
Claudio Lucifora

16 Sep 2015

16 Sep 2015 • by Claudio Lucifora

Are performance pay schemes effective?

Performance-related pay schemes have become more widespread in recent decades. The hope is that such incentive schemes boost firm productivity, revenues and profits; firstly by incentivising existing employees, and secondly by encouraging the most productive employees to apply for and stay in jobs. But do these employee incentives work?

The available evidence shows that performance-related pay (PRP) schemes are indeed associated with significantly more productive employees. But the scale of the benefits vary according to the type of scheme. The most effective schemes are those that reward employees for individual effort, rather than group performance.

Individual incentives can deliver significant results

The benefit of individual incentive schemes has been demonstrated in a number of studies. One seminal study in this area examined the effect on productivity at a company fitting car windscreens when fixed hourly rates were replaced by a piece-rate pay regime.

The study found a 44% increase in productivity, half of which was due to the “incentive effect” (workers being more motivated and putting in more effort) and half to the worker “sorting effect” (e.g. more productive workers joined or stayed with the firm, while the less productive left).

Group incentives offer positive, but smaller, benefits

Group incentive schemes, meanwhile, can involve teamwork incentives, profit-sharing, and share ownership. The effects of such schemes are also positive but smaller, due to “free-riding” (where less productive workers take advantage of being in a larger group, and less easily monitored), and the lower psychological power of group incentives. This has been reported to be more relevant in larger-sized firms.

Are there any drawbacks to PRP schemes?

It is important to note that, while PRP schemes may boost employee productivity, the effect on an organisations’s profitability is less clear-cut. The introduction of incentive schemes, particularly in smaller and younger firms, may be difficult and costly, and this could potentially offset any benefits from greater productivity.

Also, while some employees are incentivised to earn more for the company and themselves by personal PRP rewards, there may be resistance from other more risk-averse workers (and unions) who prefer flat-rate salaries in place of any bonus scheme. Such workers may suffer from psychological issues as they try, and potentially fail, to qualify for the performance-related payouts.

PRP acts as a method for organisations to detect and retain their best employees, but care needs to be taken with those employees struggling to survive in a workplace driven by individual performance.