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What Is a Merit Pay Increase?

Julie Thompson
Julie Thompson
business.com Contributing Writer
Updated Feb 15, 2022

Merit increases can boost worker productivity and retention, but you need to know if they're right for your business and the best ways to implement them.

A merit increase can motivate top-performing employees and improve worker retention. However, successfully implementing a merit increase takes planning and strict guidelines. Before proceeding with merit pay, it is important to understand exactly what it is and how best to develop a system for pay increases over time. 

What is merit pay?

Merit pay may be given to employees who excel at their job by reaching specific company goals in a particular time period. The employee receives a financial incentive for their hard work that could take the form of a pay increase, a one-time bonus or a promotion. 

Merit pay improves retention and builds more productive employees. It is often part of performance-based jobs like marketing and sales.

The first merit pay increases were introduced in 1908 in the education sector of Newton, Massachusetts.

TipTip: All of the best online payroll services make it simple to change pay rates and support merit pay increases. Learn more about some top options in our Paychex review and our review of Gusto.

What is a standard merit increase?

According to Salary.com, the projected 2021 merit increase averages 2.6%. The average is up from 2.3% in 2020, largely due to the economic impact of the COVID-19 pandemic.

Standard merit increases may be lower or higher than the average depending on the company. Alternatively, a business might offer employees other tangible incentives like more paid time off or better health benefits to make up for a lower-than-average merit increase.

Plus, the department the employee works in might contribute to the percentage amount. Achieving a company’s yearly goals can favor one department or team over another. For instance, if a business aims to improve market reach, the marketing department may see a more sizable merit increase than customer service.

Always watch your overall merit budget, since merit increases can max out a top performer’s salary. Changing incentives to a one-time bonus can still reward your top-performing employees without bumping their salaries up to management levels.

FYIFYI: Merit increases are expected to rise to 3% for executives, management and professional employees in 2022.

Merit increase vs. pay raise

Merit pay is given to an employee for reaching a company goal or for going above and beyond expectations. Pay raises are often a small percentage of the employee’s income (usually 1% to 5%) offered to all employees who have worked at the business for a certain time, or to account for a rise in the cost of living.

Merit pay increases encourage top-tier talent to work for your company and can increase overall employee retention. However, you should establish precise requirements regarding how to receive a merit pay increase, or employees who don’t receive one may create a toxic work environment.

Pay raises can be the safer option. However, if all your employees receive regular pay raises and turnover is low, that can significantly affect your payroll costs.

Benefits of merit pay

Merit increases can help boost revenue and profits for your business.

It engages employees in company goals.

It’s difficult to grow your business without an active workforce. By clearly explaining your quarterly or yearly goals, you provide a performance standard for each employee. 

Once an employee exceeds those standards, you can reward them just as they have rewarded you with more customers or revenue.

It can identify weak links.

Working as a team is important, but any team can burn out if there is a weak link (or two). By setting merit increase standards, managers can easily see which employees pull their weight and which workers need guidance to improve their performance.

It can reduce risk.

The standards set for merit increases give workers a way to know if their performance is below average, average or above average. 

Since merit increases encourage employees to work harder by providing a financial incentive or promotion, companies can retain top talent and reduce the risk of overpaying below-average employees.

Best practices for setting up merit pay

Managers or employers who develop merit increase standards should follow best practices to prevent employees from becoming disgruntled or confused by the new program. 

1. Plan carefully.

There is nothing worse than a confusing new policy that lacks transparency or doesn’t account for all situations. Develop a policy that is consistent across departments. Employers, managers and employees should all be versed in the guidelines so everyone is on the same page.

2. Ask for suggestions.

When providing a merit increase for a department or team, ask for their input before finalizing the policy. If part of the merit increase guidelines are unclear, managers and employees can voice their opinions and even offer suggestions on how to improve them.

If you make any policy changes, be transparent. That’s especially important if an employee is close to reaching their salary increase, and the change means additional requirements are needed to receive their financial reward.

3. Hold managers accountable.

Managers are responsible for giving merit pay increases to the employees who deserve them. Give your managers adequate training so they are confident when addressing their team. 

Let managers know that it bodes well for them to have a team that strives to exceed goals and is motivated to receive merit pay.

4. Keep communication with employees open.

Don’t take your employees for granted. Consistently ask for their feedback to solidify what your company does well and to locate any weaknesses that could be improved.

TipTip: When employees leave the company, conduct an exit interview. Learning what they liked about their job and what made them seek out a new one can help you reduce turnover and improve systems such as merit increases.

5. Run reports and analyze data.

Monitor your merit increases so you know exactly how many employees are qualifying, what the added payroll costs are, and what is working or not working with the merit pay system.

Try not to concentrate merit increases within one department or team. Offering benefits to employees companywide for outstanding performance can keep your company running smoothly and encourage worker engagement.

Merit pay FAQs

How is a merit pay increase calculated?

First, consider your merit pay budget. Determining if your company pays below market, at market, or above market can help finalize your budget and how to grade your employees’ performance.

There are a couple of ways to calculate merit pay increases: broadband and compa-ratio.

Broadband

After determining your budget, review last year’s evaluations to find the average rating. Once the average rating has been calculated, set an average percentage increase, as in the example below. Work above and below the average to create tiered merit pay increases.

Example rating system:

  • Outstanding = 4.5% to 6%
  • Above average = 3.5% to 4% 
  • Average = 2.5% to 3%
  • Below average = 0.5% to 2%
  • Unsatisfactory = 0%

Compa-ratio

This approach makes your most productive employees’ pay more competitive than their co-workers’. Once an employee reaches a high payroll threshold, their raises are lower. 

The compa-ratio approach keeps pay more evenly distributed while still compensating exceptional employees. For example, a worker who performs well but is low on the pay scale would receive a higher merit pay increase, whereas a worker with a lower performance receiving higher pay would receive a lower merit pay increase.

FYIFYI: While a bonus or merit increase is great, there are other innovative ways to reward top performers, such as giving them a flexible work schedule or making a donation in their name to a nonprofit of their choice.

What are the disadvantages of merit pay?

While merit pay can raise the bar on company standards, encourage employee engagement, and increase profits, there are a few disadvantages to merit pay.

Manager subjectivity

In some cases, managers may distribute merit pay subjectively to certain employees. Fair merit pay increases require time to analyze each employee individually and effective communication to express why the employee may or may not have received the increase they felt they deserved.

In addition, subjective merit pay increases can make top-performing employees feel slighted if they do not receive the top percentage, and below-average employees to feel left out if their performance is improving but not being noticed.

Extra resources

Some businesses may not have the resources available to complete annual evaluations and merit increases.

Employee expectations

Once an employee receives a merit increase, they will expect the same increase in pay year after year. However, their performance could wane or the company could fall into financial straits be unable to provide a merit pay increase.

Decreased company morale

Even with a solid system in place, merit pay increases can have a negative affect on company morale if employees compare their work. If the merit pay increases don’t line up in your employees’ eyes, it could cause a decrease in productivity or result in work that doesn’t benefit the company.

Can a merit increase be negotiated?

Although it is possible to negotiate a merit pay increase, keep in mind that managers may not have access to additional funds.

Merit pay programs usually have an overall budget for a set period. That budget is divided between managers. Each manager has to be fair to their employees and divide it based on their evaluation of their employees’ work performance.

However, don’t be afraid to ask if additional merit pay funds are available. Armed with your accomplishments, awards and market value salary, have an upfront conversation with your manager about your financial expectations.

Your manager should be able to provide a timeline for additional raises and provide you with the specifics on what you need to do to receive the pay you are asking for. If your manager asks you to complete skills by a specific date, stick to the deadline. Use this to your advantage when the next raise opportunity arises.

Image Credit:

AndreyPopov / Getty Images

Julie Thompson
Julie Thompson
business.com Contributing Writer
Julie Thompson is a professional content writer who has worked with a diverse group of professional clients, including online agencies, tech startups and global entrepreneurs. Julie has also written articles covering current business trends, compliance, and finance.