As the old adage goes: you get what you pay for.

Top-performing employees are a valuable asset to your company; it makes sense to do everything you can to retain them, including rewarding them with merit increases. 

That being said, any merit increase should be done thoughtfully and, if possible, with data to back it up. 

This guide shows you everything you need to know to incentivize strong performance and increase employee retention with merit increases. We discuss what a merit increase means, who should get them, and how to use people analytics to make merit increases more target, impactful, and cost-effective.

What is a merit increase?

A merit increase is a pay increase given to an employee based exclusively on high-value performance. This differs from annual raises, seniority pay, and cost-of-living increases in that an employee’s performance is the primary factor determining a salary merit increase. 

Typically, merit-based pay increases serve as an incentive for employees to achieve company objectives and meet or exceed performance targets. Merit increases are also an excellent employee retention tool.

Well-structured merit increase programs not only motivate employees to perform their best, they also connect company success to employee success. People are much more likely to be invested in their work and the growth of the company if they are directly rewarded for it.

Merit increase vs. annual raise

The difference between merit increases and annual raises is that merit increases are performance-based pay increases and annual raises are time-based pay increases. Both types of pay raises work as incentives and employee retention tools, but they incentivize different behaviors and encourage retention in different ways.

Merit increases can be given any time and are usually calculated based on the employee’s contribution to company success. Annual raises are given on the employee’s employment anniversary, regardless of performance.

Merit increases incentivize employees to contribute maximally to company goals and meet KPI targets. These pay increases improve employee retention by making employees feel recognized for their efforts and giving them more control over their financial success.

On the other hand, annual raises encourage employees to stay with the company for a period of years as a method of career advancement, rather than changing employers regularly to increase their salary. However, these raises have less impact on incentivizing performance.

Merit pay vs. incentive pay

Merit pay and incentive pay are both intended to incentivize employees. However, they are distinct in that merit increases are typically permanent raises, based on performance, and incentive pay usually comes in the form of one-time rewards such as bonuses.

Merit increases are also most often based on persistent performance metrics, whereas incentive pay is given for hitting one-time targets like finishing a big project within budget or ahead of deadline.

Seniority pay vs. merit pay

Seniority pay is similar to annual raises in that it’s based on time with the company. However, seniority pay isn’t always given as regularly as annual raises. Seniority pay increases can be given out at notable milestones such as five or ten-year anniversaries, or for being the most senior member of a team.

Like a merit increase, a seniority pay increase is typically a permanent salary increase. 

Merit increase vs. cost of living increase

A cost of living increase (AKA a cost-of-living-adjustment or a COLA) is a permanent pay raise given at regular intervals, most often annually. A cost of living increase is calculated based on the average rise in the cost of living in the area where the employee works. 

Who should get a merit increase?

In addition to incentivizing strong performance, the primary purpose of merit increases is to retain your most valuable employees. It’s probably clear that merit increases should go to high performers. However, merit increases aren’t given just because an employee is good at their job.

When you evaluate an employee for a merit based pay increase, consider these factors:

• Does the employee’s exceptional performance also make a measurable impact on the company’s success?
• Does the employee’s proficiency or expertise make it difficult or prohibitively expensive to replace them? 
• Is the employee at high risk of attrition and are they likely to be retained by a pay raise? 

Of course, it’s nearly impossible to retain an employee through a salary merit increase after they’ve already quit. It’s also difficult to do so after they’ve made the definitive decision to leave. To use merit increases effectively, you need to be proactive and data-driven.

A people analytics platform like Praisidio helps you easily and proactively identify employees who are at high risk of attrition. Praisidio also gives targeted suggestions for retaining those employees, including merit increases as well as other proven talent management strategies. 

The bottom line is that your merit increases should target high-performing employees whose impact on company success can be measured. The more targeted you are with your merit based salary increases, the more impactful and cost-effective those increases will be.

How to calculate merit increase

A major pitfall with merit increases is giving them to employees who are high performers without carefully assessing the financial impact of that performance or determining if merit increases are the best way to retain high performing employees or incentivize even better performance.

It’s important to approach calculating merit increases as an evaluation process, rather than just crunching numbers to determine a merit increase dollar amount. Here’s how to go about it.

1. Determine the financial impact of an employee’s performance

The first step is to determine the link between an employee’s performance and financial outcomes for the organization. This can be tricky because many positions don’t directly impact revenue.

For instance, it’s relatively simple to assess the financial impact of sales team members, because sales translate directly to revenue. However, it may be more challenging to assess the financial impact of, say, an executive assistant or a communications manager.

For those positions with a more convoluted connection to financial outcomes, it’s useful to use a few assessment criteria to identify critical roles that should be considered for merit increases:

• How integral is this role to the success of the company’s business strategy?
• How challenging or costly would it be to replace an employee in this role?
• How much do mistakes in this role cost the business?

There may be other factors in your business that determine which roles are most critical within the company. The above criteria should be taken as merit increase guidelines, rather than hard and fast rules.

But, given that merit increases are largely used to increase retention, the overarching goal of this assessment is to identify employees who have the biggest upside to retaining and the biggest downside if they leave.

2. Objectively evaluate employee performance

The purpose of objectively evaluating employee performance is to reveal who is really making a difference with their performance. Identifying employees who are objectively high performers requires looking beyond performance reviews.

Even consistently high performers can have rough periods which might negatively impact a recent performance review. Therefore, identifying true top performers requires gathering data from multiple sources.

Use long-term data such as tenure, all-time recognition rewards, and job specific metrics such as units produced or deals closed. The goal is to get a complete, unbiased view of an employee’s performance.

Combining HR metrics with financial data, performance reviews, and job specific metrics will give you the best objective evaluation for identifying your highest performing employees. 

3. Assess the effectiveness of a merit increase

The last step is to determine the effectiveness of a merit increase. In the specific situation you’re facing, is a merit-based pay increase really the best way to increase employee retention? 

It seems like it would be a given that a performance-based pay increase improves retention. However, this isn’t always the case.

There are a multitude of factors that contribute to employee attrition. Workloads, connection, management styles, and several other factors can all cause employees to quit.

If one or more of these factors is impacting high performing employees in critical roles, merit increases are unlikely to solve your employee retention issues. Similar to objectively evaluating employee performance, this requires gathering data from many sources.

This is another area where a people analytics platform like Praisidio is crucial. Praisidio helps identify these other factors and determine if you need to solve another employee retention issue before you consider giving merit increases..

After all this, if you determine merit increases are the silver bullet for retaining employees in critical roles, then the next step is to set up a merit matrix to determine exact merit increase amounts.

Setting up a merit matrix

A merit matrix is the best way to calculate the appropriate monetary amount for a merit raise and determine how this will impact your budget. A merit matrix, also called a merit increase grid, is a relatively simple table that shows which high performers get merit increases and how much those increases are.

A merit matrix does more than just help you budget for pay raises. When communicated effectively, a merit matrix also offers your employees more transparency around compensation and allows you to gather feedback from your teams about your merit increase structure.

Broadly, there are two ways to set up a merit matrix: standard and two-variable.

A standard merit matrix creates a merit increase structure based on performance alone. A two-variable merit matrix creates a merit increase structure based on performance and on an employee’s position in pay range.

Standard merit matrix

A standard merit matrix has four columns: employee performance; raise for performance; percent of employees; percent of budget.

This is a sample standard merit matrix:

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Employee performance is simply a quantification of your objective employee evaluations. These numbers can correlate with objective performance ratings however you need, based on the position and number of employees.

The purpose of quantifying employee performance is to create employee cohorts based on performance, so that you can assign a raise for performance to each cohort.

Raise-for-performance represents the merit increase given for each level of performance, as a percentage of the employee’s salary. In this example, the raise for performance is linear, increasing by one percent at each performance level.

However, you can structure the raise-for-performance category any way you see fit. The raise for performance could ramp up at each performance level, instead of increasing by just one percent.

Percent of employees is simply the percentage of employees who fall into each performance category.

Percent of budget is the raise for performance multiplied by the percent of employees. The sum total of your percent of budget should be equal to or less than the percent of your total payroll budget that’s allocated to merit increases. 

For example, if the percent of your total payroll budget given for merit increases was 3.2%, this table shows that your merit increases would be within that budget at 3.14%.

A standard merit matrix is relatively simple to set up, and it enables you to create a merit increase structure that respects budgetary constraints. However, a single variable merit matrix can exacerbate pay inequities because it can perpetuate salary outliers.

A high-performing employee with a high salary for their position could easily end up being paid quite a bit more than the rest of the team if they consistently get the highest merit increase.

Conversely, an employee who is already on the lower end of the average salary range for the position could get even further behind everyone else if they consistently place in the middle or bottom of the performance pack.

A two-variable merit matrix helps solve this issue.

Two-variable merit matrix

The two-variable merit matrix is based on employee performance and the employee’s position in salary range or compa-ratio.

A two-variable merit matrix gives a slightly lower merit increase to employees who are already near the top of the salary range for that position and gives a slightly higher merit increase to employees who are near the bottom of the salary range for that position.

In this example, employees are divided into four cohorts (Q1 to Q4), based on their salary position in range, with Q1 being the employees at the lowest position in range and Q4 being the highest position in range.

As you can see in the table, the merit increase structure is built so that employees who are at the bottom of their salary range move toward the middle of their salary range more quickly than the employees who are already near the top move to the top of their salary range.

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This two-variable merit matrix can be combined with the standard merit matrix to determine if your two-variable merit increase program falls within your payroll budget. It helps ensure that your merit increase program doesn’t cause employees to feel they’re being paid unfairly over the long term.

Employee retention beyond merit increases

Ultimately, merit increases are an excellent employee retention and motivation tool, but only if they’re done right. It’s critical to go through the process of evaluating who should get a merit increase, determining if merit increases are the solution you need, and then ensuring that your merit increases truly increase employee satisfaction and retention.

However, merit increases only address a few employee attrition factors and are far from the only employee retention tool.

Praisidio uses real-time data analysis to spot a wide variety of employee attrition factors and offers a range of employee retention strategies tailored to each employee (including and beyond pay increases), so you can retain more people and spend less.

Book a demo to see how much Praisidio can save your company in employee retention costs.

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FAQs

Q. How do merit increases align with broader compensation strategies within a company, such as bonus structures or profit-sharing programs?

A. Merit increases often complement broader compensation strategies within a company, such as bonus structures or profit-sharing programs, by providing an avenue for recognizing and rewarding individual performance. While bonuses or profit-sharing may focus on collective achievements or company-wide success, merit increases specifically acknowledge and incentivize high-value contributions from individual employees.

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Q. Are there specific industries or sectors where merit increases are more commonly utilized, and if so, what are the typical criteria or benchmarks for performance evaluation in those contexts?

A.The prevalence of merit increases can vary across industries and sectors, often depending on the nature of work and organizational cultures. In sectors where performance metrics are more quantifiable and directly tied to financial outcomes, such as sales or finance, merit increases may be more common. Criteria for performance evaluation in these contexts could include sales targets achieved, revenue generated, or cost savings realized. However, in industries where performance is less easily quantifiable or teamwork is highly emphasized, merit increases might be less prevalent, or performance evaluation criteria may include more qualitative measures such as leadership abilities or innovation.

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Q.What are the potential drawbacks or unintended consequences of relying heavily on merit-based pay increases as a primary method for retaining talent, particularly in terms of employee morale or team dynamics?

A. While merit increases can be effective in recognizing and retaining top talent, there are potential drawbacks to relying solely on this method for employee retention. Overemphasis on individual performance and merit-based rewards may create a competitive atmosphere within teams, potentially undermining collaboration and teamwork. Moreover, employees who consistently receive lower merit increases may feel demotivated or undervalued, leading to decreased morale and productivity. Additionally, merit increases may not address underlying issues such as work-life balance, job satisfaction, or career development opportunities, which are also crucial factors in employee retention. Therefore, organizations should consider implementing a holistic approach to talent management that includes various retention strategies beyond just merit increases.