What is incentive-based compensation?

Incentive-based compensation, also known as incentive compensation or incentive pay, is a form of compensation that employers provide employees to encourage strong performance. This compensation is separate from the employee’s guaranteed salary or hourly rate. It’s a variable component of their compensation that acts as an additional way to reward or encourage them. 

Incentive compensation plan examples

Employee incentives fall into two general categories: monetary and non-monetary incentives. A typical example of monetary incentives that most people are familiar with is a cash bonus. Other monetary incentives include:

• Company equity
• Stock options
• Sales commissions
• Profit sharing
• Performance-based raises
• Gift or debit card rewards

Companies can also provide employees with non-monetary incentives. Some annual incentive plan examples include flexible work arrangements and wellness programs.

A good example of a monetary incentive is a sales-based incentive. Sales-based incentive compensation is ideal for employees who are responsible for talking to customers and closing sales. Employers often structure these incentive plans as a percentage, like 5% of all the deals each sales rep closes. So if a sales representative’s employer offers this incentive-based compensation and the worker is responsible for $100,000 in sales over the year, her incentive payment would be $5,000.   

What are the characteristics of the best incentive compensation plans?

Creating an incentive compensation program for your workers can be tricky. If you don’t structure your incentive plan carefully, it can have unintended negative consequences. For example, some employees may act unethically or illegally to meet the performance goals, such as in Wells Fargo’s incentive compensation system. 

To create the best possible incentive pay plan, make sure it meets the key criteria below.

Consistency and fairness

Poorly structured incentive compensation plans can quickly lead to resentment between coworkers. You can prevent this by making your incentive program as consistent and fair as possible. Evaluate all your workers based on their work and check in regularly to ensure that managers are applying the incentive pay fairly. 

Simplicity

The incentive program should be simple—both for your employees to understand and for your company to operate. If employees don’t understand the program, it won’t motivate their performance. And if the program is too complicated to administer, the costs may outweigh the benefits for your company.

Measurability

Tie your incentive payment directly to measurable metrics. In sales-based positions, for example, you can measure performance for incentives with metrics like total revenue, average sale value, or call volume. It may be difficult to quantify performance for employees in other positions, but you still need to use clear, easily measurable metrics for them as well. 

Attractiveness

Your incentive compensation program won’t improve employee performance unless its incentives are attractive to your workers. If the incentives are too small or unappealing, your employees won’t change their behavior. Of course, making the incentives too attractive would be overly expensive for your company. Find a middle ground where you’re offering incentives that appeal to your employees while keeping your total compensation costs manageable. 

Is incentive pay the same as a bonus?

People often use the phrases “incentive pay” and “bonus” interchangeably when discussing compensation. While bonuses can be incentive pay, there are many other types of compensation incentives. Bonuses are also generally not guaranteed or communicated ahead of time the way incentive plans are. 

Incentive plans aim to influence employee behavior and motivate your workforce to perform better. Bonuses are more general and almost always offered as cash or cash equivalents. Incentives are more varied since they can include travel, memberships, and perks like additional leave. 

Does incentive pay actually work?

If you’re going to invest in an incentive pay program, you need to know whether these types of programs actually affect employee behavior. The answer is yes—annual incentive plans are effective. It’s no surprise, then, that the vast majority of companies and organizations use some type of incentive program. When structured properly, these programs can benefit both the employer and the employee.