Everyone wants to be acknowledged for their hard work. That’s why tangible rewards are a surefire way to retain top talent and increase employee morale.
Monetary incentives like bonuses, commissions, PTO, and gift vouchers all push employees to do their best, but a merit increase is perhaps the most powerful tool in an employer’s arsenal. Merit increases show your team that hard work doesn’t go unnoticed.
This guide defines merit increases and explains how they differ from other types of salary adjustments and pay raises.
What is a merit increase?
A merit increase is a pay raise given to employees who excel in their job performance. Unlike a bonus or other one-time reward, a merit increase represents a permanent boost to an employee’s base salary. It’s usually reserved for high performers and achievers who contribute significantly to the business’s success.
When administered properly, this type of pay increase can incentivize performance and retain long-term talent.
Comparing merit increases to other pay raises
Not all pay raises boost an employee’s base salary based on performance. An employer may grant salary increases for numerous reasons.
Here’s an overview of the criteria that differentiate a merit increase from other types of pay raises:
Merit raise vs. annual raise
A merit raise is reserved for top-performing individuals, whereas employers give annual raises across the board to keep compensation competitive and promote employee loyalty. A company may grant a merit pay raise in addition to a yearly salary raise, typically after conducting performance reviews.
Merit raise vs. cost-of-living adjustment
A cost-of-living adjustment is an annual raise given to all employees to keep up with rising living costs, usually based on a consumer price index (CPI). A CPI measures inflation and deflation based on price changes for common consumer goods. Without an annual adjustment, inflation can decrease the actual spending power of an employee’s salary, even if the dollar amount stays the same.
A cost-of-living raise can also be given if a worker moves to a more expensive area (e.g., from a small town to a large city). This form of adjustment is vital for global employers, as the cost of living can vary radically across regions.
5 factors to determine merit increase amounts
Merit increases must be substantial enough to entice employees but conservative enough to keep budgets balanced. The following factors can determine a suitable performance-based pay increase:
- Employee performance evaluations: Performance reviews are valuable tools for assessing an individual’s performance over the past quarter, six months, or year. They provide evidence of what the employee has accomplished during that time and whether they’ve exceeded targets. You may include a numerical rating in the performance review, giving merit increases to employees who score above a certain threshold.
- The frequency of merit increases (e.g., annually or after major reviews): If you give merit raises frequently throughout the year, consider making the percentage increase smaller. Conversely, the amount may be higher if you give them out annually.
- Experience and seniority: Employees with a great deal of experience or seniority in the company usually receive higher merit increases. This is a way to thank them for their long-standing service and increased responsibilities.
- Budget considerations: Every employer needs to budget wages. Keep raises within budget when allocating merit pay.
- Industry standards: The average merit increase is typically 3–5%, but this varies widely by industry. Salary benchmarking is essential when awarding merit raises. High-performing team members who receive industry-aligned merit raises will be less tempted to move jobs.
How to calculate a merit increase
This five-step process will help you determine exactly how much to include in a merit-based pay increase:
1. Evaluate employee performance
Determine how an employee’s performance affects the business. Do they contribute to the bottom line directly (e.g., sales) or indirectly (e.g., HR)? Also, does the person meet company objectives? Are they hard to replace? The answers to these questions during a performance review can define how and when you give merit raises.
2. Set budget limits
Align with company, departmental, and HR budgets to ensure you don’t go over (or significantly under) budget. Speak to the different departments to determine the budgets for compensation and increases, and set your limits accordingly.
3. Align with company goals
Is your organization trying to reduce staff turnover? You may be more generous with performance-based raises. Do you need to reduce overall expenses? Compare how much a merit increase is going to cost versus the potential cost of replacing a top performer who leaves for greener pastures.
4. Use performance differentiation
Establish specific criteria for receiving merit increases. This should be clear to every team member in the company. Create a straightforward document that outlines these criteria and share it company-wide. This gives people something to work toward and minimizes the role of unconscious bias when determining who is eligible for a pay raise.
5. Model different scenarios
Decide who gets a merit increase by modeling different scenarios and their budgetary impacts. Here are three examples that could inspire you:
- Scenario 1: The baseline scenario—everyone receives a standard annual salary increase (e.g., 3%).
- Scenario 2: Here, everyone who scores a 4/5 or 5/5 on a performance evaluation gets a 5% increase, while everyone else receives 2.5%.
- Scenario 3: Only the top talent in the most critical roles get a 6% salary increase. Everyone else gets 2%.
As you review each scenario, consider budget constraints and business goals as your guides.
Pros and cons of merit-based pay structures
Merit increases are a valuable incentive, but they aren’t the only way to reward top performers. Consider these benefits and drawbacks when determining whether merit pay increases are right for your organization:
Pros
- Motivates employees: A merit increase shows employees you appreciate their hard work. They feel valued and acknowledged, leading to increased engagement.
- Improves employee retention among high-performing workers: The job market is competitive. Giving merit increases to exceptional talent makes your company a more attractive workplace than your competitors.
- Aligns individual contributions with business goals: Hardworking employees help achieve company objectives. Rewarding high-performing individuals with a merit increase aligns their goals with the company’s.
- Fosters a culture of recognition and reward: People want to work at a company where their hard work is recognized. Fostering a culture of acknowledgment improves morale for all employees.
Cons
- Increases expenses: The bottom line is a company’s top priority, and merit increases can strain budgets. Think carefully about the cost of losing employees versus the cost to keep them.
- Causes salary disparity: Merit increases can cause significant salary differences between employees at the same seniority level. Ensure that salaries are fair and aligned with international benchmarks.
- Negatively impacts culture and morale: Employees pursuing a merit increase might place their own needs above others—and what’s best for the business. Additionally, some may think merit pay is awarded unfairly and feel disgruntled when they don’t receive a salary increase.
Best practices for a merit increase
These tips will ensure your merit-based compensation plan goes off without a hitch:
Ensure transparency in merit-based decisions
Pay increases of any kind should follow a set policy to ensure fairness for all employees. The criteria for awarding merit increases should be universally communicated. Otherwise, raise allocations may seem arbitrary or biased.
Train managers on performance assessments
Management comes with numerous responsibilities, including performance reviews. An experienced HR professional should train your company’s managers on how to evaluate behavior and performance to ensure that top performers are recognized.
Reduce biases and promote fairness
We all have biases, but they shouldn’t prevent us from rewarding people who deserve it. When training managers, focus on how they can recognize their own biases and move past them.
Listen to employee feedback
Every employee should have an opportunity to give honest feedback on the merit increase policy, regardless of whether they’ve received merit pay. Employees may use a confidential questionnaire or—if your team members feel comfortable—a one-on-one session. When you hear recurring feedback on your policy, you can adjust it accordingly.
Recognize your team’s hard work with Oyster
Employers must consistently recognize and reward employees to maintain a motivated workforce. Merit increases are just one reward structure. A culture of appreciation extends beyond monetary rewards.
A comprehensive benefits strategy creates an environment where employees feel valued. With Oyster’s Total Rewards, you can support your global team by offering competitive, country-specific salaries, equity, and benefits.
With Oyster, you can prioritize continuous appreciation, boost engagement, and drive your business’s success.
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About Oyster
Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.
Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.
