Compensation Fundamentals: Common Pay Structures

Author: Joseph J. Martocchio, Professor Emeritus, University of Illinois at Urbana-Champaign

Introduction

Employee compensation encompasses the rewards employees receive for performing their jobs, to adjust for cost-of-living increases, for their seniority, job performance over time, or acquiring new competencies, skills or knowledge sets.

HR professionals collaborate with high-level managers to determine the optimal compensation plans that will facilitate recruitment, employee job performance and retention - all within budgetary limits. Then, HR relies on its expertise to create and oversee the implementation of compensation programs.

This guide discusses common pay structures in an employee compensation system. It should be reviewed together with the other parts of the Compensation Fundamentals series:

Common Pay Structures

HR professionals apply the fundamentals of pay structures to establish and administer two common pay structures:

Merit-Based Pay Structures

Merit pay is an example of a pay-for-performance compensation system. A merit pay increase is calculated as a percentage of current base pay. For instance, an employee currently earns an annual salary of $50,000. Their manager awards a 5 percent merit pay increase, which equals $2,500 (that is, .05 x $50,000). This employee's new salary will be $52,500 (that is, $50,000 + $2,500).

HR professionals create merit pay increase grids for use by supervisors and managers responsible for appraising performance and awarding performance-based pay raises. Before applying the merit pay increase grid, HR professionals approach preliminary considerations starting with timing of merit pay increase awards and, in collaboration with the leadership of finance and accounting, setting the merit pay budget.

Timing

HR professionals decide the frequency for determining merit pay increases. In most cases, merit pay increase awards are made annually. The timing usually corresponds with annual performance reviews and the end of the organization's fiscal year. Another option is to determine pay increases annually based on the employee's employment start date.

Merit Pay Budget

The merit pay budget is expressed as a percentage of current base pay made available to award merit pay increases to employees. Simply consider the total amount of base pay for the employee group. Then determine the available monetary resources to fund pay increases. For instance, the sum of base pay for the employee group is $10 million. HR leadership determines that $1 million is available for merit pay awards. The merit pay budget is 10 percent (that is, $1 million ÷ $10 million).

Merit Pay Increase Grid

After determining the timing of merit pay increases and the merit pay budget, HR professionals establish merit pay increase grids based on two factors:

Sample Merit Pay Increase Grid
Annual Salary Job Performance
Excellent Above Average Average Below Average Poor
Fourth quartile: $70,000-$84,999 5% 3% 1% 0% 0%
Third quartile: $55,000-$69,999 7% 5% 3% 0% 0%
Second quartile: $40,000-$54,999 9% 7% 6% 2% 0%
First quartile: $25,000-$39,999 12% 10% 8% 4% 0%

The pay increase percentage equals the amount specified where the quartile position and job performance rating intersect. For instance, an employee whose performance is rated as excellent and paid in the second quartile range will receive a nine percent merit pay increase.

Job Performance Ratings

The performance appraisal is an essential component of pay-for-performance systems. A performance appraisal must be reliable (that is, it produces consistent results if conducted by multiple supervisors rating the same employee) and valid (that is, it measures the job performance expectations and outcomes communicated to employees in the job description or assignments). HR professionals work with managers and supervisors to review the merit pay increase program guidelines, and those managers and supervisors work within those guidelines to determine an employee's merit pay increase.

Supervisors and managers typically rate the performance of each employee based on a numerical rating scale of job-related criteria such as teamwork and quality of work. Then, the numerical ratings are totaled to provide an overall job performance score and these scores correspond to an overall qualitative rating such as excellent. When considering just the performance appraisal rating, pay increase percentage amounts are larger for better job performance attainment.

Pay Position Within the Pay Grade

HR professionals group each employee's pay into one of four quartiles for ease of administration, rather than determining pay increase percentages based on every salary level.

Considering quartile position alone, the lower an employee's pay falls within its designated pay grade (for example, the first quartile versus the second quartile), the higher the percentage pay raise. Along those lines, the higher an employee's pay is within its grade (for example, third quartile versus the first quartile), the lower the percentage pay raise.

There are two reasons for this pattern of merit pay increase percentages.

First, HR professionals apply lower merit pay increase percentages at higher quartile positions to control employees' progression through pay ranges. For instance, if two excellent performers earn the same percentage increase (10 percent), but their pay differs in quartile position ($100,000 versus $60,000), the former employee would receive a $10,000 pay raise while the latter employee would earn a $6,000 pay raise. If these two employees continue to perform equally well, the former employee is likely to reach the pay range maximum amount more quickly, beyond which pay would be positioned above the maximum allowable pay rate.

Second, HR professionals recognize the possibility that lower paid employees may feel inequities because their pay in dollar amount falls substantially below the more highly paid employees with the same performance rating. Most employees consider the dollar amount to be more important than the percentage amount when judging the value and equity of pay increases. The dollar amount represents status, reinforces one's perception of value in the organization, and directly influences standard of living.

Person-Focused Pay Structures

Person-focused pay programs reward employees for acquiring specified knowledge, skills, or competencies. Person-focused pay rewards employees on their potential for demonstrating excellent job performance based on learning new knowledge, skills, or competencies.

Person-Focused Pay Structure

Person-Focused Pay Structure

HR professionals create person-focused pay structures for use by supervisors and managers to guide employees to the designated training courses. Upon successfully completing courses, employees earn a higher pay rate.

Before finalizing the person-focused pay structure, consider the following preliminary issues:

Establishing Skill, Knowledge and Competency Blocks

Skill blocks, knowledge blocks or competency blocks are sets of skills, knowledge or competencies required to perform a designated job. (For simplicity, reference will be made to skill blocks. The considerations for skill blocks discussed below apply equally to knowledge blocks and competency blocks.) The development of skill blocks should occur with two matters at the forefront.

First, companies must prepare job descriptions, which will serve as the roadmap for building a person-focused pay system. Well-prepared job descriptions should enable the identification of important skills, the training programs employees must complete to acquire the skills, and accurate measures of learning.

Second, jobs should be placed into job structures. The information contained within job descriptions should facilitate HR professionals' identification of skills that are common to all jobs in the structure and unique skills. For example, the human resource management jobs within its structure share knowledge about the role of HR within the organization. HR specialists' skills, knowledge and competencies differ based on areas of HR. For instance, job analysts are knowledgeable about how to collect job- and worker- related information to prepare written job descriptions. A compensation survey specialist possesses knowledge of the methodologies used to select companies for inclusion in the data collection effort.

Transitioning to a Person-Focused Approach

HR professionals establish person-focused pay programs for a variety of factors based on changes that influence how work is done. When creating person-focused pay structures, HR professionals should consider two transition matters.

The first matter relates to skills assessment. This issue highlights who should assess whether employees possess skills at levels that justify a pay raise, on what basis assessments should be made, and when assessments should be conducted. Unlike merit pay, which focuses on performance attained, person-focused pay rewards employees on their potential for demonstrating excellent job performance based on learning new knowledge, skills or competencies. Gaining employee trust is essential during the transition period because employees may view the new system as a threat to job security.

The second transition issue concerns timing of skills assessment. During the transition period, HR professionals should appraise job performance more often to inform employees about how well they are performing under the new system. In addition, frequent appraisals should highlight the goal of person-focused pay structures - to learn more. Feedback is crucial for this process to succeed.

Training and Certification

For person-focused pay to succeed, sound training programs must be regularly developed, implemented and assessed to determine effectiveness in educating workers. It is also essential to provide sufficient training opportunities so that employees may become more skilled and earn higher pay; otherwise, a fairness problem emerges. A systematic method for ensuring appropriate training coverage entails matching training programs with skill blocks.

In-House or Outsourcing Training

Organizations must decide whether to develop and deliver training in-house, engage in a contract with a learning provider that develops and delivers training, or rely on existing curricula such as through vocational schools and colleges.

Organizations typically call on internal resources if they can rely on existing experience. If lacking, organizations find an external provider either to train employees directly or to prepare managers or supervisors to become instructors. Organizations mainly use in-house expertise for company- and product-specific training. Such training is compatible with organizational philosophies and procedures and thus is not freely offered in the external market.

Providing training on a timely basis is important. Organizations contract with outside services if the in-house staff does not have sufficient time to develop and deliver training. When using outside resources, organizations sometimes require training on demand as new hires are brought on board or employees leave the organization, thus requiring training of some remaining employees.

Additional Resources

Compensation Fundamentals: Building Blocks

Compensation Fundamentals: System Design Elements

Compensation Fundamentals: Legal Considerations and Assessing Effectiveness

Compensation Philosophy

Manage Effective Employee Compensation Systems Checklist

How to Develop a Compensation Strategy

How to Use the Point Method of Job Evaluation