Designing an 


Effective Pay for


Performance 


Compensation System


A Report to the President and the 

Congress of the United States by the 

U.S. Merit Systems Protection Board 
THE CHAIRMAN

U.S. MERIT SYSTEMS PROTECTION BOARD

1615 M Street, NW

Washington, DC 20419-0001

January 2006

The President

President of the Senate

Speaker of the House of Representatives

Dear Sirs:

In accordance with the requirements of 5 U.S.C. 1204(a)(3), it is my honor to submit this 

Merit Systems Protection Board report, “Designing an Effective Pay for Performance Compensation 

System.”

Federal Government agencies are moving to better align pay with performance and create 

organizational cultures that emphasize performance rather than tenure. From our research, we have 

learned that agencies must invest time, money, and effort in the design and implementation of their 

pay for performance compensation systems in order to succeed. A credible and fair pay for 

performance system will require an effective performance evaluation system and supervisors who are 

able and willing to use it properly. Agencies will also need mechanisms such as training and 

systematic monitoring of pay decisions and outcomes to ensure that pay for performance systems 

operate as intended. 

Although the requirements listed above are universal, we believe the long-standing principles 

of providing “equal pay...for work of equal value” and “appropriate incentives and recognition...for 

excellence in performance” are best met by agencies designing pay for performance systems to suit 

their individual missions, workforces, and circumstances with respect to uniform guidelines and 

principles. Accordingly, this report discusses the critical choices that agency leaders will make 

during the design and implementation of a pay for performance compensation system. This 

discussion is intended to help agency leaders better understand how they can adapt pay for 

performance systems to their organizations and to help them choose wisely among alternatives for 

measuring and rewarding performance. 

I believe you will find this report useful as you consider the implementation of pay for 

performance across the Federal Government. 

 Respectfully,

 Neil A. G. McPhie 
Designing an 

Effective Pay for 

Performance 

Compensation System

A Report to the President and 

the Congress of the United States 

by the U.S. Merit Systems Protection Board
U.S. Merit Systems 

Protection Board

Neil A.G. McPhie, Chairman

Barbara J. Sapin, Member

Office of Policy and Evaluation

Director

Steve Nelson

Deputy Director

John Crum, Ph.D.

Project Manager

Cynthia H. Ferentinos, Ph.D.

Project Analyst

James J. Tsugawa
Table of Contents

Executive Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .ix

Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x

Conclusions and recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xi

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A summary of pay for performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Benefits and risks associated with pay for performance . . . . . . . . . . . . . . . . . . . 2

Pay for Performance Decision Points . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

Is the agency ready for pay for performance? . . . . . . . . . . . . . . . . . . . . . . . . . . 3

What are the goals of pay for performance? . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Who should be paid for performance? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 

What should be the timing for implementing pay for performance? . . . . . . . . . 8

What should be rewarded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

How should employees be rewarded? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

How much pay should be contingent upon performance? . . . . . . . . . . . . . . . 18

How should performance-based pay be funded? . . . . . . . . . . . . . . . . . . . . . . . 20

How can costs be managed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Who makes performance rating and pay decisions? . . . . . . . . . . . . . . . . . . . . 25

Who provides input to performance ratings? . . . . . . . . . . . . . . . . . . . . . . . . . 26

How can agencies facilitate pay system integrity? . . . . . . . . . . . . . . . . . . . . . . 28

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Conclusions and Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

A Report by the U.S. Merit Systems Protection Board vii

Executive Summary

Decisions that are made during the design and implementation of a pay for 

performance system are crucial. Therefore, agency decision makers should 

carefully consider their design options with full awareness of potential advantages 

and disadvantages. To assist agency leaders with these crucial decisions, we have 

prepared this report to address topics such as who should be covered, what should 

be rewarded, how to reward employees, and suggestions for preserving the integrity 

of the pay system. We hope that this discussion will assist agencies in anticipating 

important issues and tailoring their pay systems to their unique needs, which will 

facilitate their success.

Background

In the past, individual Federal Government agencies have obtained approval 

to introduce pay for performance systems in limited demonstration projects 

or in a few cases on an agency by agency basis. However, the transition of the 

Federal Government from the traditional General Schedule accelerated when the 

Department of Defense and the Department of Homeland Security obtained 

approval to implement performance-based pay systems. To further facilitate this shift 

from recognizing tenure to focusing on performance, legislation has been proposed 

to implement pay for performance across the Federal Government.1

However, moving from a pay system that rewards tenure to a pay system 

that emphasizes and rewards performance, will require more than legislation. 

Performance-based pay systems present unique opportunities and challenges, and the 

transition from tenure-based pay systems will be neither quick nor easy. With that 

in mind, we have prepared this report to support agencies who are planning to use 

(or are already using) pay for performance. Specifically, we discuss how agencies can 

design, implement, and operate a pay for performance compensation strategy.

Past experience with the General Schedule suggests that in pay systems, “one size 

does not fit all.” Agencies need to customize compensation systems to their own 

unique circumstances. Based on this premise, readers should understand that 

although this report is presented as a “how to” guide, it is not our intent to prescribe 

a single solution. Instead, our goal is to help agency leaders anticipate and better 

understand some of the most critical decision points they are likely to face.

1 Working for America Act (draft proposal) as of February 2006.

A Report by the U.S. Merit Systems Protection Board ix
x Designing an Effective Pay for Performance Compensation System

Purpose

As the guardian of the Federal merit systems, the U.S. Merit Systems Protection 

Board (MSPB) hears employee appeals of covered personnel actions and conducts 

studies to ensure that these systems adhere to the merit system principles and are 

free of prohibited personnel practices. In this report, we provide an overview of the 

options inherent in the design, implementation, and operation of an effective pay for 

performance system. For a summary of the primary questions that agencies should 

ask themselves and a sample of the possible answers, see Table 1. This table serves 

as a roadmap to preview the decision points that we discuss in further depth later 

in the report. We urge agencies to carefully consider each of these decision points 

because effective operation of the pay system requires agency leaders to make design 

choices that best suit their organizations.

Executive Summary

Table 1. Key Decision Points When Considering Pay for Performance

(Including a sample of issues and/or options) 

1. Is the agency ready for pay for performance? 

n The organizational culture supports pay for performance

n Management is committed to changing the culture

2. What are the goals of pay for performance? 

n Improved recruitment and/or retention

n Increased individual and/or organizational performance

n Greater fairness in pay

3. Who should be paid for performance?

n All employees

n Front-line employees

n Top-level managers

4. What should be the timing for implementing pay for performance?

n Wholesale

n Stages

5. What should be rewarded?

n Individual, team, and/or organizational achievements

n Short-term and/or long-term goals

n Efforts vs. outcomes when external constraints exist

6. How should employees be rewarded?

n One-time cash bonus

n Increase to base pay

n Combination, such as control points

7. How much pay should be contingent upon performance?

n Less than 5 percent

n Approximately 30 percent
A Report by the U.S. Merit Systems Protection Board xi

Executive Summary

Table 1. Key Decision Points When Considering Pay for Performance (Continued)

(Including a sample of issues and/or options) 

8. How should performance-based pay be funded? 

n Existing funding (e.g., general increases, within-grade increases)

n Additional funding 

9. How can costs be managed?

n Forced distribution

n Reward only top performers (as a percentage of the workforce)

10. Who makes pay decisions?

n First-level supervisor

n Second-level supervisor

11. Who provides input on the performance ratings?

n First-level supervisor

n Second- or higher-level managers

12. How can agencies facilitate pay system integrity?

n Improved performance evaluation process

n Supervisor and employee training

Conclusions and Recommendations

Agencies must tailor pay for performance systems to their mission and 

environment. Agencies have many options when designing a pay for performance 

system. These options include the coverage of a pay for performance system, the 

types of performance to be rewarded, how performance will be measured, the form 

that pay for performance will take, and the delegation and review of pay decisions. 

However, there is no universally correct choice for any of these options. A choice 

that is appropriate in one organization may be ineffective or counterproductive 

in another. For example, rewarding individuals who generate the greatest amount 

of output may be appropriate in some organizations that are very productionoriented. However, this approach could be problematic in an organization whose 

work demands close attention to how results are achieved, particularly in regard 

to matters such as quality, safety, or teamwork. Thus, an agency designing a pay 

for performance system must think carefully about its goals and how they are to 

be achieved to create measures and incentives that can orient its workforce toward 

meeting those goals.

For pay for performance to be effective, agencies need to meet several 

requirements. Although agencies have options to tailor their pay practices, 

successful pay for performance systems do have some features in common. A pay for 

performance system can only be effective if employees: value the pay or recognition 

that the organization offers in return for high performance; understand what is 

required of them; believe that they can achieve the desired level of performance; and 
xii Designing an Effective Pay for Performance Compensation System

Executive Summary

believe that the organization will actually recognize and reward that performance. 

Those conditions are not likely to be achieved unless an agency meets certain 

requirements. These requirements include:

1. A culture that supports pay for performance;

2. Effective and fair supervisors; 

3. A rigorous performance evaluation system;

4. Adequate funding;

5. A system of checks and balances to ensure fairness; 

6. Appropriate training for supervisors and employees; and

7. Ongoing system evaluation.

Research and experience indicate that agencies need to attempt to meet all of 

these requirements. For example, well-designed performance measures are not a 

satisfactory substitute for trained, conscientious supervisors; similarly, a high level of 

funding does not compensate for a lack of checks and balances.

To make pay for performance successful, agencies need to make 

a substantial investment of time, money, and effort. To meet the 

requirements listed above, agencies will need to make investments that extend 

far beyond the money needed to fund bonuses and pay increases. For example, 

supervisors will need: training in designing performance measures and providing 

performance feedback; a performance evaluation system that enables them 

to accurately distinguish among levels of performance; and guidelines for 

determining pay increases or performance bonuses. The introduction of a pay for 

performance system can also identify weaknesses in other areas—such as training, 

communications, and employee relations—that should be addressed.

Performance evaluation serves as the foundation of a pay for 

performance system. A pay for performance system links an employee’s pay 

to some measure of individual and/or pay organizational performance, usually 

through a formal performance appraisal. Consequently, performance standards 

and measures—and the application of those standards and measures—matter 

greatly to both the agency and the employee. Agencies should therefore ensure 

that (1) performance goals and measures are relevant, reasonable, and usable; (2) 

employees understand and participate in the performance evaluation process; and 

(3) performance is evaluated fairly and rigorously. Agencies considering a pay for 

performance system should be prepared to devote considerable effort to performance 

evaluation. One frequently cited challenge is that performance is often difficult to 

define and measure in public sector organizations. Even so, it is critical that this 

effort be made.
A Report by the U.S. Merit Systems Protection Board xiii

Executive Summary

Agencies should select supervisors based on their supervisory 

potential, develop and manage them to function as supervisors rather 

than technicians or staff experts, and evaluate and pay them based 

on their performance as supervisors. Performance evaluation systems do not 

evaluate performance; supervisors do. Although agencies should take steps to define 

and measure performance as precisely and reliably as possible, they should recognize 

that it is not possible to predetermine or quantify every important aspect of 

employee performance. Therefore, agencies need to allow some room for supervisors 

to use discretion and judgment when evaluating employee performance—which 

is to say, some element of subjectivity. But they should also provide guidelines and 

training to equip supervisors to exercise that judgment responsibly because trust 

between supervisors and employees is critical to success. 

Supervisors also perform other tasks that directly affect employee performance 

and how employees will fare under a pay for performance system. For example, 

supervisors assign work; they translate organizational goals into work unit and 

individual performance goals; they identify training needs and provide access to 

training opportunities; and they provide coaching and feedback. Consequently, 

any agency considering pay for performance needs to ensure that its supervisors are 

willing and able to perform supervisory duties and should hold them accountable for 

how they discharge their responsibilities.

Communication, training, and transparency are essential elements 

of a good pay for performance system. Pay for performance systems are 

most effective when they encourage employees to manage and improve their own 

performance—when they help employees to understand what is expected of them, 

to choose wisely among various courses of action, and to identify, seek, and obtain 

the resources (such as training and equipment) that they need to succeed.

A pay for performance system cannot have these desirable effects unless employees 

understand the organization’s goals, their role in achieving those goals, and 

how the pay system works. Agencies should not assume that these matters are 

self-explanatory, but agencies should make a conscious effort to create this 

understanding. That includes describing how the pay for performance system 

operates; informing employees what behaviors and accomplishments will be 

rewarded; providing regular, constructive performance feedback; training employees 

on how they should present their efforts and accomplishments; and telling 

employees how they have fared under the pay for performance system and the 

reasons for the outcome.

Checks and balances are necessary. As discussed above, a pay for 

performance system requires that agencies allow supervisors to exercise some degree 

of discretion and judgment in evaluating and rewarding employee performance. 

However, a pay for performance system also requires fairness—both actual and 

perceived—for it to have any credibility or motivating power.
xiv Designing an Effective Pay for Performance Compensation System

Executive Summary

Consequently, agencies must also ensure that supervisory decisions concerning 

employee performance and pay are fair and reasonable. Training and guidance are 

necessary but not entirely sufficient. Agencies should establish internal checks and 

balances—such as limited delegations of authority, review panels, and internal 

appeals processes—to ensure that supervisors are, in fact, using their judgment and 

discretion appropriately.

A pay for performance system needs sufficient funding to provide highperforming employees with meaningful pay increases and bonuses. Pay 

for performance represents a commitment from the agency to recognize and reward 

excellence. A pay for performance system will lose all credibility if high performance 

goes unrewarded. Therefore, agencies should ensure that adequate funds are 

earmarked for performance awards.

Pay for performance systems should be evaluated regularly and 

modified when necessary. The General Schedule classification and pay system 

has remained in place, with relatively few changes, for more than 50 years. Although 

we expect that the practice of pay for performance will endure, the useful life of even 

the best-designed pay for performance system will most likely be measured in years, 

not decades. 

Pay for performance systems need ongoing attention to keep them functioning 

properly. Organizational goals will change; performance goals and measures will 

become obsolete; performance may improve or decline; managers may make 

errors in evaluating performance or allocating rewards. For all these reasons and 

more, agencies need to monitor the operation and effectiveness of their pay for 

performance systems and modify them accordingly. Only by giving the pay systems 

and related organizational requirements the ongoing attention that they warrant will 

agencies be able to obtain optimal results from their pay for performance systems. 
A Report by the U.S. Merit Systems Protection Board 1

2

Introduction

A summary of pay for performance

The term “pay for performance” refers to a pay strategy where evaluations of 

individual and/or organizational performance have significant influence on the 

amount of pay increases or bonuses given to each employee.

When a pay for performance system functions properly: 

1. Outstanding performers will receive the greatest rewards, to acknowledge their 

superior contributions and to motivate them to continue high performance. 

2. Average performers will receive substantially smaller raises, which may encourage 

them to work harder to achieve larger raises in the future.

3. Poor performers will receive no increase, which is intended to persuade them to 

improve their performance or leave.

However, agencies should not rely only upon the motivational ability of money 

to improve individual or organizational performance because more employees 

are motivated by factors, such as “personal pride or satisfaction in my work” 

or a “personal desire to make a contribution” rather than a “monetary award.”2

Additionally, conditions in the Federal work environment (e.g., limited funding to 

support performance-based increases or awards, skepticism about whether or not 

supervisors will reward high performance) have created a rather tenuous link from 

pay to performance.

In fact, focusing on pay in “pay for performance” may be misleading. Rather, it may 

be the associated emphasis on the performance evaluation process that produces 

the most significant gains. For example, the initial clarifying of organizational 

goals and translating them into individual expectations, the emphasis on ongoing 

communication and progress checks, and the careful assessment of individual 

accomplishments, which are used to justify the variation in rewards, may prove to be 

more critical than the rewards themselves in improving organizational performance. 

Similarly, rather than concentrating entirely on the monetary benefits, individuals 

may be more likely to join and stay with organizations where they witness effective 

Pay for 

performance 

– a pay 

strategy where 

evaluations 

of individual 

and/or 

organizational 

performance 

greatly 

influence the 

amount of 

pay increases 

or bonuses 

given to each 

employee

U.S. Merit Systems Protection Board, “The Federal Workforce for the 21st Century: Results of the 

Merit Principles Survey 2000,” Washington, DC, September 2003, p. 25.
2 Designing an Effective Pay for Performance Compensation System

3

supervisory practices because this creates an environment where employees are more 

likely to have a sense of accomplishment and satisfaction. 

Benefits and risks associated with pay for performance

Agencies often have many objectives for pay for performance. For example, they 

may aim to improve the organization’s ability to attract and retain high performers. 

They may hope to improve individual effort and consequently, organizational 

performance. They may also be searching for a fairer way to pay since those who 

contribute more to the organization should receive a larger salary in return.

Unfortunately, researchers have found that pay for performance has not achieved 

these objectives in all instances.3 This should not be surprising: pay for performance 

is a complex process that demands a large investment from those who seek to use 

it. The effectiveness of a pay for performance system can be undermined by flaws 

in the design, implementation, and operational phases. For example, an adequate 

budget must be available to fund performance-based increases that are large enough 

to be meaningful. Additionally, for agencies to fairly determine who receives these 

increases, the performance evaluation system must be accurate and supervisors 

must be well-versed in its use. Checks and balances should be built in to help hold 

supervisors accountable for their decisions. Finally, the pay for performance system 

must be evaluated on an ongoing basis to detect when changes are needed as the 

organization and the pay system evolve. We discuss these requirements and more in 

the following section. 

Introduction

For example, the National Research Council’s 1991 report, “Pay for Performance: Evaluating 

Performance Appraisal and Merit Pay,” discusses problems encountered with pay for performance 

during the operation of the Merit Pay System and the Performance Management and Recognition 

System. 
A Report by the U.S. Merit Systems Protection Board 3

Pay for Performance Decision Points

Overview

Understanding the theory behind pay for performance and its potential impact is 

critical to understanding the role performance-based pay can play in an organization. 

Nevertheless, agencies also need to pay attention to technical design points to 

ensure that the mechanics of the system are sound. The effectiveness of pay for 

performance in facilitating recruitment, retention, and motivation (and the resulting 

improvements in individual and organizational performance) depends heavily upon 

matching the approach to the situation. Thus, agencies need to carefully consider 

numerous decision points, such as those discussed below. To make it even more 

challenging, the various choices often have both advantages and disadvantages. 

Although it is tempting to simply transplant compensation systems from other 

organizations where they appear to be functioning well, agencies need to tailor pay 

systems to fit their unique circumstances and needs. Fortunately, agencies can learn 

from the dilemmas others have faced and base their decisions on experience gained 

elsewhere combined with information they glean from within.

Questions agencies need to ask themselves range from the most basic—“Is the 

agency ready for pay for performance?”—to the more specific, questions such as 

who should be covered, what behaviors should be rewarded, and how bonuses 

should be distributed. Obtaining adequate funding and ensuring fairness can also 

challenge agencies, so these goals need to be pursued early in the planning process. 

Anticipating the substantial decision points and understanding the available options 

can help agencies make the best possible decisions. While exploring these issues 

requires some time and effort, it is worth the investment to avoid potential negative 

consequences in the long term.

Is the agency ready for pay for performance?

Given the appeal of paying for performance instead of tenure, many agencies have 

already moved past deciding whether to adopt a performance-based pay system 

and are rapidly moving towards implementation. Some of these organizations may 

already have in place an organizational culture conducive to pay for performance. 

However, many do not. Fortunately, these agencies do not have to passively wait 

for the conditions to improve. They can use pay for performance as a tool for 

organizational change to move the agency in the desired direction. For example, 
4 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

agency leaders can drive major organizational change by demonstrating commitment 

to a performance-based pay strategy through their words and actions. As time 

progresses, the emphasis on performance perpetuates itself as the components 

of an effective pay for performance system facilitate further evolution towards a 

performance-based culture. Figure 1 depicts the cyclical nature of this process.

Figure 1. Changing Organizational Culture With Pay for Performance

Since organizational culture may influence the ease with which pay for performance 

can be implemented, agencies may find it useful to do a self-assessment before 

deciding how to design and implement a new pay system. Table 2 displays relevant 

dimensions of organizational readiness and selected indicators to help agencies gauge 

where they currently are.
A Report by the U.S. Merit Systems Protection Board 5

Pay for Performance Decision Points

Table 2. Assessing Organizational Readiness for Pay for Performance

Dimension Indicator

Organizational Culture n Open, two-way communication is valued and pursued.

n Trust exists between employees and supervisors/managers.

n Human resources management (HRM) systems such as selection, training, 

and performance evaluation have clear and consistent objectives and support pay 

for performance.

Supervisors n Employee efforts support organizational goals.

n Work assignment, evaluation of performance, and distribution of awards are fair.

n Discretion and accountability go hand-in-hand.

Performance Evaluation n Assessment of employees is fair and accurate.

n Employees receive timely, accurate, and meaningful feedback.

Funding n Appropriate pay increases and bonuses are given.

n Top leadership is willing to make difficult choices when allocating funds and awards.

Fairness n Checks and balances are in place.

n Transparency is valued and ensured.

Training n Training is provided to both supervisors and employees.

n Training covers both pay system philosophy and mechanics.

System Evaluation n The organization evaluates how the pay for performance system is being administered 

and whether the pay for performance system is accomplishing its goals.

n Employee attitudes are tracked.

Agencies may use the results of their self-assessment on the dimensions above 

to determine what areas they need to improve. As we discuss in the following 

paragraphs, many of the indicators listed above will serve readily as tools for 

facilitating organizational change or for monitoring the progress of organizational 

change as pay for performance is implemented.

Organizational Culture. The concept of organizational culture covers numerous 

“values and ways of behaving that are common in a community.”4 Alignment among 

human resources management (HRM) practices is one aspect of culture that can 

greatly affect the success of pay for performance in an organization. Aligning the 

pay system with other HRM practices, such as selection, training, and especially 

performance evaluation, serves to focus employees on shared goals and values and 

delivers a consistent message regarding the value of performance. It also provides 

supervisors with the tools to move the workforce towards the desired performancebased culture. If agencies devote the proper attention to the supporting HRM 

systems, they can optimize the effectiveness of their pay for performance system and 

strengthen or create a performance-based organizational culture.

4 John P. Kotter and James L. Heskett, “Corporate Culture and Performance,” The Free Press, 

New York, NY, 1992, p. 141. 
6 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Another important indicator of an organization’s culture involves communication. 

Open communication ensures that employees will understand the “what” and the 

“why” behind coming changes to the pay system and the organizational culture. 

However, the downward transmission of information is generally insufficient to 

achieve effective communication. Upward communication is also needed. By 

providing employees a means to voice their questions and concerns, management 

has an opportunity to address these issues and thereby, enhance employee trust.

Supervisors. As a linchpin between management and front-line employees, 

supervisors play a pivotal role in pay for performance settings. Not only do they 

translate organizational goals into concrete objectives for individual employees, 

but they also control employees’ access to the resources they need to accomplish 

these goals. Although supervisors typically perform critical functions within any 

organization, pay for performance demands a higher level of supervisory skill than 

traditional tenure-based pay systems.

By granting supervisors more discretion to determine pay increases, pay for 

performance places more pressure on supervisors to perform their responsibilities 

well. For example, supervisors must treat employees fairly in terms of the assignment 

of work, evaluation of performance, and allocation of rewards—and they must be 

held accountable for their decisions. That may include linking supervisors’ pay to 

how well they perform these duties, among their other responsibilities.

Performance Evaluation. Supervisors need an effective performance evaluation 

system—and adequate time to properly use it—to help them to monitor and 

document employees’ performance on a regular basis throughout the assessment 

cycle. That system should enable supervisors to provide feedback that is timely, 

accurate, and meaningful—preferably on a continuing basis rather than simply 

once or twice a year. The absence of a fair and frequent interchange can jeopardize 

the trust between the supervisor and employees that is essential to an effective 

performance-based pay system.

Funding. The credibility of the new pay system can also be undermined if funding 

is inadequate to provide high performers with bonuses or pay increases that are 

commensurate with their contributions and that motivate others to improve their 

performance. In addition to having adequate funding, top-level decision makers 

must be willing and able to make difficult decisions to allocate resources among 

components of the organization. Most importantly, those who evaluate employee 

performance must be willing and able to allocate resources to make clear distinctions 

among different levels of employee performance.

Fairness. To ensure that supervisors’ actions are justifiable, the pay system must 

include checks and balances. In addition to providing pay increases, supervisors 

must have the necessary discretion and judgment to appropriately deal with poor 

performers. While the first step is for supervisors to assist poor performers, through 

measures such as feedback and training, supervisors must also be able to withhold 

pay increases from or remove employees who cannot or will not improve.
A Report by the U.S. Merit Systems Protection Board 7

Pay for Performance Decision Points

Training. To facilitate system integrity, one of the most fundamental steps is simply 

to ensure that supervisors and employees understand how the system is supposed to 

work. This objective can be achieved through training—not only on the mechanics 

of the system—but also on the underlying philosophy. By fostering transparency 

regarding the rules by which the system operates, the organization promotes a shared 

understanding of the expectations between supervisors and employees regarding 

behaviors and outcomes. This serves to build trust, provided that both sides can and 

will uphold their commitments.

Evaluation. Finally, ongoing evaluation of the new compensation system is 

necessary to determine whether it is accomplishing the desired objectives in a 

fair and cost-effective manner. Measures of employee attitudes, such as employee 

engagement and motivation, as well as outcome indices, should be tracked and 

analyzed to determine how rating and pay decisions and other factors are affecting 

employee satisfaction and performance. Such evaluation will also help agency leaders 

assess progress in changing the organization’s culture. 

What are the goals of pay for performance?

In order to guide themselves through the decision-making process, agencies should 

establish clear, realistic goals for pay for performance before taking any action to 

change their pay systems. Although recruitment, retention, and motivation (and 

resulting individual and organization performance) represent broad areas that 

agencies often wish to improve through pay for performance, agencies should also 

consider other goals and priorities. For example, another goal that agency leaders 

may have in mind when implementing pay for performance is to improve the equity 

of pay practices by providing more compensation to the highest performers.

It is also useful to keep in mind the impact that pay system changes will have on 

the organizational culture and the importance of maintaining alignment between 

agency values and pay strategies. For example, if the nature of the work requires 

collaboration, an agency may choose a team-based reward structure or at least 

incorporate teamwork into the reward structure to avoid pitting employees against 

one another in competition for individual rewards. Many of these issues are 

discussed in more detail later in this report.

Who should be paid for performance?

Pay for performance systems can be inclusive or exclusive. To choose the appropriate 

range of coverage, an organization needs to decide the message it wants the pay 

system to send to the workforce, including what is to be measured and how. Some 

organizations cover all employees with a single pay for performance plan to unify the 

workforce in pursuit of common goals. Other organizations limit performance-based 

pay to those employees with direct responsibility for the organization’s core functions 

and results. For example, a pay for performance plan might be limited to front-line 

employees whose work is directly linked to mission accomplishment because their 
8 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

work is more readily measured (and of more immediate importance to the 

public) than work performed by employees whose activities indirectly support 

organizational goals.

In other cases, performance-based incentives may be reserved for those employees 

at the top levels of the organization. The logic behind this strategy is that 

accountability should be limited to those with the most control over results. In 

other words, since executives exert substantial influence over organizational success, 

they are entitled to significant recognition or blame for what they do or do not 

accomplish. In the private sector, Chief Executive Officers often receive sizable 

bonuses or performance-based pay increases that are linked to organizational 

outcomes, such as attainment of profit or other financial goals. Likewise, in the 

Federal Government, Senior Executives are eligible for annual bonuses and pay 

increases linked to their achievement of organizational objectives.

Limiting pay for performance plans to select groups may enable the organization to 

highlight clearer links between employee behavior and outcomes, but doing so may 

create divisiveness. Depending upon the circumstances, such as whether the dual 

pay systems offer markedly different earning potential, coverage may be viewed as 

distinguishing between the “haves” and the “have nots,” creating some dissension 

between the two groups. This is particularly relevant if the benefits provided to one 

group are viewed as coming at a cost to the other group.

What should be the timing for implementing 

pay for performance?

Organizations often have the flexibility to decide whether the system should be 

implemented wholesale or in stages. If in stages, coverage can start with a single 

occupation or a limited group of occupations as a pilot test, and expand later to 

additional groups of employees once the system has proven itself. Starting with a 

small group of employees and later expanding coverage may enable the organization 

to demonstrate successes before rolling the system out to the entire organization. 

This also provides an opportunity to fine-tune the system and remedy any problems 

before they undermine its long-term success. 

In contrast, wholesale implementation may be preferable when the agency’s intent is 

to convey a dramatic organizational change message and foster a sense of solidarity. 

Implementing the new pay system wholesale also avoids the confusion and increased 

difficulty associated with administering multiple systems within an agency.

What should be rewarded?

An essential point to keep in mind is that pay for performance is a powerful tool, 

which must be used wisely. The axiom that “what gets measured, gets done” has 

particular relevance when measures are reinforced by monetary incentives. For 
A Report by the U.S. Merit Systems Protection Board 9

Pay for Performance Decision Points

that reason, organizations must be very careful when deciding what to measure 

and reward, because they are quite likely to get what they measure—which may or 

may not be what they really want. In other words, agencies must be sure they are 

reinforcing desired behaviors associated with the most critical outcomes and not 

encouraging counter-productive responses.

An effective performance appraisal system requires clearly defining expectations in 

advance, while recognizing that priorities may shift along the way. Enumerating 

specific goals gives employees a clear “road map” that they can use to decide how to 

allocate their time and efforts. Some jobs lend themselves more easily to this type 

of direction, while for others it is more difficult to specify in advance the precise 

accomplishments expected since the nature of the work is more complex or fluid. 

In these cases, flexibility regarding anticipated outcomes can be incorporated in 

the evaluation process. In the meantime, supervisors and employees should engage 

in continuing discussions so that expectations can be shared, despite necessary 

adjustments. Additionally, when circumstances outside the employees’ control 

determine outcomes, comparisons across employees in similar positions may assist 

the supervisor with evaluating employee performance. In such circumstances, 

supervisors’ subjective judgments necessarily play a role in evaluating performance. 

While subjective judgments cause some employees discomfort, supervisory 

discretion to evaluate performance is generally not something that can—or should 

be—orchestrated out of the process.

Use of multiple measures. Given the complexity of work, multiple measures are 

often necessary to adequately capture accomplishment. To decide what to measure, 

agencies need to ensure that they focus on important outcomes without excluding 

other critical aspects of individual or organizational performance. One common 

problem in this area involves organizations that set quantitative goals only to find 

a negative impact on quality because important qualitative aspects of performance 

were not included in the goals. In other cases, organizations accurately identified top 

objectives, but overlooked subtle, yet important, priorities or activities. For example, 

by focusing employees’ attention only on part of a work process, such as timeliness, 

an agency can unintentionally instigate cutting corners and unsafe activities, which 

may serve to speed up the work process production at an unacceptable cost. While 

granting flexibility to employees who are pursuing difficult goals may encourage 

innovation, safeguards may need to be built in to ensure that necessary steps have 

not been inappropriately sacrificed. Additionally, it is important that the reward 

system does not undermine desirable aspects of performance, such as teamwork, 

that may not be explicitly recognized yet are important to organizational success. 

In situations that warrant looking at multiple facets of employee performance, a 

“balanced scorecard”5 perspective may prove to be very useful. Although notable 

5 A “balanced scorecard” typically provides managers with a “fast but comprehensive view of the 

business” by featuring “financial measures” complemented by measures on “customer satisfaction, 

internal processes, and the organization’s innovation and improvement activities.” Robert S. Kaplan 

and David P. Norton, “The Balanced Scorecard—Measures That Drive Performance,” Harvard 

Business Review, 70(1), 1992, p. 71.
10 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

differences between the private and public sectors impact what measures would 

be appropriate, a balanced scorecard approach for the Federal sector could include 

measures such as quantity and quality of output, teamwork, safety, and customer 

satisfaction, while focusing attention on the organization’s overarching mission.6

Alignment of organizational goals and measures. Supervisors frequently 

derive employees’ goals, at least in part, from high-level organizational goals. This 

“cascading” of goals is useful for aligning employee efforts with organizational 

objectives. To achieve this, employees need to understand how their individual 

performance supports organizational outcomes. However, supervisors should also 

recognize the value of a “bottom-up” approach that gives employees a voice in 

how they will be evaluated and some discretion in deciding how best to achieve 

the results desired. Excessive top-down control of goals, work methods, and job 

behaviors may stifle risk-taking and innovation by employees. In contrast, rewarding 

an open exchange of information may result in improved organizational outcomes 

over time as trust between the levels grows. Further, by aligning individual success 

with organizational success, there is a greater likelihood that agencies will be able to 

encourage employees to exert effort to achieve organizational objectives in concert 

with their personal goals.

Standardized (organizational) vs. tailored (individual) criteria. 

Choosing between standardized organization-wide evaluation criteria and evaluation 

criteria tailored to individuals largely reflects an organization’s philosophy regarding 

the relative priority of what should be rewarded. Having a clear, overarching mission 

facilitates the use of standard criteria. Evaluating everyone against a common set 

of standards, linked to high level organizational goals, also serves to focus the 

attention of all employees on the highest level priorities. Likewise, using an agencywide competency model reinforces agency values and promotes consistency across 

occupations and organizations. 

The downside of standardized criteria is that with their generality, the evaluation 

measures may not seem applicable to everyone. For example, front-line employees 

typically have a clearer line of sight to accomplishing mission objectives than 

administrative employees, who support the mission in a secondary manner. In 

other cases, the functions within an organization may be so diverse that it becomes 

difficult to use universal criteria. Providing leeway for tailoring criteria may be more 

appropriate in many organizations. This individuation of evaluation criteria may be 

by organizational subcomponent, occupation, grade level, or other categories.

Individual vs. team vs. organizational performance. Similarly, the level 

at which performance is assessed for award purposes should reinforce the desired 

breadth of collaboration, although this must be balanced with the need to be able to 

identify individual contributions. It is important to consider whether cooperation 

should be encouraged within a discrete work unit or across a broader context, such 

6 Robert S. Kaplan and David P. Norton, “Transforming the Balanced Scorecard from Performance 

Measurement to Strategic Management: Part I,” Accounting Horizons, 15(1), 2001, pp. 98–99.
A Report by the U.S. Merit Systems Protection Board 11

Pay for Performance Decision Points

as organizational components. For example, when employees work independently, 

it may make more sense to evaluate them individually. However, when high levels 

of interaction and communication are necessary, it becomes much more difficult 

to accurately measure the accomplishments of individual employees. Rewarding 

only individuals when mutual support helps advance the organizational goals may 

discourage cooperation and teamwork, to the organization’s detriment. 

In other cases, the connection between individual performance and organizational 

performance appears relatively clear and individuals tend to provide relatively similar 

levels of contributions. In these cases tying individual fortunes to the organizational 

outcomes rallies the entire workforce to work together. Discord may result if 

some people do not pull their weight, although peer pressure can often remedy 

these situations.7 Organizations may also wish to supplement group measures 

with individual measures, such as “teamwork,” to recognize personal efforts. For 

example, the company Johnsonville Foods has team leaders and employees rate each 

member on “contribution to team goals, communication effectiveness with other 

team members, willingness to work with other team members, and attendance and 

timeliness at team meetings.”8

Focusing on employees’ overall contributions can increase flexibility and encourage 

employees to focus on outcomes rather than the process of how to get there. 

However, the best approach may be to include both specific individual goals and a 

broader view of contributions. Along these lines, the Government Accountability 

Office (GAO) (formerly the General Accounting Office) recommends linking 

individual performance with organizational goals to identify how daily activities 

eventually support high-level organizational goals.9 Maintaining the connection to 

the bigger picture provides employees with a bit more context than if they are only 

aware of their individual roles. The link to broader goals also enables consideration 

of additional behaviors that may not be explicitly described in a performance 

agreement,10 yet are important to the organization’s overall functioning. 

Ultimately, what works best in an organization will depend on the nature of the 

workers and the work, as well as the corporate philosophy. Some work groups are 

relatively homogeneous in their level of contributions, while the performance in 

others varies so much that individual differences should be recognized. Some work 

is clearly independent, while other projects require extensive collaboration and 

teamwork. Finally, some organizations want to promote active cooperation, while 

others may encourage a healthy level of competition. 

7 Robert L. Heneman and Courtney von Hippel, “Balancing Group and Individual Rewards: 

Rewarding Individual Contributions to the Team,” Compensation and Benefits Review, 27(4), 1995, 

pp. 63–68.

8 Heneman and von Hippel, p. 64.

9 U.S. General Accounting Office, “Results-Oriented Cultures: Modern Performance Management 

Systems Are Needed to Effectively Support Pay for Performance,” GAO–03–612T, April 1, 2003, 

Washington, DC, p. 10.

10 A performance agreement is a document that describes what the employee plans to accomplish during 

a performance rating period or a given span of time. Generally, a performance agreement is confined to 

accomplishments and results, with little or no discussion of underlying tasks or work behaviors.
12 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Possession vs. demonstration of competencies. Pay for performance plans 

may also vary depending on whether they reward possession of desired competencies 

or require the actual demonstration of these competencies. Some agencies 

forgo an outcome-oriented evaluation and instead focus on the development of 

competencies.11 For example, an organization may reward employees for possessing 

or obtaining certain competencies that the organization values because it believes 

it is useful to have staff on-board who possess certain capabilities. As a result, once 

the employee has been certified as possessing certain competencies, the agency 

may increase the employee’s pay whether or not the employee is called upon to 

demonstrate these competencies during the performance appraisal cycle.

Other agencies compensate individuals only for the time that they demonstrate 

the competencies. Agencies may take this strategy a step further by focusing on 

demonstrated competencies in relation to organizational goals and performance.12

Under this strategy, employees must demonstrate that their increased competence 

enables them to perform more effectively to support achievement of organizational 

outcomes. For this system to be effective, an organization must clearly identify the 

competencies that are required for optimal organizational performance and measure 

employees’ possession of those competencies. If done properly, advantages of this 

approach may include the opportunity for ambitious employees to be compensated 

for developing themselves, which in turn benefits the organization by increasing the 

depth and breadth of its talent pool. Consequently, career progression can be tied 

more closely to competencies that support organization goals rather than to tenure.13

Short-term vs. long-term goals. Performance appraisal cycles in the Federal 

Government are typically one year in duration. As a result, short-term goals may be 

more easily assessed than long-term projects, which may cross multiple assessment 

cycles. For assessments to be fair, the life cycle of projects should be taken into 

account and proper credit given for progress towards the end goal. Further, complex 

projects can usually be broken into intermediary steps to evaluate progress against 

these milestones. Taking both short and long perspectives into account helps ensure 

that employees on the extended projects will be rewarded for their achievements to 

date and not forced to wait until project completion years down the line. Without 

intermediate reinforcement, employees might gravitate toward quick-return 

assignments and neglect the more challenging endeavors.

External constraints. A common frustration for employees involves the 

inability to control all of the factors that affect their performance and results. 

These include changing priorities; supervisor-controlled work assignments and 

resources; geographical variations in workload or other conditions; and access to 

11 Michael Armstrong and Duncan Brown, “Relating Competencies to Pay: The UK Experience,” 

Compensation and Benefits Review, 30(3), 1998, pp. 28–39. Competencies are defined as “the skills, 

knowledge and behaviors which need to be applied for effective performance.”

12 Armstrong and Brown, 1998, p. 35. 

13 Kathryn Tyler, “Compensation Strategies Can Foster Lateral Moves and Growing in Place,” HR 

Magazine, 43(5), 1998, pp. 64–71.
A Report by the U.S. Merit Systems Protection Board 13

Pay for Performance Decision Points

equipment and information, as shown in the following examples. An employee may 

work diligently toward a goal, only to have the priorities shift just before project 

completion. Supervisors also exercise control over some of the parameters of what 

an employee can accomplish by allocating job assignments and training. Another 

external variable is location, which often drives workload and therefore, could be 

factored into performance-based pay decisions. For example, one location, such as 

a large airport, may have a greater volume of traffic than a smaller facility. Similarly, 

the work done at a headquarters office is usually quite distinct from that done at a 

field office. The unavailability of needed equipment or information can also prevent 

employees from working at their optimal level. Therefore, many of the variables 

that determine individual productivity operate outside of employees’ control. 

Although some agencies may focus exclusively on outcomes, others may decide to 

keep external constraints in mind when making pay and award decisions to avoid 

penalizing high performers who are negatively impacted by circumstances beyond 

their control. 

At a group level, work units are sometimes dependent upon another unit for a 

critical step in the process and cannot proceed until that entity completes its role. 

There may also be uncontrollable external events that hamper successful completion 

of objectives, such as budget limitations or technical failures. Therefore, individuals 

or groups may find that they have worked hard and have done everything they can, 

but are impeded by factors outside their control. Again, in these cases, raters must 

consider how to evaluate performance—whether to rely entirely on outcomes or 

to give at least partial credit for efforts—keeping in mind that it can be quite 

de-motivating to employees if the rating system is so rigid that it does not take 

external factors into account.

Should performance-based pay be tied to the performance appraisal 

system? Although annual award decisions in the Federal Government have often 

been tied closely to performance appraisal ratings, this is not always the case in 

pay for performance settings. For example, when going to a pay for performance 

system, the Federal Aviation Administration converted its performance appraisal 

process into an ongoing qualitative discussion between the supervisor and the 

employee regarding accomplishments and areas for improvement. Separate from 

the performance appraisal review, the supervisor’s recommendation triggers 

individual pay for performance increases, while all eligible employees receive the 

organization-wide pay increases, dependent upon organizational goal achievement. 

The purpose of de-linking the performance appraisal process and monetary rewards 

was to defuse the emotionally-charged annual process of assigning a numerical 

value to performance. However, the Government Accountability Office (GAO) has 

expressed concerns that this approach is insufficient to “provide enough meaningful 

information and dispersion in ratings to recognize and reward top performers, help 

everyone attain their maximum potential, and deal with poor performers.”14

14 U.S. General Accounting Office, GAO–03–612T, April 1, 2003, p. 10.
14 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

In other cases, agencies tie pay decisions tightly to the performance appraisal process. 

As an example, some organizations operate a point-based pay for performance 

system, assigning individuals a score on a 100 point continuum that correlates with 

a performance level. Those above a certain level receive salary increases, with the 

amount corresponding to placement along the range. Although these systems appear 

precise and rigorous, their ability to make such fine distinctions between employees 

is questionable. Even if it may be easy to separate the “stars” from the “average 

performers,” it tends to be much more difficult to make fine distinctions among 

average employees given the complex nature of job performance and the inexact 

and subjective nature of many evaluation systems. As a consequence, employees 

may feel that their ranking relative to colleagues is incorrect, which undermines 

confidence in the overall system.

How should employees be rewarded?

Pay for performance can encompass a variety of rewards for above average 

performance. The two most common are bonuses, which are one-time cash 

payments, and performance-based pay, which provides a permanent increase to 

base pay. Each of these has advantages and disadvantages, which are explored 

further below.

Bonuses. Bonuses represent an amount of pay that is “at risk” every year. In 

contrast to base pay, which is stable and primarily reflects an employee’s market 

value, bonuses should depend purely on performance and are not guaranteed. 

Employees in these types of systems frequently receive a base pay that is considered 

comparable to average market rate to facilitate recruitment and retention of a highquality workforce, but additional dollars are distributed (often annually) on the basis 

of performance during the rating period. As a result, employees are guaranteed a 

certain salary, with the potential for earning more. The amount generally depends 

on a variety of factors, such as the available funding and the evaluation of the 

individual’s contributions, but the agency retains discretion over how much to spend 

each year.

As illustrated by the example shown in Figure 2, bonuses serve to raise an 

employee’s salary above average market rate but only on an annual basis. In other 

words, each year an employee must earn an amount above the base rate of pay. Since 

each year’s bonus is independent of the bonus earned in prior years, total salary can 

fluctuate dramatically from year to year. When the employee excels, he may receive 

a sizable bonus, but if the employee’s performance is “average” or lower, he may not 

receive a bonus and his salary drops to the base rate.
A Report by the U.S. Merit Systems Protection Board 15

Pay for Performance Decision Points

Figure 2. Impact of Bonuses on Total Salary

1

60

50

40

30

20

10

Dollars in thousands

0

Base pay with bonus Average market rate (Base pay)

70

2 3

Time in Years

4 5

Advantages. Advantages of bonuses include the following:

n Employee performance may vary from year to year so an employee may deserve 

a bonus one year, but not the next. Since the increase resulting from bonuses 

does not carry over to subsequent years, agencies can distribute a larger pool of 

bonus money each year rather than continue to fund performance-based pay 

increases from prior years.

n Agencies may use bonuses throughout the rating period to facilitate timeliness, 

thereby strengthening the connection in employees’ minds between efforts and 

outcomes.

n If agencies direct funding for increases into a bonus pool, they may provide 

sizable bonuses to top performers.

Disadvantages. Disadvantages include the following:

nn Putting a large amount of pay “at risk” to be earned each year makes the 

employee’s salary less predictable.

n If base pay levels are not fully competitive, reliance on bonuses as a reward may 

increase turnover.

n At this time, bonuses are typically small relative to base salary in the Federal 

Government (but not necessarily in the private sector). Therefore, a culture 

change will be required to view bonuses as a mechanism for providing 

substantial amounts of money to recognize high performers.
16 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Performance-based pay increases. In contrast to bonuses, performancebased pay increases are incorporated into the employee’s base pay and are usually 

only adjusted upward. Organizations differ in how they move employees through 

the performance-based pay scales. Some pay systems include pre-determined 

levels, which employees step through in an orderly manner, while others allow the 

supervisors to determine salary amounts anywhere within a broad range. 

Figure 3 demonstrates how performance-based pay increases can operate. As in 

the prior example, average market rate may be used to set a baseline for pay. The 

employee may be hired at this rate, but salary progression depends primarily upon 

performance. When the employee’s performance warrants a raise (during Years 2, 

4 and 5), the employee receives an increase. The upward trend highlights the main 

difference between bonuses and performance-based pay increases: pay increases are 

typically treated as permanent increases.

Figure 3. Impact of Performance-Based Pay Increases on Total Salary

Year 1

60

50

40

30

20

10

Dollars in thousands

0

Performance-based pay Average market rate

70

Year 2 Year 3 Year 4 Year 5

Advantages. Advantages for the employee include the following:

n Employees may perceive the continual increases (or at least a plateauing 

of salary) to be more desirable than the potential for ups and downs with 

individual bonuses.

n Employees may also view increases to base pay as more attractive than bonuses 

because salary increases enhance the dollar value of several benefits, such as 

retirement earnings, thrift savings plan, and life insurance. Although employees 

often realize that much of the value of a base pay increase is “hidden,” agencies 

may enhance the motivational impact of the base pay increase by making sure 

employees are aware of the total value of a salary increase.
A Report by the U.S. Merit Systems Protection Board 17

Pay for Performance Decision Points

Disadvantages. However, performance-based pay increases also have notable 

disadvantages. For example, they:

n Limit an agency’s flexibility to adjust pay to reflect an employee’s current level of 

performance. An individual may demonstrate outstanding performance in one 

year and base pay is increased accordingly. However, in the following years, the 

employee may decrease performance while continuing to receive an enhanced 

salary based on previous outstanding performance, resulting in overpayment. 

Very few pay for performance systems incorporate a mechanism for decreasing 

pay based on not performing at the same level in the years following the 

increase. Under current Federal regulations, a reduction in pay is an adverse 

action, and therefore, subject to the appeals process.

n Generate long-term costs. Not only do performance-based increases add to 

salary and benefits costs for the current year, but they also impact budgets in 

future years.

n Eliminate or at least greatly reduce the incentive of offering future pay increases 

based on performance for those who top out in a pay band.

n May be too small to be meaningful. Funding limits or formulas may result in 

small base pay increases for many employees.

Combination strategies. As an alternative to choosing one or the other, agencies 

may use both bonuses and base pay increases. Combining bonuses and base 

pay increases enables organizations to realize the benefits of both while limiting 

the downsides. For example, agencies may use bonuses to recognize exceptional 

achievements, while pay increases may be reserved for longer term accomplishments.

Another option that eliminates or at least reduces some of the disadvantages 

associated with the use of one-time cash payments and performance-based pay 

increases, involves building a “control point” into the pay band. Base pay increases 

enable the employee to reach a certain salary level, often the average market rate 

for the skills encompassed in the pay band, which then serves as a ceiling for base 

pay. If an employee reaches this level and his performance would otherwise warrant 

a pay increase, a one-time payment may be given in lieu of increases to base pay. 

Consequently, such employees must compete each year for a bonus above the 

established market rate for their skill set. Another strategy is to set a higher “control 

point” for high performers, so these employees continue to receive pay increases 

until they reach a point higher than the average market rate (at which point they 

may continue to receive bonuses to recognize superior performance). Using these 

flexibilities enables an organization to set policies to help them recruit and retain 

employees with critical areas of knowledge, skills, and abilities.

In the example shown in Figure 4, a control point has been set at $45,000. The 

employee is paid at the average entry level pay rate of $30,000 in the first year. 

During the second year, he receives a performance-based pay increase to $40,000. 
18 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

He does not receive an increase in the third year. In his fourth year, his performance 

warrants a $50,000 salary, which would exceed the $45,000 control point. 

Therefore, he receives a $5,000 increase in base pay and the additional amount is 

paid as a bonus of $5,000. In the fifth year, the control point holds his salary at 

$45,000 and he receives a $15,000 bonus.

Figure 4. Impact of Control Points on Total Salary

1

60

50

40

30

20

10

Dollars in thousands

0

70

2 3

Time in Years

4 5

$5,000

Bonus

$15,000

Bonus

Year 1

$30,000

Year 3 $40,000 Year 2 $40,000

Year 5 $45,000 Year 4 $45,000

Bonus Control point (average market rate)

Performance-based pay Average entry level pay rate

As the example helps illustrate, control points ensure that employees do not receive 

pay above a certain level unless they sustain high performance levels. Employees at 

the control point may see this as a downside, since they cannot accurately predict 

what their salary will be each year, but at least they can be confident that their pay 

will not slip below the control point once they reach it.

How much pay should be contingent upon performance?

Although Federal agencies have long had the legal authority to provide highperformers with cash awards, within-grade increases, and/or quality step increases, 

the total amount of these awards or increases has typically been quite small—

generally less than 5 percent of a Federal employee’s salary.15,16 Pay for performance 

compensation strategies should offer a larger percentage to ensure that the increases 

are large enough to be noticed by both recipients and nonrecipients.

15 U.S. Office of Personnel Management, Central Personnel Data File, 2003.

16 U.S. Office of Personnel Management, website, www.opm.gov/oca/pay/html/wgifact.htm.
A Report by the U.S. Merit Systems Protection Board 19

Pay for Performance Decision Points

The Senior Executive Service (SES) appears to be leading the way in terms of having 

more pay “at risk” based on performance. The SES pay for performance plan has 

eliminated pay levels within the SES pay band to create an open range and set a 

higher “aggregate compensation level.”17 Within this revised pay structure, the link 

between pay and performance will be emphasized, not only by tying pay increases 

to performance, but also by virtue of the size of the new performance-based pay 

increases. Whereas only a 2.2 percent increase was available for distribution to 

recognize performance by SES members in January 2004, future increases can 

draw from the sum of the general increase and locality pay increases.18 Therefore, 

future pay increase pools may contain more funding to appropriately recognize 

performance. 

In the private sector, the amount of performance-based bonuses has also grown in 

recent years. The average amount that companies spend on performance-based 

bonuses as a percentage of payroll gradually increased from 3.8 percent in 1991 

to 10.5 percent in 2002, before declining slightly to 8.8 percent in 2003 and 

rebounding to 9.5 percent in 2004 and 11.4 percent in 2005, with these fluctuations 

due primarily to economic constraints.19,20,21 However, the amount devoted to these 

incentives varies widely by job characteristics, such as job type, level, industry, and 

geographic location. For example, WorldatWork reported that bonuses range from 

an average of 5.4 percent of base pay for hourly workers and 11.7 percent for exempt 

salaried workers to 29.1 percent for executives, for whom bonuses can equal millions 

of dollars.22 Of course, since many employees may receive small bonuses or no 

bonuses, these averages may mask much larger bonuses for a sizable portion of the 

private sector workforce.

Several factors should influence the decision regarding size of the bonus or pay 

increase. First, the amount should be proportionate to the contribution of the 

employee. For example, those who contribute the most should receive the largest 

payoff. Those who made relatively minor contributions should receive little or 

nothing, to reinforce the message that rewards are reserved for those who exceed the 

evaluation criteria. Although many organizations like to spread bonuses over a large 

population, the resulting amount often ends up being insignificant and the failure 

to distinguish between high and low performers undermines the purpose of a pay 

for performance system. High performers may become demoralized and decrease 

their output, while the low performers have no incentive to change their behaviors. 

Second, bonuses should be large enough to get the attention of all employees, 

17 U.S. Office of Personnel Management, Memorandum for Heads of Departments and Agencies From 

Kay Coles James, Director. Subject: New Performance-Based Pay System for the Senior Executive 

Service. December 16, 2003. 

18 Stephen Barr, “Pay-for-Performance System Makes an Uneven Debut Among SES Corps,” Federal 

Diary column, the Washington Post, February 9, 2004, p. B2.

19 Hewitt Associates, press release, Sept. 9, 2003.

20 Hewitt Associates, press release, Sept. 8, 2004.

21 Hewitt Associates, press release, Aug. 31, 2005. 

22 WorldatWork, salary survey from the website www.worldatwork.org, 2003.
20 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

whether or not they received a bonus or performance-based pay increase. In other 

words, the amount of the cash bonus or pay increase should be sizable enough to be 

viewed as worth the extra effort and employees should understand what is required 

to earn such a reward. Finally, the organization must work within its short- and 

long-term budgets and communicate openly with employees to avoid creating false 

expectations regarding current and future salary levels.

How should performance-based pay be funded?

In the private sector, financial results (e.g., income and profits) frequently determine 

and fund bonuses and pay increases. In this manner, employees are able to share in 

the increased proceeds that their efforts have brought to the company. In good years, 

funding is readily available. In bad years, the employees often share the downturn 

in the company’s fortunes by receiving little or no salary increase or bonus, whether 

or not the company’s decreased profit is due to their efforts or to external economic 

factors over which they have no control.

Funding is dramatically different in the public sector. Few Federal agencies obtain 

financial returns from their work. Even when they do (e.g., revenue collection, law 

enforcement), it is rarely appropriate to allow Federal employees to directly benefit 

from these returns. Furthermore, most agencies are funded through appropriations, 

and the relationship between performance and appropriations is tenuous at best. 

High performance and mission accomplishment does not necessarily lead to 

larger appropriations, and mediocrity or failure may have few, if any, financial 

consequences. 

Therefore, most Government agencies must allocate funding for performance-based 

salary increases and bonuses from their existing salary budgets (i.e., funds that might 

otherwise be used for pay increases that are not tied to performance) and prudently 

manage the long-range impact on salary costs when awarding increases to base 

pay. However, the amount available each year for pay increases is typically quite 

limited—regardless of whether agencies have met or exceeded their performance 

goals. For example, the general increase provided to Federal employees has varied 

from 2.1 percent to 3.8 percent over the past 7 years (2000 through 2006).23

Within-grade increases (WGIs) for employees provide another source of funding for 

performance-based pay, but amount to only about 3 percent of annual pay for those 

who are scheduled to receive them.24 Only employees in the first three steps can 

receive annual within-grade increases, while those at midrange steps progress every 

other year and those at the highest steps wait 3 years before their next within-grade 

increase.25 Therefore, the total amount available through pooling the general increase 

and the WGI funding is still somewhat limited and subject to fluctuations over 

time. Nevertheless, employee groups and unions have strongly opposed eliminating 

23 U.S. Office of Personnel Management, website, www.opm.gov/oca/06tables/index.asp.

24 U.S. Office of Personnel Management, website, www.opm.gov/oca/pay/html/wgifact.htm.

25 5 CFR 531.405.
A Report by the U.S. Merit Systems Protection Board 21

Pay for Performance Decision Points

standard increases.26,27,28 One of the primary reasons for their opposition is employee 

concern that supervisors will abuse the additional discretion over pay increases and 

unjustly reward their “buddies.”

It is important to note that reallocating existing funding sources as discussed so 

far creates a win-lose situation in the organization. A pay for performance system 

funded by money earmarked for the general increases and WGIs typically results 

in some employees obtaining more than they would have otherwise and others 

receiving less. This may create resistance among those who perceive that their 

incomes are falling behind and heighten competition among employees in a negative 

way. This discrepancy appears most problematic for the “good, solid employees” 

who may no longer receive regular, though modest, increases to recognize their 

contributions.

An alternative strategy to relying upon the existing salary budget would be for 

agencies to increase the total amount available for performance-based pay increases 

by tapping other sources of funding. For example, the Human Capital Performance 

Fund (HCPF) provides managers with additional funds (not drawn from within 

their agency budgets) for rewarding outstanding performers. However, agencies 

must cover any future increases in personnel costs and benefits resulting from such 

rewards.29 It may also be possible for agencies to pursue other funding options, 

such as through a working capital fund or through a supplemental appropriation to 

support the implementation of a pay for performance plan.

Greater budget creativity and advance planning will most likely be necessary to 

appropriately fund pay for performance systems because such systems represent a 

shift away from the predictable pay increases and salary budgets associated with 

the General Schedule pay plan. More budget flexibility may also be needed to 

allow agencies to carry over funds when organizational performance does not 

warrant paying out the full amount of available salary dollars. Similarly, it would 

be advantageous for agencies to be able to carry over any excess funding to support 

adequate bonuses during lean years. Since insufficient funding has seriously 

undermined performance-based pay in the past,30 long-term financial support under 

a variety of scenarios should be carefully planned before implementing pay for 

performance.

26 National Coalition for Equity in Public Service, briefing presented by Julius Crouch at the Diversity 

Summit, Washington, DC, April 8, 2004.

27 Jacqueline Simon, Statement by Jacqueline Simon, Public Policy Director, American Federation 

of Government Employees, AFL–CIO, before the House Committee on Government Reform 

Subcommittee on Civil Service and Agency Organization regarding replacing the General Schedule 

with Pay for Performance, April 1, 2003.

28 Stephen Barr, “Pay Parity Amendment’s Rejection Complicates Debate Over Raises,” Federal Diary 

column, the Washington Post, March 18, 2004, p. B2.

29 U.S. Office of Personnel Management, Memorandum for Human Resources Directors from Ronald 

P. Sanders, Associate Director for Strategic Human Resources Policy. Subject: Recent Legislative 

Changes, December 24, 2003. 

30 National Research Council, “Pay for Performance: Evaluating Performance Appraisal and Merit 

Pay,” National Academy Press, 1991, Washington, D.C., p. 27. 
22 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

How can costs be managed?

Historically, the performance appraisal process has been linked to cash awards. 

Consequently, managers felt pressures that often conflicted with their responsibility 

to accurately evaluate employee performance. Instead of focusing exclusively on 

employee behaviors and the results of those efforts, raters sometimes considered the 

potential impact of their ratings on outcomes for the individual, such as whether 

the employee would receive a cash award (and the amount). As a result, the process 

often became corrupted by inflated ratings, which made it difficult or impossible to 

distinguish among levels of performance. In addition, since a limited pot of award 

money was available, the awards produced by simply dividing the money among 

many employees often became insignificant—too small to motivate individuals 

to improve their performance and too small to motivate supervisors to draw 

distinctions among their subordinates.

Some agencies have attempted to preserve the integrity of the performance appraisal 

process by separating rating decisions and award decisions. Such efforts have 

generally been ineffective. Separating appraisals and awards decisions removed one 

potential barrier to accurate performance appraisal, but did nothing to ensure that 

supervisors actually used the system as intended. In some instances, the alreadycompromised appraisal process further degenerated into a paper exercise that 

produced neither accurate ratings nor constructive feedback to employees.

It is important to keep in mind that implementing a pay for performance plan will 

not solve such fundamental problems as inadequate funds, inaccurate evaluations, a 

lack of commitment to providing meaningful performance feedback, and reluctance 

to reward employees appropriately. In many cases, these problems have reflected 

the inability or unwillingness of supervisors and managers to properly use the tools 

available to them, rather than any constraints of the compensation system. For 

example, in some cases, such as very limited pools of awards funding and relatively 

similar levels of performance, supervisors may have judged it not worth the potential 

strife to provide substantially different awards to employees.

The approaches discussed below have frequently been adopted in attempts to 

preserve the integrity of the performance evaluation process. However, these 

techniques do not necessarily solve all of the issues mentioned above and may also 

present some additional challenges to supervisors and employees.

Forced distribution. Forced distribution refers to constraining the number of 

employees who can achieve a certain performance rating, such as by establishing 

a predetermined number of employees to receive each level of rating (and 

corresponding pay increases or bonuses). (See Figure 5 for a 5 point rating scale.) 

Using a forced distribution often assumes a somewhat normal (“bell-curve”) 

distribution of performance levels, so a small percentage receive the largest increases 

or awards, a larger percentage receive smaller amounts, and the rest receive nothing. 

Some allocation strategies even require a certain number of employees to receive 

below average ratings that could result in a pay freeze, reduction in pay, or 

(eventually) termination.
A Report by the U.S. Merit Systems Protection Board 23

Pay for Performance Decision Points

Figure 5. A Forced Distribution of Performance Ratings

1

30

25

20

15

10

5

Frequency rating

0

35

2 3

Performance rating

4 5

An advantage of the forced distribution system is that it forces supervisors to 

make distinctions among employees rather than taking the easy way out and 

rating everyone the same. The impact on employees may also be useful when the 

work environment is conducive to competition because this strategy increases the 

incentive to outperform one’s peers.

However, the forced distribution approach has a number of flaws.31 First of all, 

performance in organizations rarely fits a normal distribution. Although everyone 

cannot mathematically be “above average,” one would hope that a distribution 

of actual performance levels using an anchored rating scale would be positively 

skewed—that is, the vast majority of employees would perform at an acceptable or 

higher level. See Figure 6 for an illustration of this scenario.

31 Edward Lawler, “Rewarding Excellence: Pay Strategies for the New Economy,” Jossey-Bass Inc., 

Publishers, San Francisco, CA, 2000. 
24 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Figure 6. A Forced Distribution of Performance Ratings 

Contrasted with Actual Performance Levels

16

60

50

40

30

20

10

Frequency of rating

0

Actual performance level Performance rating

70

2 3 4 5

Under this scenario, rather than preserving the integrity of the system by limiting 

the number of employees who receive the highest rating, a forced distribution 

may undermine the accuracy of ratings by requiring a set number of employees to 

receive each rating. Consequently, their ratings will not necessarily correspond to 

their actual performance. For example, in some organizations, there are many who 

excel and should receive the highest ratings, but when the number of “outstanding” 

and “exceptional” ratings is limited, supervisors must make arbitrary distinctions 

between employees. In response, some supervisors resort to having employees “take 

turns” receiving the top ratings, which creates a situation where an individual’s 

excellent performance may not be recognized in the appropriate timeframe. This 

is de-motivating for the employee and fails to serve the purpose of recognizing role 

models. At the opposite end of the performance spectrum, it would seem illogical to 

specify a minimum number of very low ratings (i.e., a number of poor performers 

on board) because poor performers should have improved their performance to an 

acceptable level or been dismissed.

Another potential drawback of the forced distribution model for ratings is the fact 

that it pits employees against one another as they compete for scarce resources. Since 

many organizational cultures value teamwork, the net impact may be decreased 

organizational performance as employees become less likely to cooperate with one 

another since they view each other as “competition.” Employees may also withhold 

information from supervisors if they are concerned that this feedback may result in 

negative ratings.
A Report by the U.S. Merit Systems Protection Board 25

Pay for Performance Decision Points

Reward top 5 percent, 10 percent, 20 percent, etc. Another method to 

limit performance-based pay costs requires designating only the top percentage to 

receive increases. Such exclusivity may be driven by a number of considerations. 

Choosing a larger percentage translates into more people sharing the wealth, while 

a smaller percentage means that fewer people will be recognized, but they will be 

likely ro receive sizable increases. The organization’s culture often drives the decision 

regarding how many people should be included. In a strong team environment, 

broader coverage may make more sense, while more stringent limits may work in an 

individualistic culture.

Some private sector corporations have begun implementing a restrictive policy to 

reward only the very top performers. Research into return on investment in these 

companies has found that the cost of providing sizable monetary incentives to the 

“stars” can be recouped as a direct result of their subsequent improved outcomes. 

Nevertheless, such elitism may leave the majority of the workforce demoralized. 

Federal agencies should carefully consider the implementation and effects of such a 

strategy, lest they turn the large group of average and above average performers into 

disgruntled employees. This is especially true since it is likely that the employees 

at the very top of the distribution will often be there year after year and others will 

never see positive monetary feedback no matter how hard they try.

Control points in pay bands. As discussed earlier, control points in pay bands 

limit individual pay progression and thus serve as a “brake” on growth in total 

salary costs. Since they are frequently established in the middle of the pay band 

(i.e., below the band maximum) and usually correspond to the average market 

salary for the relevant job family or occupation, they help keep costs down although 

employees at this level are still eligible for annual cash bonuses to recognize their 

outstanding contributions.

Who makes performance rating and pay decisions?

Although supervisors typically rate employee performance and those ratings are 

usually linked with the actual distribution of pay increases, organizations may 

choose to retain higher-level control over both decisions. For example, at one 

extreme, control over rating and pay decisions may be centralized at the top level. 

This strategy works best in small organizations, and may be used to focus attention 

on the organization’s values, especially when all components and/or employees are 

rated on the standardized criteria or when organizational components are evaluated 

on whether they accomplished their unique objectives (and everyone within the 

component then receives the same award). A central board of senior managers 

may also exercise sole discretion over pay decisions when rating criteria are not 

standardized (i.e., a variety of individual competencies and outcomes are assessed), 

consistent treatment of all employees remains a primary goal, and the senior 

managers have enough perspective to be able to accurately judge performance across 

the organization. However, a potential hazard inherent in centralized evaluation of 

performance and distribution of pay increases relates to the likelihood that senior 

managers will not be knowledgeable about performance within subunits of the 
26 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

organization. Lacking first-hand knowledge of each employee’s accomplishments, 

senior managers may have a tendency to over-value highly visible employees and 

undervalue the quiet, behind-the-scenes, high performer.

In contrast is the model of decentralizing performance rating and pay decisions 

to the lowest possible level: first-line supervisors. In this manner, the organization 

defers to the knowledge of the supervisors and assumes that they will make correct 

rating and pay decisions and treat all employees fairly. Some organizations provide 

for higher-level review by a pay panel or other decision-making authority to assure 

consistent evaluations for comparable performance and contributions. However, any 

review typically takes place before ratings are communicated and rarely results in 

overturning supervisors’ decisions because that would undermine their authority.

One danger of delegating rating authority to the lowest levels involves the natural 

tendency of supervisors to protect their employees’ interests rather than objectively 

assessing accomplishments against a standard. Explanations abound regarding 

why this would occur, but two of the most likely are: (1) supervisors rate their 

employees highly to ensure that they will receive at least a fair share of the pie, 

believing other supervisors are also going to embellish performance evaluations 

to help their employees receive increases, and (2) supervisors realize that superior 

accomplishments by their employees will be rolled up to support their own 

achievements and subsequent rewards.

Other organizations choose approaches between these extremes to balance the 

advantages and disadvantages of complete centralization or delegation. For example, 

some distribute authority at a mid-level, such as by allocating resources to major 

organizational subunits. In this case, the organization’s top level may designate 

which subunits will receive discretionary salary dollars and the amount based on 

organizational accomplishments. Managers and supervisors within the subunits may 

then have discretion regarding how to subdivide the pot.

Other organizations involve separate entities to promote fairness in rating and pay 

decisions. One technique is to have pay review panels that examine trends across the 

organization to determine if there are any patterns of concern. Pay panels can also 

serve to mediate disputes between employees and supervisors over what pay increase 

(if any) is warranted.

Who provides input to the performance ratings?

Given that various perspectives often offer a more complete view of an employee’s 

performance, it may be worthwhile to consider input from a variety of sources, 

including the first-level supervisor, the second-level manager, and the employee’s 

colleagues and customers, as well as directly from the employee. A 360 degree 

feedback instrument that includes input from higher levels, peers, and subordinates, 

and/or a balanced scorecard that includes business results and customer feedback can 

help to ensure that important input is not overlooked. See Figure 7 for a summary 

of potential sources of input on employee performance ratings.
A Report by the U.S. Merit Systems Protection Board 27

Pay for Performance Decision Points

Figure 7. Potential Sources of Input on Employee Performance

Supervisor

Employee

Manager Customers

Employee Peers

Supervisor. In most pay for performance systems, supervisors have the greatest 

influence on employees’ pay increases because they make the assignments and 

evaluate performance. However, relying exclusively on supervisors may increase 

a pay for performance system’s vulnerability to errors and abuse, as discussed 

previously. The risks are increased when some employees are experts at “impression 

management” and can convince a supervisor that they are performing above 

their actual level, while other employees achieve more but do not tout their 

accomplishments as well. Some supervisors may also be more effective at identifying 

and presenting their employees’ accomplishments. In other cases, supervisors may 

skew their ratings to unfairly reward favored employees at the expense of those who 

may be more deserving of pay increases.

Manager. Involvement of higher level managers in rating and pay decisions may 

introduce a “reality check” whereby their perspective may be used to calibrate ratings 

and pay increases. For example, supervisors may accurately or inaccurately believe 

that their employees are above average. However, the next-level manager has the 

advantage of being able to compare accomplishments across work teams and may be 

able to provide feedback to bring a supervisor’s ratings in line with those for the rest 

of the organization. Another advantage may be that any intentional or unintentional 

biases that a supervisor has may be noticed if a second-line manager reviews the 

recommendations. Involving someone outside of the employee’s management chain 

may further increase perceptions of fairness, though it also probably reduces firsthand knowledge of performance that such a reviewer will have.
28 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Employee (Self-rating). With increasing supervisory ratios and the need for 

supervisors to devote time to tasks other than observing the work of their employees, 

it is understandable that supervisors may not be familiar with all of an employee’s 

accomplishments during a rating period. Hence, it is advantageous for employees 

to provide their supervisors with a summary of accomplishments during the rating 

period. This enables employees to explain extenuating circumstances that prevented 

achievement of all the established objectives and to highlight accomplishments 

supervisors may otherwise overlook. Although some employees may embellish or 

underestimate their achievements, effective supervisors will use this exchange of 

information as an opportunity to clarify actual accomplishments and discuss with 

employees past, present, and future goals and ways the employees can improve 

their performance.

Peers. Peers often occupy a position that provides them with insight into the dayto-day performance of their coworkers. Peers see coworkers on a regular basis and 

may be best able to judge the effort a colleague makes. Since their work is often very 

similar, peers are able to assess whether the outcomes reported by the employee are 

reasonable and if other constraints are operating that prevented the employee from 

accomplishing the desired objectives. However, peer input must be given weight 

cautiously, especially in a pay for performance setting where employees may view 

each other as competition because this may lead employees to undermine others 

to build themselves up or to establish mutually beneficial pacts with colleagues to 

rate each other positively. Further, opinions may be clouded by irrelevant biases if 

employees do not receive extensive training in proper evaluation techniques, which 

should raise their awareness of any discriminatory tendencies. 

Customers. Many Federal agencies have customers outside the Government, 

although the definition of customer may not correspond with what we typically 

view as a customer in a retail or service environment. In these agencies, employees 

need to treat their customers in a way that accomplishes the desired interaction 

in a professional, effective, and efficient manner. Additionally, Federal employees 

who work in support functions, such as human resources, finance, and information 

technology, have customers within their agency. In some cases, customer satisfaction 

can be traced directly to individual employees and may be an appropriate factor to 

consider in evaluating performance.

How can agencies facilitate pay system integrity?

Organizations can take a number of steps to evaluate the integrity of their 

compensation systems, even when significant supervisory discretion has been built 

into the structure. Differential treatment of employees—which, in the Federal 

Government, will require abandoning the practice of basing individual pay decisions 

on tenure and a low threshold level of performance—is both a primary strength and 

a potential weakness of a pay for performance system. Therefore, building safeguards 

in the system from the very beginning is critical to the acceptance and long-term 

viability of a performance-based pay system. Possible safeguards are discussed next.
A Report by the U.S. Merit Systems Protection Board 29

Pay for Performance Decision Points

Employee/union involvement in the development process. To obtain 

input from those who know the work best, agencies should consult their in-house 

experts—employees and the representing unions and other employee groups—early 

in the process. A truly collaborative process enables the organization to benefit from 

the perspectives of those who will be most affected by the new pay system and also 

facilitates buy-in by having all levels involved from the outset, rather than trying to 

pull everyone onboard after the plan has been finalized. Such involvement also sets 

the stage for participation in the future evaluations, revisions, and other steps that 

will be needed to fine-tune the pay for performance system.

Supervisor’s role in the performance evaluation process. Having a fair 

and effective performance evaluation process is absolutely essential to preserving the 

integrity of a pay for performance system. However, a great process is meaningless 

without capable first-level supervisors who are able and willing to properly evaluate 

performance. Unfortunately, many supervisors do not feel prepared for the demands 

of the supervisory role, particularly those relating to performance evaluation. This 

is not surprising since some supervisors have been selected for technical ability 

rather than supervisory skills and have not been subsequently trained for significant 

components of their new role. Complicating matters further is the tendency for 

some of these supervisors to gravitate toward what they do well—serving as technical 

experts—leaving little time for the important responsibility of effectively managing 

their employees.

Implementing a pay for performance system often magnifies the demands of the 

supervisor’s job because of the greatly increased significance of the supervisory 

responsibilities. Those responsibilities include communicating with the employee 

throughout the appraisal cycle, observing and documenting employee behavior, 

assimilating those details, and evaluating the employee’s performance in comparison 

to established standards and to other employees. Often, these responsibilities must 

be discharged in an increasingly complex and fast-paced work environment, for an 

increasing number of subordinates.

Although none of these responsibilities is new, basing pay on performance 

evaluations ups the ante for employees. That, in turn, ups the ante for supervisors. 

Supervisors may experience even greater trepidation about the already contentious 

appraisal process, knowing that their decisions will affect employees’ livelihoods. 

Supervisors need the training, the tools, and the time to be able to function 

effectively in this difficult role.

In general, change often creates an uncomfortable degree of uncertainty for 

everyone involved, but challenges to the status quo regarding pay can be particularly 

unsettling. Over time, supervisors and employees may develop mutual trust as 

both sides become more familiar with the pay for performance process. Holding 

supervisors accountable for their decisions can encourage them to make the 

right decisions despite the discomfort associated with efforts to change their own 

behaviors and those of their subordinates.
30 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Supervisor and employee training. Training serves as a critical though often 

overlooked step in the transition process of implementing a pay for performance 

system. Organizations must be willing to invest the necessary resources, even 

though training often seems superfluous compared to the need to fund the pay 

pool. Supervisors and employees need to be trained in the mechanics of the pay 

for performance process. Even more important, they should be educated on the 

philosophical underpinnings of the new pay system so they understand what the 

organization is trying to accomplish through it. Effective supervisor training is 

particularly essential, since the success of the system depends upon the ability of the 

supervisors to effectively communicate with employees, whether setting performance 

expectations, sharing ongoing feedback, or providing feedback during performance 

evaluation discussions.

Training should be delivered via a variety of media to ensure that everyone 

understands the message. For example, when Honeywell’s Commercial Avionics 

Division implemented an incentive compensation plan, it educated their employees 

with two major training tools: a traditional HR manual to explain the new system 

to employees and a comic book that showed employees discussing pay.32 These two 

tools provided employees with information in the formal language needed to explain 

the details of the system, plus a more user-friendly version to which employees may 

have been better able to relate.

Since rating performance usually relies heavily on subjective appraisals, learning 

how to fairly rate employee performance remains one of the most critical skills for 

supervisors (and for employees when they provide input on themselves, their peers, 

or their managers). Given that Federal Government work generally does not involve 

piecework or sales, rating Federal employee performance typically requires a great 

deal of judgment. Training is essential to ensure that judgment is not impaired by 

the failings described below:

Leniency. In order to maximize benefits for their staff, supervisors may be inclined 

to be lenient and rate their employees too favorably. When a team is competing with 

other teams for a fixed pot of money (and especially if the team accomplishments are 

rolled up to reflect the supervisor’s accomplishments), a supervisor is likely to rate all 

of his employees as “outstanding.” Even when money has been divided among teams 

and the supervisor must decide how to allocate a limited amount of money among 

team members, many supervisors find it less stressful to rate everyone as basically the 

same to ensure that everyone receives a benefit. It may actually make sense to do this 

if the amount of money at stake is small, because to do otherwise could engender ill 

feelings without a good reason. However, there are downsides of spreading around 

award money, including: (1) each individual receives an amount so small it is not 

influential, and (2) it fails to distinguish between “average” and “better than average” 

performers, which means the motivational message is lost.

32 Shari Caudron, “How Pay Launched Performance,” Personnel Journal, 75(9), 1996, pp. 70–75.
A Report by the U.S. Merit Systems Protection Board 31

Pay for Performance Decision Points

“Halo”. Another common tendency of raters is to succumb to the “halo” effect 

by generalizing their overall opinion based on familiarity with one characteristic, 

particularly a noticeable trait, of the employee. For example, if an employee is 

knowledgeable in one content area, the supervisor may assume the employee is equally 

competent in another content area although that may not necessarily be the case. 

Supervisors must be careful to evaluate employees on each critical quality independently, 

without being influenced by the employee’s performance in another area.

Discrimination. A more insidious form of rater inaccuracy is discrimination, 

often based on gender, race, or other factors not related to the job. Unfortunately, 

supervisors are not always aware of biases that may result in their treating employees 

inequitably.

Proving that discrimination is sometimes more subtle than the consistent 

mistreatment of a particular group, research has shown that context also matters. 

For example, in cases where women work in nontraditional roles, supervisors with 

traditional sex role stereotypes tend to rate females less accurately, and often more 

harshly, when the ratings are to be used for performance-based pay and promotion 

decisions.33,34 In male-dominated fields, females tend to be paid less for the same

work, a pattern that is exacerbated by what some research has identified as a tendency 

of women to settle for a lower salary than men at career entry and career peak.35

In other cases, females receive higher than average ratings (although this does 

not automatically translate into monetary outcomes). There are a number of 

explanations for this. Since stereotyping may result in lower expectations for 

women,36 ratings may be overly lenient, especially for supervisory accolades that can 

be freely given, such as compliments and perhaps even high performance ratings that 

are often linked with nominal cash awards. However, when competing with men for 

scarce resources (e.g., promotions or performance-based pay increases), males may be 

more likely to reap the greatest rewards.37 An even more significant impact of these 

shifting standards involves the confusion that this contradictory feedback conveys 

to women. Positive feedback suggests that the employee is doing what she needs 

to do in order for her career to progress. Yet, if a supervisor is saying only that the 

employee is doing a better job than expected from a woman, the feedback is neither 

truly positive nor helpful: the employee’s performance may be less competitive than 

she has been led to believe, and she does not learn of areas where she could improve.

33 Gregory H. Dobbins, Robert L. Cardy, and Donald M. Truxillo, “The effects of purpose of appraisal 

and individual differences in stereotypes of women on sex differences in performance ratings: a 

laboratory and field study,” Journal of Applied Psychology, 73(3), 1988, pp. 551–558.

34 Deborrah E. S. Frable, “Sex typing and gender ideology: Two facets of the individual’s gender 

psychology that go together,” Journal of Personality and Social Psychology, 56(1), 1989, pp. 95–108.

35 Linda A. Jackson, Philip D. Gardner, and Linda A. Sullivan, “Explaining gender differences in 

self-pay expectations: Social comparison standards and perceptions of fair pay,” Journal of Applied 

Psychology, 77(5), 1992, pp. 651–663.

36 Monica Biernat, “Toward a broader view of social stereotyping,” American Psychologist, 59(12), 

2003, pp. 1019–1027.

37 Biernat, 2003. 
32 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

Given the growth of diversity in the workplace, communicating with others of a 

different race or gender has become a common issue. Unfortunately, supervisors 

may feel uncomfortable providing constructive criticism to employees who are 

visibly or culturally unlike them—perhaps because they fear that a discrimination 

complaint might be lodged against them. Yet, as suggested above, the damage done 

by neglecting or avoiding coaching may be significant, even if that damage is not 

immediately obvious.

To avoid inadvertent discrimination, supervisors should be aware that “perceived 

similarity” (the degree to which people see others as resembling them) can be a 

critical determinant of how frequently and effectively they interact with their 

employees.38 Supervisors are more likely to communicate well with the employees 

they view as most like themselves. This open exchange of information and feedback 

may result in improved performance by the similar employees and a greater 

likelihood that the supervisor will be aware of their accomplishments. In return, 

these employees are more likely to feel positively toward the supervisor and the 

organization, and consequently, may be inclined to work even harder.39 In response, 

the supervisor rates the “in-group” employees higher than “out-group” employees. 

This helps establish a self-perpetuating pattern of “in-group” employees who have 

more rewarding relationships with the supervisor than the “out-group.” As noted 

above, the inception of these groups may lie in unintentional, but subtle distinctions 

supervisors make among employees based on how similar the employees seem 

to themselves. However they arise, the existence of these groups may ultimately 

produce sizable differences in outcomes for the affected employees and the 

organization. 

Another likely outcome of having “in-groups” and “out-groups” is that employees 

may suspect a supervisor of playing favorites when it comes to pay decisions. 

Since these biases are not necessarily based on sex, race, age, or other obvious 

characteristics, anyone may feel that they are being passed over for performancebased increases due to favoritism.

Transparency. Rather than being a one-dimensional concept, transparency has 

several different aspects. The first aspect of transparency is systemic: how the pay 

system operates. The General Schedule features an obvious, orderly system of pay 

progression which makes its operation quite transparent. Since pay for performance 

offers greater flexibility in pay progression, making a pay for performance system 

transparent requires some effort.

The second aspect of transparency relates to individual performance expectations 

and rewards: whether supervisors tell employees what is required (e.g., behaviors, 

38 Daniel B. Turban and Allan P. Jones, “Supervisor-subordinate similarity: Types, effects, and 

mechanisms,” Journal of Applied Psychology, 73(2), 1998, pp. 228–234.

39 Sandy J. Wayne, Lynn M. Shore, William H. Bommer, and Lois E. Tetrick, “The role of fair 

treatment and rewards in perceptions of organizational support and leader-member exchange,” Journal 

of Applied Psychology, 87(3), 2002, pp. 590–598.
A Report by the U.S. Merit Systems Protection Board 33

Pay for Performance Decision Points

outcomes) to obtain bonuses and pay increases. While most organizations provide 

some direction to employees, clarifying what is expected and what the organization 

will provide in return is absolutely essential in a pay for performance system if the 

bonuses are to have any value in motivating employees or focusing work efforts 

across the organization. The necessary communication must be at the organizational 

and individual supervisor level so employees receive a consistent message. Employees 

also need to understand the basis for pay decisions and how those decisions are made 

to bolster their perceptions of fairness, which is critical to job satisfaction.40

The third aspect relates to openness about pay outcomes: the disclosure of pay data 

at the organizational and individual levels. Some organizations publish information 

on their intranet websites regarding the distribution of performance ratings 

and accompanying bonuses and pay increases, without revealing any identities. 

Employees can view the data to see how they compare to others on the performance 

continuum and to learn the full range of monetary consequences associated with 

improving their performance (or allowing it to decline). Even fuller disclosure would 

reveal pay increase amounts by individual, although this appears to be a much less 

common practice despite the fact that the specific details on Federal employees’ pay 

and awards are considered public information. Revealing individual outcomes may 

generate jealousy and misunderstandings, especially when employees are not in a 

position to accurately evaluate their peers’ contributions. Releasing information on 

the aggregate level enables organizations to manage the message by clarifying what 

needs to get done to achieve a certain level of reward and demonstrating that the 

organization delivers what is promised.

Ongoing evaluation of the system. To ensure that the pay for performance 

system is operating as intended, organizations should conduct ongoing data analyses 

to evaluate the system’s impact. These analyses should provide a comprehensive 

perspective on the effects of the pay system at various points in time, comparing, for 

example, pre-implementation measures with data for the system as it progresses and 

when it becomes firmly entrenched in the organizational culture. The focus of the 

analyses will vary according to organizational emphases, but issues such as fairness, 

cost, and the distribution of funds should be relevant to every agency.

At a minimum, organizations should conduct some basic analyses of data from 

the human resources management data files to ensure that the system is operating 

in a fair, efficient, and effective manner. For example, agencies should compare 

performance ratings, salary levels, and pay increases by various demographic 

groupings, while keeping other factors in mind, such as employees’ tenure, 

education, and job series. They should also monitor the frequency (as a percentage 

of the population) of bonuses or increases and their amount to ensure that the 

distribution is consistent with organizational philosophy. Finally, agencies need to 

develop objective measures to help examine the impact of the pay system 

on outcomes.

40 L. Alan Witt and Lendell G. Nye, “Gender and relationship between perceived fairness of pay or 

promotion and job satisfaction,” Journal of Applied Psychology, 276(4), Dec. 1992, pp. 910–917.
34 Designing an Effective Pay for Performance Compensation System

Pay for Performance Decision Points

To assure the fairness of pay for performance systems, organizations should also 

evaluate the relationship between performance-based pay increases (and other 

pay increases) and sex, race and national origin (RNO), grade, occupation, and 

similar variables.41 Assuming that these analyses do not reveal patterns of apparent 

discrimination, publicizing them should further bolster employees’ perceptions that 

the process is fair.

Review process. To facilitate consistent treatment of employees, some 

organizations have instituted a review process to examine ratings (and anticipated 

pay increases) within work groups or across parts of the organization. The reviewers 

may utilize demographic data, especially on sex and RNO, to identify disparate 

treatment of individuals by group membership. Managers may be required to justify 

individual ratings with summaries of employee accomplishments, although review 

panels are generally hesitant to overrule ratings because this would undermine the 

rater’s authority.42 The review panel may also question patterns of ratings that show a 

higher average for one group or organization than for others. In response, a manager 

may need to demonstrate that the team has made above average contributions to 

organizational goals, thus warranting greater bonuses.

Appeals process. The credibility of a pay for performance system may be greatly 

enhanced by establishing an appeals process to provide employees a means to 

challenge rating or pay decisions that they believe to be unfair. That process could 

involve employees presenting their cases before an impartial panel tasked with 

reviewing these disputes.

Summary

Clearly, no one model exists for how to design, implement, and operate a pay 

for performance system. While agencies can learn from the experience of others, 

ultimately, each organization must consider the issues carefully in order to make the 

best decisions given their unique circumstances.

Although paying for performance requires attention to an extensive list of serious 

issues, considering them in advance of implementation enables organizations to 

lay the groundwork for a successful performance-based compensation system. 

Since many of the decisions are interrelated, it is critical that they be considered 

simultaneously. While one best answer may not be readily apparent, agencies must 

consider the best information that they can gather during the design phase. Upon 

implementation, an ongoing effort to evaluate results and adjust the system as 

necessary should be viewed as a logical and critical aspect of supporting the system.

41 Michael M. Harris, Brad Gilbreath, and James A. Sunday, “A longitudinal examination of a merit 

pay system: Relationships among performance ratings, merit increases, and total pay increases,” Journal 

of Applied Psychology, 83(5), 1998, pp. 825–831.

42 Michael O’Donnell, “Creating a performance culture? Performance-based pay in the Australian 

public service,” Australian Journal of Public Administration, 57(3), 1998, pp. 28–40.
A Report by the U.S. Merit Systems Protection Board 35

Pay for Performance Decision Points

Change—especially change as momentous as introducing pay for performance—

creates stress in an organization. When agencies embark on significant changes with 

low levels of trust in place, employees frequently experience anxiety about how they 

will be impacted. However, properly building, implementing, and operating a pay 

for performance system can actually serve as a tool for developing trust between 

supervisors and employees. For example, a review of the Department of Defense 

demonstration projects typically found that after a few years, many employee 

concerns regarding pay for performance were proven unfounded as employees 

became comfortable with the new system.43 Therefore, the fear of the unknown may 

be overcome if the right approach is taken.

43 U.S. General Accounting Office, “Implementing Pay for Performance at Selected Personnel 

Demonstration Projects,” GAO–04–83, Washington, DC, January 23, 2004, and U.S. Office 

of Personnel Management, “Summative Evaluation 2002 DoD S&T Reinvention Laboratory 

Demonstration Program,” Washington, DC, August 2002.
36 Designing an Effective Pay for Performance Compensation System
A Report by the U.S. Merit Systems Protection Board 37

Conclusions and Recommendations

Because of the longstanding practice in the Federal Government of basing pay 

primarily on position tenure, shifting to pay for performance will require careful 

planning, implementation, and operation to facilitate the organizational change that 

produces a performance-based organizational culture. Such organizational change 

impacts readiness for implementing pay for performance, but agencies need not wait 

for the ideal organizational culture to be present before they move forward. Pay for 

performance can serve to drive an organizational culture in the desired direction.

Agencies must tailor pay for performance systems to their mission and 

environment. Pay for performance focuses attention on the monetary aspect of the 

relationship between employees and organizations. However, the greatest changes 

that pay for performance effects in individual and agency performance are probably 

those stemming from increased emphasis on defining and communicating goals 

to employees, providing concrete feedback, and heightening employees’ sense of 

responsibility for contributing to well-defined portions of their organization’s goals. 

To ensure that employees’ efforts are aligned with agency priorities, supervisors 

need to take the agency’s unique goals, needs, and environment into account when 

defining employee objectives.

For pay for performance to be effective, agencies need to meet certain 

requirements. 

These include:

1. A culture that supports pay for performance;

2. A rigorous performance evaluation system;

3. Effective and fair supervisors; 

4. Appropriate training for supervisors and employees;

5. Adequate funding;

6. A system of checks and balances to ensure fairness; and 

7. Ongoing system evaluation.
38 Designing an Effective Pay for Performance Compensation System

While many of these requirements relate to effective human resources management 

practices that are important to any organization, pay for performance further 

increases their necessity. Attending to these human resources management issues 

provides agencies with a much greater likelihood of achieving a fair and effective pay 

for performance system.

To make pay for performance successful, agencies need to make a 

substantial investment of time, money, and effort. Pay for performance 

systems require substantial initial and continuing investment. These resources must 

be carefully spent on building and maintaining a system that suits the organization’s 

mission and objectives.

Performance evaluation serves as the foundation of a pay for 

performance system. An effective performance evaluation system is a 

fundamental prerequisite of pay for performance. Agencies must be able to 

communicate with employees regarding what the organization values and how 

it will accurately measure employee contributions to these goals. Without this 

information, agencies would be unable to appropriately distribute performancebased pay increases and bonuses.

Agencies should select supervisors based on their supervisory 

potential, develop and manage them to function as supervisors rather 

than technicians or staff experts, and evaluate and pay them based on 

their performance as supervisors. Because supervisors play a pivotal role in 

pay for performance systems, it is essential that they be able and willing to perform 

the important supervisory functions inherent in performance-based pay systems. 

To achieve this goal, agencies must select, train, and pay supervisors based on their 

demonstration of qualities that are suited to a pay for performance environment.

Communication, training, and transparency are essential elements 

of a good pay for performance system. The key to the effectiveness of a 

pay for performance system rests with clarifying the mission and objectives of 

the organization, how these are linked with employees’ efforts, and consequently, 

what competencies, behaviors, and/or outcomes the organization values. Open 

communication regarding goals and progress; training in the philosophy and 

mechanics of the pay system; and transparency regarding how the system operates 

can mobilize the workforce in the desired direction.

Checks and balances are necessary. Agencies can greatly facilitate the real 

and perceived fairness of the pay system by building in appropriate checks and 

balances. Although knowledge about the agency’s pay for performance plan and 

transparency regarding its outcomes can help supervisors and employees understand 

how the system should work, other mechanisms to ensure fairness are needed to 

further raise and maintain confidence in the system.

Conclusions and Recommendations
A Report by the U.S. Merit Systems Protection Board 39

A pay for performance system needs sufficient funding to provide high 

performing employees with meaningful pay increases and bonuses. 

Being able to provide high performers with meaningful pay increases is critical to 

operating an effective pay for performance system. Therefore, agencies need to have 

adequate funding to support pay increases for those who deserve them. 

Pay for performance systems should be evaluated regularly and 

modified when necessary. Agencies should conduct an ongoing evaluation of 

the compensation system to help them ascertain whether organizational goals are 

being met and identify ways to improve the process.

Summary

In this report, we have discussed requirements of a successful pay for performance 

environment. Table 3 summarizes the characteristics that organizations should 

demonstrate to most effectively support pay for performance. However, taken 

as a whole, these qualities represent an ideal setting that exists in few, if any, 

organizations. Given that organizations cannot (and should not) wait for perfect 

circumstances to begin to implement pay for performance, agencies should keep 

these features in mind as a goal, and work towards them.

Fortunately, if done correctly, implementing a performance-based pay system can 

also help agencies move in the direction of these critical success factors—if they 

understand how pay for performance can help them reach these goals. Agency 

leaders need to understand that they have enormous discretion and can select from 

a multitude of options to build a performance-based pay system that will work well 

under their unique circumstances. The greatest challenge for many decision makers 

is likely to be making the choices that will best enable their pay system to help them 

to achieve their goals.

Conclusions and Recommendations
40 Designing an Effective Pay for Performance Compensation System

Table 3. Features of a Successful Pay for Performance Environment

Organizational culture 4 Organizational culture supports the concept of pay for performance.

4 Organizational leaders demonstrate commitment to a performancebased pay strategy through their words and actions.

4 Open communication is present.

4 A high degree of trust exists betw+een supervisors and employees.

4 Human resources management systems support pay for performance. 

For example, an effective performance management system is critical to 

support a pay for performance system, and both should be built on the 

same values.

Training 4 Supervisors and employees receive advance and ongoing training that 

covers both the mechanics of the system and its underlying philosophy.

Supervisors’ role 4 Supervisors treat employees fairly when assigning work, evaluating 

performance, and allocating rewards. 

4 Supervisors monitor and document employees’ performance on a 

regular basis throughout the assessment cycle and provide feedback that 

is timely, accurate, and meaningful.

4 Supervisors assist poor performers, through measures such as feedback 

and training, to help them to improve their performance. If their 

performance does not improve, the employee may be subject to an 

adverse action, such as a pay reduction.

4 Supervisors have the necessary discretion to make personnel decisions.

Performance evaluation 4 Supervisors and managers are held accountable for ensuring that 

performance ratings distinguish between levels of performance.

4 Performance measures have been carefully designed to encompass the 

most critical outcomes.

4 Performance is evaluated at the appropriate level.

4 Employees understand how their individual performance supports 

organizational outcomes.

Fairness 4 The system includes checks and balances to ensure fairness.

4 Pay and bonuses are distributed according to performance.

Funding 4 Adequate funding ensures that employees receive compensation that 

corresponds to their contributions.

Evaluation 4 The compensation system is evaluated on an ongoing basis to 

ensure that it is accomplishing the desired objectives in a fair and 

cost-effective manner.

4 Measures of employee attitudes, such as employee engagement and 

motivation, as well as outcome indices, are tracked and analyzed to 

determine the impact of pay and other factors on employee satisfaction 

and performance. 

Conclusions and Recommendations
A Report by the U.S. Merit Systems Protection Board 41

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