Understanding Merit Increases, Merit Increase Grids, and Merit Budgets in Compensation Practices

by Mark Morgenfruh | Jul 13, 2025 | Compensation Practices

How does your organization diligently spend it’s merit increase budget so that you are rewarding top performers and decelerate the pace towards the range max for those in the top two quartiles?  We help every business in America 

Understanding Merit Increases, Merit Increase Grids, and Merit Budgets in Compensation Practices

In the landscape of employee compensation, merit-based pay remains one of the most widely used tools to reward and incentivize performance. Companies aim to motivate employees, retain top talent, and drive organizational goals by linking salary increases to individual achievements and contributions. Central to this approach are three interconnected concepts: merit increases, merit increase grids, and merit budgets.

This article explores each concept thoroughly, explaining their purposes, how they work, and best practices for integrating them into a fair and effective compensation program.

What Are Merit Increases?

Definition

A merit increase (sometimes called a merit raise or merit-based salary increase) is a salary adjustment awarded to an employee based on their job performance or contribution to the organization. Unlike cost-of-living adjustments (COLAs), which are generally across-the-board raises to keep pace with inflation, merit increases specifically reward individual achievement.

Purpose of Merit Increases

Merit increases serve several strategic objectives:

• Recognize Performance: They reward employees who exceed or meet performance expectations, signaling that excellence is valued.
• Motivate Employees: Linking pay to performance incentivizes employees to maintain or improve their productivity and engagement.
• Retain Top Talent: Providing competitive pay raises helps retain high performers who might otherwise seek better compensation elsewhere.
• Support a Performance Culture: Merit increases align compensation with business goals and individual accountability.

How Merit Increases Work

Typically, merit increases are expressed as a percentage of an employee’s current salary. For example, an employee earning $50,000 annually might receive a 4% merit increase, resulting in a new salary of $52,000.

The size of the increase depends on several factors:

• Performance Ratings: Companies often use performance appraisal ratings (e.g., exceeds expectations, meets expectations, below expectations) to determine merit increase eligibility and amount.
• Salary Position in Range: Employees closer to the maximum of their pay range might receive smaller increases.
• Budget Constraints: The total pool allocated for merit increases affects the amount distributed.
• Market Competitiveness: Employers consider external market conditions to ensure pay remains competitive.

Types of Merit Increases

• Standard Merit Increase: An annual raise based on performance evaluation.
• Spot or Lump-Sum Merit Bonus: A one-time payment for exceptional performance, which may not increase base pay.
• Promotional Merit Increase: A raise awarded when an employee is promoted, typically higher than a standard merit increase.

What Is a Merit Increase Grid?

Definition

A merit increase grid is a structured tool used by organizations to systematically determine merit increase percentages based on two variables:

• An employee’s performance rating.
• The employee’s position within the pay range (e.g., how close their current salary is to the midpoint or maximum of their pay range).

This grid serves as a guideline to managers, promoting consistency, fairness, and alignment with organizational compensation philosophy.

Structure of a Merit Increase Grid

Typically, a merit increase grid is displayed as a table or matrix. The vertical axis lists performance rating categories (e.g., exceeds expectations, meets expectations, below expectations), and the horizontal axis shows the employee’s salary position relative to the pay range (e.g., 0-50% of range midpoint, 50-75%, 75-100%, above 100%).

Each cell in the grid provides the recommended merit increase percentage. For example:

Purpose and Benefits of a Merit Increase Grid

• Consistency and Fairness: Ensures similar performance and pay position yield similar raises across the organization.
• Transparency: Helps managers understand how increases are calculated and communicate rationale to employees.
• Control of Pay Range Penetration: By linking increases to pay range position, the grid helps avoid overpaying employees near the top of their range.
• Budget Management: Facilitates alignment with overall merit budget by setting clear parameters for increase percentages.

How to Develop a Merit Increase Grid

• Determine Performance Categories: Establish clear and measurable performance ratings.
• Define Salary Position Bands: Segment pay range into meaningful bands that reflect pay progression stages.
• Set Increase Ranges: Establish minimum and maximum merit increase percentages for each cell, considering market data and company philosophy.
• Review and Adjust Regularly: Periodically update the grid to reflect business realities and market conditions.

What Is a Merit Budget?

Definition

A merit budget is the total pool of funds an organization allocates annually to fund merit increases for eligible employees. It represents the financial ceiling for merit-based salary adjustments and is typically expressed as a percentage of the total payroll.

For example, a company with $10 million in total payroll might allocate a 3% merit budget, equaling $300,000 available for merit increases.

Importance of Merit Budgets

• Cost Control: Helps organizations manage payroll expenses and avoid unplanned salary inflation.
• Strategic Alignment: Ensures merit pay aligns with company performance, profitability, and financial health.
• Equity and Fairness: Helps distribute merit increases fairly within budget constraints.
• Planning and Forecasting: Provides a framework for salary planning during budgeting cycles.

How Merit Budgets Are Determined

Several factors influence the size of the merit budget:

• Company Financial Performance: Strong financial results often translate into larger merit budgets.
• Market Conditions: Competitive labor markets may require higher merit budgets to attract and retain talent.
• Industry Practices: Benchmarking against industry peers informs appropriate merit budget levels.
• Employee Performance Trends: The distribution of employee performance ratings can affect total merit pay needs.

Allocating the Merit Budget

Once the merit budget is set, organizations must decide how to allocate it:

• Across-the-Board Percentage: Distributing the budget evenly as a flat percentage increase to all eligible employees.
• Performance-Based Allocation: Allocating different percentages based on performance ratings, guided by the merit increase grid.
• Salary Position Adjustment: Considering employees’ position in their pay ranges to ensure pay equity and avoid overpayments.

Challenges in Managing Merit Budgets

• Balancing Equity and Competitiveness: Ensuring top performers are rewarded adequately while maintaining internal equity.
• Budget Constraints: Managing limited budgets while meeting employee expectations.
• Handling Exceptions: Addressing outliers such as employees with salaries below market or those approaching the pay range maximum.

Integrating Merit Increases, Merit Increase Grids, and Merit Budgets

These three components form the backbone of merit-based compensation systems. When integrated effectively, they create a fair, motivating, and sustainable approach to rewarding employee performance.

Step 1: Set the Merit Budget

Start with determining the total merit budget based on financial performance, competitive data, and organizational goals. This budget caps total merit increases for the year.

Step 2: Develop or Update the Merit Increase Grid

Using the merit budget, design a merit increase grid that aligns with company pay philosophy and performance evaluation processes. The grid must balance:

• Rewarding top performers adequately.
• Avoiding excessive increases for employees near pay range maximums.
• Staying within budget limits.

Step 3: Evaluate Employee Performance and Salary Position

Managers assess employee performance and identify where employees fall within their pay ranges to determine appropriate merit increases using the grid.

Step 4: Allocate Merit Increases

Based on the grid and budget, allocate merit increases ensuring consistency and fairness across departments.

Step 5: Communicate Decisions

Clear communication to employees about merit increases—how they were determined and what they mean—is essential for engagement and trust.

Best Practices for Merit Increase Programs

1. Link to Robust Performance Management
   Merit increases should be based on thorough and fair performance evaluations, supported by clear goals and feedback.
2. Maintain Transparency and Consistency
   Use merit increase grids to standardize decisions and minimize bias.
3. Align with Pay Ranges
   Monitor employee pay relative to ranges to avoid red circling or green circling and adjust as necessary.
4. Monitor and Adjust Budgets
   Regularly review merit budget adequacy and adjust based on financial and market changes.
5. Train Managers
   Equip managers with tools and training to apply merit increase guidelines fairly and effectively.
6. Consider Broader Rewards
   Combine merit increases with other incentives like bonuses or career development opportunities for a holistic approach.

Conclusion

Merit increases, merit increase grids, and merit budgets are fundamental components of compensation practices that support fair, performance-driven pay management. Merit increases reward individual contributions, merit increase grids provide a structured framework for allocating raises consistently, and merit budgets ensure overall pay costs remain sustainable.

By integrating these elements thoughtfully, organizations can create compensation systems that motivate employees, retain key talent, and align rewards with business success. The challenge lies in balancing financial realities with the need to recognize and incentivize performance—a task made more manageable through disciplined merit increase planning and execution.

The Importance of Compensation Philosophy in Compensation Programs

by Mark Morgenfruh | Jul 13, 2025 | Compensation Practices

Hope is not a plan.  A plan is derived from strategic objectives.  Are you just winging it when it comes to your firm’s compensation program?  It’s the primary motivator for your employees.  Crafted well, every dollar can be optimized towards achieving your company’s objectives.  We help every business in America 

The Importance of Compensation Philosophy in Compensation Programs

Compensation is more than just a paycheck—it’s a signal to employees about what an organization values and how it rewards those values. At the heart of any effective compensation program lies a clear and coherent compensation philosophy. This foundational framework defines the organization’s approach to employee pay and benefits, guiding decisions related to salaries, bonuses, incentives, equity, and more.

A well-articulated compensation philosophy helps organizations stay competitive, support strategic goals, ensure fairness, and drive employee motivation and retention. Without one, compensation practices can become inconsistent, misaligned with company objectives, or unintentionally inequitable. In this article, we explore what a compensation philosophy is, why it matters, and how it influences every aspect of a compensation program.

What Is a Compensation Philosophy?

A compensation philosophy is a formal statement that outlines a company’s guiding principles and objectives related to employee pay. It addresses fundamental questions such as:

• How does the company define competitive pay?
• Does it aim to lead, lag, or match the market?
• What role do performance, tenure, skills, or team contributions play in determining pay?
• How will internal equity and external competitiveness be balanced?
• What mix of base pay, bonuses, and long-term incentives will be offered?

This philosophy becomes a strategic blueprint that supports business goals, shapes organizational culture, and fosters transparency and trust among employees.

Why a Compensation Philosophy Matters

1. Alignment with Business Strategy

A company’s compensation practices should directly support its strategic goals. For instance, a startup focused on rapid growth might emphasize equity and variable incentives over high base salaries. A mature, stable organization may prioritize predictable income and long-term benefits.

A clearly defined compensation philosophy ensures that pay practices support broader business outcomes. It allows leaders to answer critical questions, such as:

• Are we incentivizing innovation or efficiency?
• Do we want to attract top-tier talent or grow talent internally?
• Are we willing to pay a premium for certain skill sets?

When pay strategy reflects business priorities, compensation becomes a driver of strategic success.

2. Consistency and Fairness

Without a guiding philosophy, compensation decisions can become reactive or subjective. This inconsistency may lead to perceptions of favoritism, pay inequality, or misalignment across departments or locations.

A documented philosophy provides a framework for making consistent, equitable pay decisions across the organization. It establishes:

• Criteria for setting salaries and bonuses
• Guidelines for pay ranges and internal equity
• Standards for evaluating and rewarding performance

Consistency not only reduces risk of legal claims but also reinforces employee trust and satisfaction.

3. Talent Attraction and Retention

In competitive labor markets, compensation philosophy can make or break an employer’s brand. Candidates and employees want to know:

• Will my pay reflect my contributions?
• Is compensation fair compared to market norms?
• Are there opportunities to grow financially?

An attractive and transparent compensation philosophy demonstrates the company’s commitment to valuing its people. It can highlight the organization’s willingness to invest in talent, offering a compelling reason for candidates to join and stay.

Moreover, as pay transparency laws and candidate expectations evolve, more organizations are being held accountable for the fairness and logic behind their pay practices. A clear philosophy ensures that the story behind compensation is intentional and defensible.

4. Supports a Performance Culture

A well-constructed compensation philosophy emphasizes performance, achievement, and contribution. When employees understand how their actions impact their compensation—and how that aligns with company goals—they are more likely to be motivated and engaged.

For example, a performance-based philosophy may promote:

• Merit-based increases
• Goal-based bonuses
• Team-based incentives
• Recognition for innovation or customer satisfaction

By tying pay to performance, employers can reinforce desired behaviors and outcomes.

5. Legal and Regulatory Compliance

A strong compensation philosophy helps organizations remain compliant with federal and state wage and hour laws, pay equity regulations, and anti-discrimination mandates.

Key regulatory areas influenced by compensation philosophy include:

• Equal Pay Act and gender pay equity
• Fair Labor Standards Act (FLSA) compliance
• State-level pay transparency and salary history bans
• Executive compensation disclosures (for public companies)

A consistent philosophy ensures pay structures are based on objective criteria and reduces the risk of unintentional bias or legal violations.

Components of an Effective Compensation Philosophy

To be effective, a compensation philosophy should be tailored to the organization’s size, industry, culture, and goals. Common elements include:

1. Market Positioning: Whether the company pays at, above, or below market rates—and why.
2. Pay Mix: The balance of fixed (salary) and variable (bonuses, incentives) compensation.
3. Internal Equity: How fairness across roles, departments, and demographics is maintained.
4. Performance Linkage: How performance impacts pay and what performance is valued.
5. Total Rewards Perspective: How benefits, retirement, wellness, recognition, and career growth fit into the compensation ecosystem.
6. Communication and Transparency: The extent to which pay philosophy is shared with employees and how decisions are communicated.

Challenges in Implementing a Compensation Philosophy

Even with a clear philosophy, putting it into practice can be challenging. Common hurdles include:

• Budget Constraints: Financial realities may limit the ability to execute the ideal compensation vision.
• Market Shifts: Wage inflation, labor shortages, or economic downturns may force adjustments.
• Leadership Buy-In: Inconsistent messaging from leadership can undermine the philosophy.
• Communication Gaps: If employees don’t understand the rationale behind their compensation, engagement can suffer.

To overcome these challenges, HR leaders must regularly review and update their philosophy, align pay programs accordingly, and train managers on how to communicate pay decisions effectively.

Evolving Compensation Philosophies in a Remote and Hybrid World

The COVID-19 pandemic and subsequent shift to remote and hybrid work have forced organizations to revisit their compensation philosophies. Questions include:

• Should remote employees in lower-cost locations receive different pay?
• How does flexibility factor into the total rewards package?
• Should performance-based pay become more central as traditional supervision fades?

Many companies are moving toward more agile, skills-based, and inclusive compensation models. A strong, future-focused philosophy can provide a foundation for navigating these changes while staying true to core values.

Conclusion

A compensation philosophy is not just an internal document—it is a strategic tool that shapes how a company rewards its people, competes for talent, and reflects its values. By clearly defining how and why pay decisions are made, businesses can align compensation with culture, strategy, and performance. In a world where employees demand transparency, equity, and purpose, a well-crafted compensation philosophy is more important than ever.

Whether you’re building a new pay program or refining an existing one, the compensation philosophy should be your North Star—guiding decisions, promoting consistency, and ensuring that compensation works for both the business and its people.

The Concept of Red Circles in Compensation Practices

by Mark Morgenfruh | Jul 13, 2025 | Compensation Practices

The devil is in the details.  The finer points of a compensation program can have significant impact on attracting and retaining talent.  If these are blind spots for you and you’re at risk of losing top talent if they are offered more money at a competitor, give us a call.  We help every business in America 

The Concept of Red Circles in Compensation Practices

In the world of compensation management, red circling is a term used to describe a situation where an employee’s current salary exceeds the maximum of the established pay range for their job or grade. This creates a “red circle” around the employee’s pay, indicating that their salary is “above the range” and outside the typical salary band for the position.

Why Do Red Circles Occur?

Red circling usually happens for several reasons:

• Salary Range Changes: When an organization adjusts its pay ranges—often lowering the maximum limit—due to market conditions or budget constraints, some employees may find their salaries exceed the new maximum.
• Promotion or Reclassification Issues: An employee may have been promoted or moved to a new job with a pay range lower than their current salary.
• Longevity and Performance: Employees who have been with the company for many years or who have received consistent merit increases might outpace the pay range limits.
• Market Adjustments: Market rates can shift, and companies may update pay ranges accordingly. Employees hired before these changes might have salaries higher than what is now considered appropriate for their role.

Implications of Red Circling

While having employees paid above the pay range might seem like a reward for loyalty or performance, it creates several challenges:

• Equity Issues: New hires or colleagues performing the same job may earn less, causing morale or fairness concerns.
• Pay Compression: The salary gap between junior and senior employees can narrow, reducing incentives for advancement.
• Limitations on Future Increases: Employers may hesitate to grant raises to red circled employees since they are already paid above the range.
• Budget Management: It can strain compensation budgets, especially if multiple employees are red circled.

Managing Red Circles

Effectively managing red circled employees requires a thoughtful approach. Here are common strategies:

1. Red Circle Freeze
   • Employers may choose to freeze the red circled employee’s salary, meaning they do not receive further base pay increases until the pay range catches up or the employee moves to a new role.
   • This helps control costs but can be demotivating if not communicated well.
2. Range Reassessment
   • Organizations might revisit and adjust pay ranges to reflect current market realities, potentially reducing the number of red circles.
   • However, this approach can be costly and may not be feasible for all companies.
3. One-Time or Lump-Sum Payments
   • Instead of increasing base pay, companies may provide lump-sum bonuses to reward performance without permanently raising salary above the range.
   • This maintains pay structure integrity while recognizing employee contributions.
4. Job Reclassification
   • In some cases, employees can be moved to a higher pay grade or reclassified to better align salary with responsibilities.
   • This is only appropriate if job duties truly warrant a higher classification.
5. Communication and Transparency
   • Employers should clearly explain why an employee is red circled and what the future pay progression might look like.
   • Transparency helps manage expectations and reduces dissatisfaction.

When Red Circling Is Acceptable

Red circling isn’t inherently negative. In fact, it can be a sign that the company values employee experience, skills, or historical compensation levels. It also avoids the risk of demotivating long-term employees by cutting their pay.

However, it should be used cautiously. Employers must balance fairness, legal compliance, and budget considerations. Having many red circled employees can signal outdated pay structures or ineffective compensation management.

Conclusion

Red circling is a common and complex issue in compensation management, reflecting the dynamic nature of salary administration in evolving markets. While it poses challenges like pay equity concerns and budgeting constraints, thoughtful strategies can mitigate negative impacts. Companies that proactively address red circles with transparency and fairness maintain employee trust and keep their compensation programs aligned with market and business needs.

The Importance of Governance and Oversight for the Compensation Programs of Businesses

by Mark Morgenfruh | Jul 13, 2025 | Compensation Practices

Good fences make good neighbors.  Good governance around compensation programs does the same.  Codifying a compensation program and ensuring appropriate monitoring and oversight not only protect your company, but make it easy to be competitive, fair and consistent with pay practices across the entire organization. 

We help every business in America 

The Importance of Governance and Oversight for the Compensation Programs of Businesses

In today’s competitive and complex business environment, compensation programs are more than just mechanisms to pay employees. They are strategic tools that influence employee behavior, motivation, retention, and overall organizational performance. However, compensation programs can also be sources of risk — legal, financial, and reputational — if not properly governed and monitored. This is where governance and oversight of compensation programs become critically important.

This article explores why governance and oversight are essential for compensation programs, how they impact business success, the risks they mitigate, and best practices to implement effective governance.

Understanding Compensation Governance and Oversight

Governance in compensation refers to the policies, frameworks, and decision-making structures that guide how pay decisions are made, approved, and reviewed within an organization. It establishes the rules and responsibilities to ensure compensation aligns with company strategy, is fair, and complies with laws.

Oversight is the ongoing monitoring, evaluation, and control mechanisms that ensure compensation programs operate as intended and adhere to governance standards. Oversight activities may include audits, reviews, approvals, and reporting.

Together, governance and oversight provide a system of checks and balances, transparency, and accountability for compensation management.

Why Governance and Oversight of Compensation Programs Are Critical

1. Ensuring Alignment with Business Strategy

Compensation programs should reflect and support the strategic goals of a business. Whether the focus is on innovation, customer service, cost control, or growth, the way employees are compensated sends powerful signals about what the company values.

Governance frameworks ensure:

• Strategic fit: Compensation plans reward behaviors and outcomes aligned with business objectives.
• Consistency: Pay practices are consistent across departments and levels, reinforcing unified company priorities.
• Flexibility: Governance structures allow for adjustments as business strategies evolve.

Without governance, compensation can become fragmented or misaligned, undermining strategic execution.

2. Maintaining Internal Equity and External Competitiveness

Proper governance ensures that compensation programs balance:

• Internal equity: Fairness among employees within the organization, preventing pay disparities that can cause dissatisfaction and turnover.
• External competitiveness: Alignment with market pay rates to attract and retain talent.

Oversight mechanisms regularly review compensation data, benchmark against market surveys, and detect inequities or anomalies. This ongoing process is essential for maintaining workforce morale and preventing costly disputes.

3. Mitigating Legal and Regulatory Risks

Employment and labor laws, tax regulations, securities rules, and corporate governance requirements impose numerous legal obligations on compensation practices. For example:

• Laws such as the Fair Labor Standards Act (FLSA) regulate minimum wage and overtime.
• Executive compensation for public companies is governed by SEC rules and requires shareholder disclosures.
• Pay equity laws at federal and state levels prohibit discrimination.

Governance frameworks establish policies and approval processes to ensure compensation plans comply with these legal mandates. Oversight activities, such as audits and legal reviews, detect potential violations before they escalate into lawsuits, fines, or regulatory sanctions.

4. Enhancing Transparency and Accountability

Compensation governance demands clear documentation, approval hierarchies, and communication channels. Transparency in compensation decisions builds trust among employees, management, and stakeholders.

Oversight bodies, such as compensation committees or HR leadership, are accountable for ensuring compensation is administered fairly and according to policy. This accountability reduces risks of favoritism, fraud, or abuse.

5. Supporting Ethical and Sustainable Compensation Practices

Governance helps companies avoid excessive or inappropriate compensation, particularly for senior executives, which can trigger public backlash, harm reputation, and impact shareholder value.

Effective oversight incorporates:

• Clear policies on pay limits and incentives.
• Independent review of executive pay.
• Mechanisms to link compensation to long-term performance rather than short-term gains.

By embedding ethics and sustainability into compensation governance, companies promote responsible stewardship and long-term success.

6. Facilitating Effective Decision-Making and Cost Control

Compensation is often one of the largest expenses for a business. Without governance, decisions can be inconsistent or driven by personal biases, leading to uncontrolled payroll costs or misallocation of incentives.

Governance structures introduce:

• Budget controls and guidelines.
• Approval workflows that require justification and documentation.
• Periodic reviews to optimize compensation spending.

Oversight ensures adherence to budgets and financial discipline, balancing the need to reward talent with cost management.

Key Components of Effective Compensation Governance

1. Clear Policies and Procedures

Formal policies define:

• Pay structures and salary ranges.
• Eligibility for bonuses, raises, and promotions.
• Criteria for special compensation such as equity or commissions.
• Rules for handling conflicts of interest and confidentiality.

Written procedures guide managers and HR staff in administering pay fairly and consistently.

2. Defined Roles and Responsibilities

Governance identifies who is responsible for:

• Designing compensation programs.
• Making pay decisions.
• Reviewing and approving compensation changes.
• Monitoring compliance and performance.

Typically, a compensation committee (often part of the board for public companies), HR leadership, and finance departments share these responsibilities.

3. Use of Market Data and Benchmarking

Effective governance requires data-driven decision-making. Benchmarking compensation against industry peers and labor markets ensures competitiveness and fairness.

Regular market reviews and updates to compensation ranges and incentives keep programs relevant.

4. Regular Audits and Reviews

Oversight mechanisms include:

• Internal audits of compensation records, approvals, and compliance.
• Analysis of pay equity across demographic groups.
• Evaluation of incentive plan effectiveness and alignment with goals.
• Monitoring of regulatory changes and adjusting policies accordingly.

5. Transparent Reporting and Communication

Transparency to employees and stakeholders involves:

• Clearly communicating compensation philosophy and program details.
• Providing managers with training on compensation governance.
• Reporting compensation decisions and rationale to leadership and, where appropriate, shareholders.

Transparency supports trust and minimizes misunderstanding or grievances.

The Role of Oversight Bodies in Compensation Governance

Compensation Committees

In many companies, especially public ones, a compensation committee of the board of directors oversees executive pay and broader compensation programs. Their responsibilities include:

• Approving executive salary, bonuses, stock options, and other incentives.
• Reviewing compensation policies for alignment and compliance.
• Engaging independent consultants to advise on market practices and regulatory issues.
• Reporting to shareholders through proxy statements.

Their independence and expertise help ensure objectivity and reduce conflicts of interest.

Human Resources Leadership

HR professionals manage the day-to-day administration of compensation programs, provide data and analysis, and ensure consistent application of policies.

They collaborate closely with finance to align pay with budgets and with legal to ensure compliance.

Finance and Legal Departments

Finance ensures that compensation plans fit within financial constraints and reporting standards, while legal reviews programs to ensure compliance with laws and regulations.

Both provide critical checks in the governance framework.

Risks of Weak Compensation Governance and Oversight

Failing to establish strong governance and oversight mechanisms exposes businesses to significant risks:

• Legal and regulatory penalties from noncompliance.
• Pay inequities leading to employee dissatisfaction, turnover, or discrimination lawsuits.
• Excessive or inappropriate executive pay causing shareholder revolt or reputational damage.
• Fraud or unethical behavior such as manipulating bonuses or hiding compensation details.
• Financial losses due to uncontrolled compensation costs or poorly designed incentives.
• Strategic misalignment where pay programs fail to support company goals.

These risks can be costly in terms of money, reputation, and employee engagement.

Best Practices for Strengthening Compensation Governance and Oversight

1. Establish a Robust Governance Framework

Develop clear policies, assign roles, and document processes. Include mechanisms for periodic review and updates.

2. Promote Independence and Objectivity

Where possible, use independent committees or external advisors for executive compensation decisions.

3. Ensure Data-Driven Decision-Making

Use market data, analytics, and benchmarking tools to support pay decisions and detect anomalies.

4. Regularly Train Managers and HR Staff

Training on governance policies, ethical standards, and legal requirements empowers consistent and fair compensation management.

5. Foster Transparency and Communication

Communicate compensation philosophy and practices clearly to employees and stakeholders to build trust.

6. Implement Continuous Oversight and Audit

Perform regular audits, compliance checks, and program evaluations to ensure ongoing alignment and effectiveness.

Conclusion

Compensation programs are powerful tools that impact employee motivation, organizational culture, legal compliance, and financial performance. The governance and oversight of these programs are vital to ensure they operate effectively, fairly, and in alignment with business strategy.

Strong governance frameworks and vigilant oversight minimize risks, enhance transparency, maintain equity, and promote ethical pay practices. They enable organizations to reward talent appropriately while safeguarding financial and reputational integrity.

In a world where compensation scrutiny is intensifying—from regulators, investors, employees, and the public—businesses that invest in solid compensation governance and oversight are better positioned to achieve sustainable success and maintain competitive advantage.

Different Pay Raise Methods: An Overview of Strategies to Adjust Employee Compensation

by Mark Morgenfruh | Jul 13, 2025 | Compensation Practices

Everyone wants more money.  Not everyone deserves it.  Many don’t deserve as much as they think they do.  Some employees are underpaid and looking for another job.  How should you handle pay raises.  We help every business in America 

Different Pay Raise Methods: An Overview of Strategies to Adjust Employee Compensation

Compensation is a critical factor in attracting, motivating, and retaining employees. One of the primary ways organizations adjust compensation is through pay raises. However, not all pay raises are created equal—companies employ various methods to determine how and when to increase employee salaries. These methods reflect organizational priorities, market conditions, and philosophies about motivating employees.

This article explores the most common pay raise methods, including Pay for Performance, Cost of Living Adjustments (COLAs), and other important approaches such as Seniority-Based Raises, Market Adjustments, Promotional Raises, and Skill-Based Pay Increases.

1. Pay for Performance Raises

Definition

Pay for Performance (PFP) is a compensation strategy that links salary increases directly to an employee’s job performance. In this model, employees who demonstrate superior work, achieve or exceed goals, or contribute significantly to business success receive larger pay raises than those with average or below-average performance.

How It Works

Typically, organizations using pay-for-performance conduct formal performance appraisals annually or semi-annually. Based on ratings (e.g., exceeds expectations, meets expectations, below expectations), employees are awarded merit increases proportionate to their performance levels. This approach often uses merit increase grids to guide raise percentages.

Benefits

• Motivates High Performance: Employees see a clear link between effort and reward.
• Encourages Accountability: Performance management systems support business goals.
• Retains Top Talent: High performers are financially recognized, reducing turnover.

Challenges

• Subjectivity: Performance evaluations can be biased or inconsistent.
• Budget Constraints: Limited merit budgets may restrict raise sizes.
• Complex Administration: Requires robust appraisal and tracking systems.

2. Cost of Living Adjustments (COLAs)

Definition

Cost of Living Adjustments (COLAs) are pay raises granted to all eligible employees to offset increases in the cost of living, such as inflation or rising housing and food costs. COLAs are typically uniform across the workforce and are intended to preserve employees’ purchasing power.

How It Works

Employers review economic indicators like the Consumer Price Index (CPI) annually and adjust salaries by a percentage reflective of inflation. For example, if inflation is 3%, the company might grant a 3% across-the-board raise.

Benefits

• Maintains Purchasing Power: Employees are protected from losing real income due to inflation.
• Simple and Fair: Equal adjustment regardless of performance avoids perceived favoritism.
• Predictable Costing: Easier to budget since adjustments apply broadly.

Challenges

• No Performance Link: High performers and low performers receive the same raise.
• May Not Reflect Market Changes: COLAs don’t address competitiveness if market salaries rise faster.
• Inflation Volatility: Unexpected spikes in inflation can cause budgetary strain.

3. Seniority-Based Raises

Definition

Seniority-based pay raises reward employees based on their length of service with the company. The longer an employee stays, the more their salary increases, often at fixed intervals (e.g., annual increments after each year of service).

How It Works

Organizations set predefined raise schedules tied to tenure milestones. For example, after every two years, an employee might receive a fixed raise percentage.

Benefits

• Rewards Loyalty: Encourages long-term employment and reduces turnover.
• Simple Administration: Easy to calculate and implement.
• Predictable Costs: Organizations can forecast pay growth based on workforce tenure.

Challenges

• Ignores Performance: Employees receive raises regardless of work quality.
• May Promote Complacency: Without performance incentives, motivation can decline.
• Less Competitive: Does not adapt to market or individual contribution differences.

4. Market-Based Adjustments

Definition

Market-based pay raises adjust employee salaries to keep them competitive relative to prevailing market rates for similar roles. When market surveys show salaries rising faster than company pay, employers may provide raises to align with the market.

How It Works

Human Resources or compensation professionals conduct benchmarking surveys annually or periodically. If a position’s market rate exceeds current pay levels, employers provide adjustments, sometimes called market adjustments or market pay increases.

Benefits

• Keeps Compensation Competitive: Helps attract and retain talent.
• Targets Specific Roles: Addresses market discrepancies without broad raises.
• Supports Strategic Workforce Planning: Aligns pay with industry trends.

Challenges

• Requires Accurate Market Data: Poor data can lead to over- or under-adjustment.
• Can Create Internal Inequities: Raises for certain jobs might disrupt internal pay equity.
• Cost Management: Significant market shifts can increase payroll expenses unexpectedly.

5. Promotional Raises

Definition

Promotional raises are salary increases awarded when an employee moves to a higher-level position with increased responsibilities and scope. Unlike merit raises, which reward past performance, promotional raises recognize a change in job status.

How It Works

When promoted, employees typically receive a base pay increase reflecting the new role’s higher value. The raise often comes as a fixed percentage or a salary increase to a new pay range minimum or midpoint.

Benefits

• Recognizes Career Progression: Reinforces organizational hierarchy and development.
• Motivates Advancement: Encourages employees to seek growth opportunities.
• Aligns Pay with Responsibilities: Reflects added duties and complexity.

Challenges

• May Cause Pay Compression: Promotions may create narrow pay gaps between levels.
• Can Create Expectations: Employees might expect frequent promotions to advance pay.
• Needs Clear Criteria: Promotion decisions must be transparent to maintain fairness.

6. Skill-Based or Competency-Based Pay Raises

Definition

In skill-based pay systems, salary increases are awarded based on acquiring new skills, certifications, or competencies relevant to the job or organizational needs. This method rewards learning and development rather than just tenure or performance outcomes.

How It Works

Employees may receive structured pay increases for completing training, gaining certifications, or demonstrating proficiency in new skills. This system often ties to career pathways or competency frameworks.

Benefits

• Encourages Continuous Learning: Supports employee development and upskilling.
• Supports Organizational Agility: Builds workforce capabilities aligned with strategic goals.
• Promotes Internal Mobility: Employees can move across roles with relevant skills.

Challenges

• Complex to Manage: Requires clear standards and tracking systems.
• May Require Investment in Training: Development programs must be available and effective.
• Needs Alignment with Job Value: Raises should correspond to market value of skills gained.

7. Lump-Sum or One-Time Bonuses

Definition

Though not technically a pay raise, lump-sum bonuses are one-time payments awarded for exceptional performance, special achievements, or company profitability. Unlike salary increases, they do not affect base pay.

How It Works

Bonuses are paid out as a flat amount or percentage of salary, typically annually or after project completion. They provide immediate financial recognition without permanent salary increases.

Benefits

• Flexible Reward: Can be tied to specific results or events.
• Cost-Effective: Does not increase fixed payroll costs.
• Motivates Short-Term Performance: Encourages focus on immediate goals.

Challenges

• No Long-Term Impact: Does not contribute to ongoing compensation growth.
• Employee Expectations: Frequent bonuses can create entitlement.
• Tax Implications: Treated differently than salary for tax purposes.

8. Step Pay or Grade-Based Raises

Definition

Some organizations, especially in public sectors or unionized environments, use step pay systems, where employees move through defined pay steps within a grade or classification, earning increases based on tenure or performance.

How It Works

Employees progress through steps with predefined pay amounts, usually annually, often linked to satisfactory performance. This method blends seniority and performance considerations.

Benefits

• Predictable Pay Progression: Employees know what to expect over time.
• Simplifies Compensation Structure: Clear steps and grades aid transparency.
• Ensures Fairness: Reduces subjectivity in pay increases.

Challenges

• Limited Flexibility: Less room for exceptional performance rewards.
• May Be Slow to Reflect Market: Pay adjustments depend on grade structure.
• Can Demotivate High Performers: Lack of differentiation may frustrate top talent.

Conclusion

Selecting the right pay raise method depends on an organization’s culture, business strategy, financial health, and workforce demographics. Many companies use a combination of these approaches—such as providing COLAs to maintain purchasing power, merit increases to reward performance, and market adjustments to remain competitive.

Understanding the strengths and limitations of each method allows employers to design compensation strategies that balance fairness, motivation, retention, and cost control. Transparent communication about how pay raises are determined is equally vital to maintain employee trust and engagement.