Every company wants to improve employee performance and retention. And one of the best ways to do both is by making merit increases a part of your salary review process.
Merit pay is a type of pay-for-performance incentive, which rewards employees for high performance by permanently increasing their salary—usually by a small percentage. It’s usually conducted on an annual basis (and sometimes semi-annually) as part of a salary review process.
When your company is in its early stages, merit pay is usually simple to implement: you increase salaries on every employee's anniversary based on their performance.
However, when you multiply that by 50, 100, or several hundred people the administrative burden of working on individual anniversaries becomes too difficult. Plus, budget predictability, consistency, and fairness issues can start to rear their heads.
That’s why every salary review process should include an important tool: a merit matrix, also known as a salary increase matrix or an increase guidelines matrix. These tables act as guidelines that help companies calculate merit pay increases consistently and (arguably) more fairly. And, when they’re built right, they can also prevent overspending and ensure better distribution of funds across teams and individuals.
In this article, we’ll show you how to build a merit matrix (with examples) that meets the needs of your HR and finance functions, empowers managers to make smart salary recommendations, and fairly rewards employees for their performance.
Questions to Ask Yourself Before Building a Merit Matrix
Before we can get into the numbers, you’ll need to define your merit pay goals.
Building your matrix should be largely based on the following four factors:
- The values and behaviors you want to promote
- How much discretion you want to give your managers
- How flexible your budget is
- The capacity or resources your team has to administer a merit pay system
1. Values and Desired Behaviors
Company values and the behavior you’d like to reward should influence your merit matrix.
For example, if you want to drive individual performance over company-wide metrics, you may want to give more weight to performance scores—especially to high-performers.
Conversely, if you value pay equity or long-term retention, you’ll want a system that incorporates your employee’s position in their pay band vs. using just performance alone.
If your company wants to lead the market in salaries, you’d likely offer bigger merit pay increases compared to a company that lags the market (but offers different types of incentives).
2. Level of Manager Discretion
Direct managers are often involved in suggesting merit pay increases since they know employee performance best. But sometimes merit pay is given to employees from HR or executives with less individual performance taken into account.
Your approach should (once again) depend on your culture and values. For example:
- If you have a strict budget and don’t want to allow any personal bias to influence pay increases, you should give managers smaller increase ranges and base a portion of merit pay on salary band position or overall company performance.
- If you want to empower managers to reward and motivate employees, giving them larger increase ranges will work best. However, they will need more guidance, training, and reviews from HR to avoid exceptions or going outside of pay bands.
3. Budget Constraints
Before you build your merit matrix, you need to have a projected spend in mind. Budgets are usually created by multiplying your total payroll by a certain percentage. (According to Payscale, 2023 merit budget increases most commonly fell between 3-5%.)
To create your budget, you must also know:
- Who is included in your merit pay cycle? (All employees? Employees who haven’t had a pay increase in a while? Just some departments?)
- How often/when will you review and implement merit pay? (Semi-annually? Annually? How long after performance reviews?)
- How much you can afford to pay? (What is finance able to allocate for salary increases? How much is for promotions vs. merit increases? What are industry benchmarks for merit increase budgets? What’s the cost of not increasing pay and having higher turnover?)
- How flexible are you willing to be with your budget? (How much flexibility do you want to provide in the guidelines you give to managers? How much more do you want to reward your high performers—and how will this impact your forecasts? How much can you budget to push those who are lower in their salary bands up?)
4. Resources to Administer Merit Pay System
Merit pay cycles can get complex quickly. Manager training, budget approvals, spreadsheets, calculations, employee communications, reviews, and generating raise letters can take up a massive amount of time each cycle.
If you have a small HR team and few tools to automate the process, a complex merit system would be difficult to administer. (We explain which ones are the easiest to implement below.)
If you have an HRIS for pulling employee data, clear pay bands, a matrix formula (in a spreadsheet or in your compensation management software), and other automation tools, expanding the factors that influence your merit system may be advisable. More variables often mean more flexibility for managers to reward employees and move team members within their pay bands.
How to Create A Merit Matrix
With a compensation philosophy and budget in hand, you’re ready to build your merit matrix.
Your matrix is designed with two things in mind: your percentage increase guidelines and the variables you’ll base pay increases on.
Step 1. Pick Your Guidelines: Single Value vs. Range
Your increase guidelines tell managers how much of a pay increase they can give to staff. It’s usually either a single value (e.g. 4%) or a range (e.g. 3-5%).
A single value serves as an increase target and means there is less variability in pay increases—which may reduce bias, decrease widening pay gaps, and prevent going over budget. However, it’s also less flexible and may not allow you to give top performers meaningful pay increases compared to lower performers.
A range of values gives managers a set of percentage ranges (from low to high) that they can award to employees based on performance. Generally, most team members will fall somewhere around the midpoint.
This method more strongly rewards employees for their individual contributions. It also gives managers more flexibility to reduce pay increases for low performers or prevent people from going over their band. However, it’s more likely than a single value to increase the potential for bias to influence pay.
Step 2. Pick Your Merit Increase Variables: Performance vs. Pay Bands
Now it’s time to decide what other variables you want to impact merit-based pay increases. There are three main variables that will impact an employee’s merit pay: their performance alone, performance and position within their pay band, and performance and compa-ratio.
A. Performance-Based Matrix
A performance-based guideline matrix gives employees a percentage increase based on their performance rating alone. High performers receive larger increase percentages than low performers.
Performance ratings usually fall within three to five different intervals based on your performance management ratings that you use at your organization. No matter how much you do or don’t give, it’s important to have a measurable performance appraisal system that employees understand so there’s little room for bias or confusion about how pay is calculated.
Pros: Simple to explain to managers and employees; Easiest to administer; Motivates employees around individual performance and contributions.
Cons: Doesn’t take past pay increases, position in band, or other factors into account; Bias can play a small factor in ratings or increases; Lower performers may feel demotivated; May expand pre-existing pay gaps.
Best Used When: Your organization has not established salary bands; You are just starting out with merit pay increases; Don’t have a large team or a lot of resources to administer merit pay; Need to drive individual performance and goals to reach company objectives.
B. Performance + Compa-Ratio Matrix
This type of merit matrix considers an employee's position in their pay band when calculating their merit pay, in addition to their personal performance. In this calculation, band positions are defined by a compa-ratio—a ratio that indicates how far from the midpoint of a band someone is, with 1.0 being the middle).
Most matrices will use three or four intervals to group positions within the band (e.g. breaking them into quartiles). Those with high compa-ratios (e.g. above 1.2) typically receive lower percentage increases than those at the lower end (e.g. below 0.8) and the midpoint. The goal is for high performers with lower compa-ratios to have an opportunity to “catch up” with those who are already at the top (or maybe over) their pay band.
This system prevents employees from getting raises that would take them beyond their pay band. It can also help identify those who are potentially too low in their band and deserving of a higher increase based on their performance and contributions
Pros: Aligns pay to both performance and market pay (via compa-ratio); Can help reduce pay disparities and increase pay equity; Allows managers more options for influencing pay increases.
Cons: Employees with high compa-ratios may receive lower increases and require extra bonuses (such as a one-time or lump sum bonus) or promotions to remain motivated; Does not take into account whether employees are below or above their pay band; Harder to calculate, explain, and administer than a performance-based matrix alone.
Best Used When: You have salary bands for each role; Are committed to pay equity and reducing pay gaps for similar work levels or experience; Don’t want to use performance alone in your merit system to drive behavior; Use compa-ratio as your primary pay band metric (i.e. focus on employee pay relative to the midpoint of each band); Are comfortable and have resources to administer mildly complex calculations for pay raises.
C. Performance + Range Penetration Matrix
This type of merit matrix also considers an employee's position in their pay band when calculating merit increases. However, for this calculation, band positions are defined as range penetration—a percentage that shows how high an employee is within their band, with 100% being the top of the band and 0% being the bottom of the band.
Range penetration takes into account each employee’s position in their pay band, which can provide more control for people below or above their pay band. It can also be a bit easier to explain band position as a percentage out of 100 to employees compared to a compa-ratio, which is a ratio that is based on the mid-point of the pay band (and does not flag if employees are outside of their pay bands).
Pros: Aligns pay to both performance and market pay (via range penetration); Allows guidelines to take into account employees who are above or below their pay band; Can reduce pay disparities and increase pay equity; Allows managers more options for influencing pay increases;
Cons: Employees at top of band may receive lower increases and require extra bonuses (such as a one-time or lump sum bonus) or promotions to remain motivated; Harder to calculate, explain, and administer than performance-based matrix alone.
Best Used When: You have salary bands for each role; Are committed to pay equity and reducing pay gaps for similar work levels or experience; Don’t want to use performance alone in your merit system to drive behavior; Use range penetration as your primary pay band metric; Are comfortable and have resources to administer mildly complex calculations for pay raises
Testing Your Merit Increase Scenarios
Once you’ve built your merit matrix, you’ll want to run a few scenarios to project your spend to see if you’ll stay within the merit increase budget you’ve allocated. (This will require you to have employee performance data, salary band information, as well as a tool—either a spreadsheet with formulas or a compensation management tool—to make quick calculations for you.)
Your employees will have a wide array of performance ratings and (if using a two-variable merit matrix) different positions in their bands. So, to test your merit matrix, you may want to run scenarios assuming every manager follows the guideline exactly.
Even small changes to percentages can make a big difference to your budget at scale.
If you’re under budget, it may be worth offering managers wider ranges for performance ratings or it could also be an opportunity to bring your budget down. You could also consider offering lump-sum payments from the budget for exceptional performers or those at the top of their band who you wish to retain.
If you’re struggling to stay within your budget, you may need to take your projections to your CFO or Finance Team to get more budget for rewarding employees. Although many budgets come top-down, it should always be a two-way conversation so employee retention and performance stay top-of-mind.
Merit Pay: Part of a Complete Compensation Review Strategy
With the right variables in your matrix, you should be able to strike a balance between motivating employees and keeping your finance team happy.
When it comes to retaining employees through compensation, there are still market shifts, bonuses, promotions, and other factors to consider. Learn how Barley.io makes it easy to design and deliver compensation reviews at scale. Book a demo now.