Designing incentive compensation management plans

Cash bonuses and commissions can motivate employees to meet or exceed their goals. But strong incentive compensation plans can do far more than promise a payout. A well-designed plan can help attract and retain top talent while pushing the company toward its core objectives.

Here, we walk you through the essential details of designing incentive plans so you can build pay programs that move the employee experience and the business forward. 

Key takeaways

• Incentive compensation is pay tied to hitting pre-defined targets or milestones. It’s not part of an employee’s base salary. 
• Incentive compensation management is the work of running those plans. It includes the tools and procedures used to administer them. 
• Plans can include bonuses, commissions, company equity, and other forms of variable pay. 
• The most effective plans are transparent and reward the behaviors that most directly contribute to the company’s success. 
• Purpose-built tools like compensation management software can cut down on the administrative burden and help keep payouts accurate. 

What is incentive compensation management?

Incentive compensation is the pay an employee earns for achieving established goals. Employees often have to put in more time and effort to hit these targets, but the financial upside often makes the trade worthwhile. 

Typically, employees receive incentive pay on top of their base salary. But some sales professionals work purely for commission, where the incentive structure is the compensation. 

Incentive compensation management involves: 
 

• Designing incentive plans 
• Tracking employee progress toward defined metrics 
• Calculating incentive payments and issuing them on time and according to the agreed metrics 
• Creating and distributing incentive compensation statements 
• Communicating program details to eligible employees 
• Auditing programs for effectiveness and fairness 
• Adjusting plans as the economy or business strategy shifts 

Simply offering incentive pay isn’t enough. When building compensation strategies, make sure they're transparent and well-governed. Also, be sure to apply them consistently across eligible employees.  

Poor plan management can lead to negative consequences, such as employee turnover or budget overruns. Research published in Employee Relations found that pay transparency is associated with lower turnover intentions, especially when employees perceive the organization as fair. 

Types of incentive compensation management plans

Incentive plans come in several forms, and it’s not uncommon for companies to use more than one. The major options each work differently: 
 

Plan type	How and why paid	When paid	Best for
Cash bonus	A one-time paycheck boost for hitting a target	Typically semi-annually or annually	Any employee your company deems eligible
Commission	A payout of a percentage of sales revenue generated in each period	Often bi-weekly or monthly	Sales roles
Company equity (e.g., stock options or restricted stock units)	Partial company ownership granted for goal achievement	Often vests over several years	Managers and executives
Profit sharing	A one-time payment when the organization is profitable	Typically annually	Any employee your company deems eligible

The right mix usually depends on timing considerations. Short-term plans like commission push employees to perform now because the reward arrives quickly. Long-term plans like equity work in the other direction, building loyalty and patience by tying financial upside to staying with the company. 

Strategies for designing incentive plans

Developing effective incentive compensation plans can be challenging, especially if it’s your first time rolling out these pay programs. Here are some plan design best practices that can help you get it right:  

Start with business outcomes you want to reward

An individual employee achieving their goals should move the company toward its objectives. That means leadership must clearly define organizational targets before setting expectations for your people.  

Different company focal points will require different employee efforts. For instance, a company intent on increasing market share could want workers to focus on lead generation. A business focused on increasing customer lifetime value may want employees to focus on upselling. 

Choose metrics people can influence

If you want your incentive compensation plan to motivate team members to hit their targets, those targets should meet a few standards. They should be: 
 

• Limited in number: Too many competing priorities can dilute an employee’s focus, setting them up to fail. 
• Measurable: Managers and employees should be able to objectively gauge progress and document it within the company’s performance management software. 
• Challenging, but attainable: Realistic stretch goals help workers develop while moving the needle for the organization. 
• Role-based: Objectives should align with employees’ existing responsibilities, so they don’t pull them away from their core duties. 
• Balanced: Team members should focus on financial, operational, and strategic metrics to holistically improve the business. 

Remember: Employees must be able to influence their odds of success with their behavior. Otherwise, achievement feels left to chance, which can be demotivating. 

Design a clear payout structure

A well-designed incentive plan lets any eligible employee answer these questions without having to ask: 

• Am I eligible for this pay program? 
• What are my targets? 
• What do I earn when I hit my goals? Can I earn a partial payout for hitting sub-milestones? 
• How is the payout calculated? 
• When will I see the money in my paycheck or the equity credited to my account? 
• How can I track my progress? 

The best incentive compensation plans are easy to understand and rewarding enough to drive desired behaviors. 

Establish governance for fairness

An incentive compensation plan should be a net positive for your company, but introducing one has some potential risks. Here are a few possible pitfalls:  

• Employees may become less inclined to collaborate with their coworkers if they are hyper focused on hitting their individual targets.  
• Workers could prioritize quantity over quality, leading to buyers’ remorse (and canceled sales), product defects, or customer dissatisfaction. 
• Team members might disengage if there’s even a hint of favoritism in plan administration.  

One way to potentially mitigate these risks is by consistently applying plan rules to all eligible workers and implementing plan governance. An example is to include a claw-back clause in your plan documentation, which gives the company the right to recoup commission paid to an employee if a customer cancels an order within a certain timeframe or the sale was made unethically.  

Use technology to simplify incentive compensation

Tracking incentive compensation eligibility, goals, and payouts is hard enough with a small team. It becomes nearly impossible if you have a large workforce or a complicated program. Compensation management software is designed to handle that administrative load and support fair plan administration. Approved awards flow directly into payroll, which helps keep payments accurate and timely.  

Benefits of a strong incentive compensation strategy

An effective incentive compensation program can create value for both employees and organizations. Here are the key perks at a glance: 
 

Employee benefits	Company benefits
Additional income or firm equity  Professional development   Increased job satisfaction and engagement  Greater stability through longer tenure	Organizational growth  Better employee retention, which helps strategic workforce planning  The ability to attract top talent  Improved financial planning (with accurate incentive pay tracking)

The bottom line: When administered properly, incentive pay programs can give employees a clearer path to growth and rewards, while organizations can benefit from a more motivated, committed workforce. 

Streamline your incentive compensation management

Incentive pay rewards employees for driving business results. When compensation reflects their contributions to the company, chances are they’ll be more invested in the company’s future. 

As you’re designing incentive plans for your organization, be sure to research the latest compensation management trends and the best tools to implement your strategy. The right platforms can help cut down on manual work and give leaders the insights they need to make confident decisions. 

Frequently asked questions

What is an incentive compensation plan?

An incentive compensation plan is a pay program that rewards eligible employees for meeting or exceeding predetermined performance targets. Depending on your plan's design, employees could earn short-term incentives, such as cash bonuses, or long-term incentives, such as stock options. 

How do you design an incentive compensation plan?

To design an incentive plan, you must determine: 

• Who is eligible to receive incentive pay 
• What eligible employees must accomplish to earn each incentive (goals should support overall company goals) 
• How the incentive compensation gets paid out (e.g., commission, bonus, equity, or profit sharing) 
• When employees can expect payouts, such as monthly, quarterly, or annually 

What metrics should be used in an incentive compensation plan?

Incentive compensation plan metrics should align with the employee’s role and the organization’s objectives. For instance, a sales representative may have a revenue quota to hit, with their success positively contributing to the company’s bottom line. 

What are common mistakes in incentive compensation plan design?

A few common mistakes companies make when designing incentive compensation plans include: 

• Prioritizing short-term results over long-term gains 
• Making the plan too complicated to understand and efficiently administer 
• Failing to communicate the plan clearly to employees 

How can technology improve incentive compensation management?

The right software can help ease the administrative burden of managing incentive compensation plans. Sophisticated tools can automatically calculate payouts, share that data with payroll, and give employees real-time visibility into their progress. 

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