Incentive compensation, or “pay for performance” plans are becoming standard practice. In the past two decades, the percentage of companies using such pay systems has risen from approximately 50 percent to 90 percent. Executive pay based on stock prices has mirrored this trend.

The intent behind tying compensation to performance is, of course, to boost performance.

But does this actually work?

Studies show that in many circumstances incentive pay does increase performance—in some cases as high as 49 percent. It may also increase job satisfaction, commitment to the organization, and trust in management.

This makes sense. If employees are compensated for working harder, it’s natural for them to work harder. If they feel their extra efforts are recognized and valued, they will feel more satisfied with their jobs and managers.

However, there are also downsides to incentive compensation that managers should keep in mind.

Impacts are limited to top performers

For instance, a nine-year study of Major League Baseball players showed that while higher pay did increase the performance of those at the top of the pay scale, it was related to worse performance for other players.

The researchers believe that lower-paid players felt less motivated and committed due to a sense of injustice or resentment.

The issue is that “fairness” is relative, not absolute.

Employees naturally use others’ pay as benchmarks for satisfaction with their own. A person’s pay signals their value relative to others in the organization. When someone feels that they deserve more money, they can become resentful, and may even decrease their performance to match what they see as low pay.

It can lead to less cooperation

Incentive compensation tends to be based on individual performance. In fact, the only incentive schemes that have been shown to improve performance are those tied to individual performance.

But these incentives can undermine cooperation and work relationships. In the same baseball study, teams with the largest differences in pay among players also had lower winning percentages, ticket sales, and team value—likely due to decreased cooperation.

It makes sense, if you’re paid based solely on hitting your own performance targets, why would you sacrifice precious time and energy helping others?

Incentives can encourage shortcuts

When big rewards are in place for meeting certain goals, individuals are more likely to cross ethical lines to attain them.

In addition, external rewards can sap internal motivation for the job. When this happens, individuals might take the easiest path to the reward, caring less about the quality of the process and what they are producing.

Is incentive compensation right for your company?

Incentive compensation makes the most sense for jobs that aren’t naturally rewarding and don’t require intensive teamwork.

That doesn’t mean you should abandon incentive schemes for other kinds of jobs, but it does mean that you should consider other levers that have been shown to increase performance.

For jobs that are naturally rewarding and do require cooperation, make sure that the right conditions are in place so that employees maintain their high internal motivation.

You can do this by fostering employees’ sense of autonomy, mastery, purpose, and connection.

• • Autonomy is having some freedom to decide how, where, and when to work.
    

• • Mastery is the opportunity to develop more specialized skills and expertise.
    

• • Purpose is the feeling that one’s work is meaningful.
    

• • Connection is the sense that one is valued as part of the community.

The next time you are looking to increase performance, you might have better luck if you don’t pay for it.