What is incentive-based compensation?

Incentive-based compensation, also known as incentive compensation or incentive pay, is a form of compensation that employers provide employees to encourage strong performance. When implemented effectively, research shows that companies with financial incentives tied to specific outcomes achieved a nearly fivefold increase in total shareholder returns compared to companies without them. This compensation is separate from the employee's guaranteed salary or hourly rate. It's a variable component of their compensation that acts as an additional way to reward or encourage them.

How does incentive compensation work?

Incentive compensation works by linking employee rewards directly to specific, measurable performance goals set in advance. When employees hit these targets, they receive predetermined rewards like cash bonuses, stock options, or other benefits.

When those goals are met, the incentive—whether it's a cash payment, stock options, or another reward—is paid out. Unlike a base salary, this compensation is variable and directly tied to performance. The key is that the rules are established upfront, making the process transparent and predictable for both the employer and the employee.

Incentive compensation plan examples

Employee incentives fall into two main categories:

• Monetary incentives: Direct financial rewards like cash bonuses, commissions, and equity

• Non-monetary incentives: Valuable perks like flexible work arrangements and wellness programs

Common monetary incentive examples include:

• Company equity

• Stock options

• Sales commissions

• Profit sharing

• Performance-based raises

• Gift or debit card rewards

Companies can also provide employees with non-monetary incentives. Some annual incentive plan examples include flexible work arrangements and wellness programs.

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A good example of a monetary incentive is a sales-based incentive. Sales-based incentive compensation is ideal for employees who are responsible for talking to customers and closing sales, and the effect on earnings can be substantial. For example, U.S. Bureau of Labor Statistics data shows that sales workers with incentive pay earned $35.31 per hour on average, more than double the $15.82 per hour earned by those on time-based pay. Employers often structure these incentive plans as a percentage, like 5% of all the deals each sales rep closes. So if a sales representative's employer offers this incentive-based compensation and the worker is responsible for $100,000 in sales over the year, her incentive payment would be $5,000.

What are the characteristics of the best incentive compensation plans?

Creating an incentive compensation program can be tricky—get it wrong, and you'll face unintended consequences. Take Wells Fargo's incentive compensation system, where poorly designed goals led employees to act unethically.

To create the best possible incentive pay plan, make sure it meets the key criteria below.

Consistency and fairness

Poorly structured incentive compensation plans can quickly lead to resentment between coworkers. You can prevent this by making your incentive program as consistent and fair as possible. Evaluate all your workers based on their work and check in regularly to ensure that managers are applying the incentive pay fairly.

Simplicity

The incentive program should be simple—both for your employees to understand and for your company to operate. If employees don't understand the program, it won't motivate their performance. And if the program is too complicated to administer, the costs may outweigh the benefits for your company.

Measurability

Tie your incentive payment directly to measurable metrics. In sales-based positions, for example, you can measure performance for incentives with metrics like total revenue, average sale value, or call volume. It may be difficult to quantify performance for employees in other positions, but you still need to use clear, easily measurable metrics for them as well. In fact, research shows that tracking nonfinancial impact in addition to financial metrics can result in higher total shareholder returns.

Attractiveness

Here's the balance you need to strike: make incentives attractive enough to change behavior, but not so generous that they break your budget. For example, to maintain wage equality, one company in a McKinsey study chose to cap the maximum payout for individuals at 80% of their annual salaries, ensuring rewards remained substantial but controlled. If rewards are too small, employees won't care—too large, and you'll hurt your bottom line.

Does incentive pay actually work?

So, do incentive pay programs actually work? The answer is yes—when designed properly, they're highly effective at driving employee behavior. While many companies use incentive programs, adoption is not universal. One study found that even when undergoing a major business transformation, only two-thirds of companies adopt a financial-incentives program to motivate their teams.

Is incentive pay the same as a bonus?

People often use the phrases "incentive pay" and "bonus" interchangeably when discussing compensation. While bonuses can be incentive pay, there are many other types of compensation incentives. Bonuses are also generally not guaranteed or communicated ahead of time the way incentive plans are.

Incentive plans aim to influence employee behavior and motivate your workforce to perform better. Bonuses are more general and almost always offered as cash or cash equivalents. Incentives are more varied since they can include travel, memberships, and perks like additional leave.

Building effective incentive programs globally

Designing a fair and motivating incentive plan is a powerful way to align your team and drive results. But when your team is distributed across different countries, complexity grows. You have to navigate different currencies, local compensation norms, and compliance rules to ensure your incentives are both attractive and legal everywhere.

A global employment platform simplifies this by providing the tools and local expertise to manage total rewards for a distributed workforce. This allows you to offer competitive, compliant incentive compensation that motivates your team, no matter where they live. Ready to build a truly global team? Start hiring globally with a partner that makes it simple.

FAQs

How is incentive compensation calculated?

Incentive compensation is calculated as a percentage of performance metrics, fixed amounts for goals, or tiered structures. The exact formula depends on your plan design.

What is an example of incentive based compensation?

A sales commission is a classic example—like earning 5% of closed deals. Project-based bonuses for meeting deadlines are another common type.

What is meant by incentive compensation?

Incentive compensation means performance-based rewards beyond base salary that motivate employees to achieve specific goals.