Employers are taking a new look at the old way of compensating workers. Familiar reward mechanisms, such as the annual seniority-based salary hike and the automatic year-end bonus, are increasingly viewed as relics in need of retooling.

It's no mystery why: Faced with increasing competition for the discretionary dollar and the modern requirement for a lean and mean profit machine, employers feel a greater need to inspire worker loyalty and dedication to the bottom line. The conventional reward system isn't getting the job done.

The root problem is that the tools employers use to stimulate achievement are too often considered entitlements by recipients, according to Ian Jacobsen, president of Jacobsen Consulting Group of Sunnyvale, Calif.

“I have yet to meet an employee who, on the first pay day after a raise, says, 'Wow! Look at my paycheck. I'm going to bust my buns for the company and strive for my very best because I am so pleased with what I am making,'” he says.

Worse, the best employees can feel trapped in a tradition-bound salary structure.

“The top performer who sees a slacker receive the same 4 percent annual bonus recognizes an inequity,” cautions Daniel Moynihan, a principal at Compensation Resources of Upper Saddle River, N.J. “This breeds discontent. Without a better incentive to work hard, the employees will tend to do just enough to get by.”

Meanwhile, ongoing salary increases and bonuses bloat payrolls until labor costs exceed value received and the business becomes uncompetitive.

Enter “pay for performance,” intended to tie a portion of compensation to the actions individuals take to enhance business profitability and, in the process, spark motivation.

“If you don't tie pay to performance, you are not using what is potentially a very powerful tool,” says Mae Lon Ding, president of Personnel Systems Associates in Anaheim, Calif. “Given that employee compensation is one of the greatest expense items on most business income statements, it's a terrible waste to not use it as effectively as you can.”

Performance-based salary increases and bonuses are sometimes referred to as “at risk” compensation. Because of the link between achievement and pay, the employee who fails to get results risks losing money, while the go-getter takes home a fatter paycheck. The goal is a win-win situation for employer and worker.

“Performance-based pay provides an opportunity to keep fixed compensation low while providing variable incentives to employees,” points out Moynihan. “Suppose you pay an individual a $50,000 salary and offer a 10 percent incentive based on personal and business success. The high achiever makes a bonus. But if objectives are not met, the employee still gets $50,000.”

The benefits of this alternative pay structure are not just for big players. Pay for performance is just as critical for smaller organizations, where the work of any one individual accounts for a greater portion of the organization's total labor cost.

“The whole performance culture is pervasive in business,” says Moynihan. “We're talking about every business, from the large corporation right down to the one-person shop with an assistant.”

The challenge for employers is to identify quantifiable workplace results that employees feel they can influence with their daily actions. But what sounds easy in theory can be difficult in practice.

“To do this right requires a significant effort to establish standards and objectives and then to measure performance against them,” says Ding.

Many employers start by designing reward systems for their salespeople, whose work can often be assessed more easily than support staff.

“Tracking the level of sales for each person is important,” notes Ding, adding that racking up sales is one thing; cultivating loyal customers is another. “Try to identify who is selling to specific customers and how often. Salespeople should be rewarded for creating customer loyalty.”

The opposite can also be true: The salesperson who makes a great number of sales may also have a rushed, impatient manner that irritates your customers.

“It's important to have a bonus plan that rewards employees for quality customer service,” adds Ding. “One great way to measure customer service is to use the telephone, a mailed survey or the Internet to find out how happy people are with your organization.”

Tracking the work of salespeople by the ring of cash registers is somewhat self-evident. But how about all those support people on your staff?

“The biggest challenge is finding a way to measure performance that is fair and reasonable,” explains Moynihan. “For results-based measurement you need to ask, 'What is this person's job and how well are they doing it?'”

Perhaps a receptionist answers the phone before three rings or greets customers in a cheerful and professional way. Or perhaps she volunteers for extra work.

“It's not always easy. Every organization is different,” Moynihan says.

Ding suggests a source for guidance: “Consider asking employees how they measure their own performance. Often you will hear good ideas.”

She adds that high-performance employees are not lone rangers; they work well with others. Identify team performance parameters and set suitable bonuses for team members, she says.

The same consideration applies to company performance: Part of the individual's compensation should be tied to the larger picture. That's where profit- sharing plans can come into the picture.

The traditional year-end bonus comes with a significant downside: Because the employee loses sight of the bonus through the year, it loses its ability to motivate.

“The employee who gets a larger bonus than expected may be extra motivated for a week or two, but the value melts with time,” cautions Jacobsen.

Usually, employees have long lost track of how the extra compensation ties into their workplace activities, viewing the additional money more as the result of luck than as a reward for work well done.

Far better are periodic performance-based bonuses accompanied by coaching, a combination that sets up anticipatory feelings of success. Keep employees continually informed about their progress, suggests Ding—at least once a quarter and ideally once a month.

“The value of an incentive plan actually comes before the payout, when people are informed about how well they are doing against your plan objectives,” she says.

The goal is to maintain what consultants call a “line of sight” between deed and reward. When this is present, the employee understands how his or her performance affects business profitability and the rationale for the compensation increase.

And what if things are going badly? Even then people can be motivated.

“Employees want a chance to make in-course corrections,” explains Ding. “If you get to the end of the year and your employees are shocked to find they did not meet their objectives, they become very demoralized. Your program can turn into a 'disincentive plan.'”

Visual cues can also help get your message across.

“Preferably, the ways for tracking performance should be easily understood and sufficiently timely that employees can monitor their progress to make corrections when they are falling short,” advises Jacobsen. “I've used a thermometer, or a couple of them, when the measures were easily displayed that way. I've used a dashboard or control panel when there were several critical measures. Display them in a place where everyone covered by the plan can see them, so everyone stays focused.”

To make a difference, performance-based compensation must represent a large enough portion of an individual's total pay.

“Money only motivates when there is a significant amount clearly tied to performance,” cautions Edward Lawler, director of the Center for Effective Organizations at the University of Southern California and author of the book “Rewarding Excellence.”

Maybe the at-risk money must be substantial, but it is also wise to proceed slowly to avoid upsetting employees who may question the value of your new system. Rather than trying to drastically reduce the amount of salary increases that are based on seniority, gradually adjust the total compensation package so a growing portion is tied to individual and team performance.

A gradual approach will allow you to obtain feedback from individuals who are participating in the program. It's easy to make mistakes in identifying the performance parameters you want to reward. A system that creates an unproductive link between performance and pay can lead to profit-busting workplace dysfunction.

“Employees will tend to spend all of their time on tasks that maximize their paycheck—and such tasks may not represent the best use of time for your business,” cautions Lawler.

An obvious example, he adds, is the salesperson that devotes every minute to selling a certain item that has a high incentive tied to it. What makes your cash registers ring more often may alienate customers for whom the touted item may not be the best selection.

You will need to ferret out the “sweet spot” in terms of what portion of total pay should reflect performance. At many successful businesses, “at risk” pay comes in around 20 percent of compensation. But the figure can be far higher—sometimes double take-home pay—at smaller organizations or in entrepreneurial departments of larger firms where employee achievement is especially critical to success.

Higher-level employees often respond more enthusiastically to performance-based compensation. They more readily understand the concept of tying employee actions to business profitability and they often possess more entrepreneurial zeal.

Such employees also tend to value the opportunity to increase their earnings with little risk.

“As salary becomes very high, say $70,000 and up, then [bonuses] can become a substitute for salary,” notes Ding. “In fact, many people at that level may prefer a bonus plan that offers the potential for higher income.”

Trading salary for bonus is good for both employer and employee: In a typical scenario, the latter gives up $1 of guaranteed salary in return for every $2 in potential bonus.

Conversely, lower level employees often fail the aforementioned “line of sight” requirement for connecting achievement with reward.

“It's hard for a receptionist to understand how what he or she does impacts profitability,” says Moynihan.

The lower the employee's salary, the higher the risk when trading guaranteed dollars for performance-based ones. Such compensation is generally a smaller portion of the total take-home pay for this group.

You might start your program with your managers and supervisors, then work it down to the staff. It's wise to gradually steer the program toward a harbor where every employee has a chance to reel in some tasty fish.

“I like reward systems in which everyone has the potential to participate and knows what they need to do to win,” says Jacobsen.

How do you track how well you're doing?

“First, ask people how they feel about the plan,” suggests Ding. “Second, observe people's behavior: Are they acting in a more motivated way and paying closer attention to things that are really important? Third, look at your financial performance: Is it improving?”

Assure success by continually expanding your plan's scope. Include more people and develop more refined performance-assessment parameters while soliciting feedback from participants. Maybe it's a lot of work, but the payoff can be considerable. And despite the time and effort required, experts say you really have no choice but to make this investment in your future.

“Performance-based pay has become an expectation and a norm,” concludes Moynihan. “Not having it will make you less competitive.”