Merit Pay

Why Merit Pay Actually Fails (And How to Make it Work in 2025)

Merit pay promises to reward top performers with salary increases of about 3% on average, but does merit pay actually deliver on this promise? While this compensation approach aims to boost productivity and retain high-performing talent, we’ve seen troubling examples like the Veterans Health Administration scandal of 2014, where performance metrics led to falsified records and significant patient care issues.

Despite some success stories—such as the Teacher Advancement Program reducing students scoring “below basic level” in math by 46%—merit based pay systems often fall short of expectations. In fact, these systems typically rely on subjective evaluations that can create feelings of jealousy and unfairness among employees. Although the merit pay definition sounds straightforward—rewarding employees based on performance—implementing an effective merit pay system requires substantial resources and careful planning. Throughout this article, we’ll examine where merit pay goes wrong and how organizations can make it work effectively in 2025.

Why merit pay was created in the first place

“On the surface merit pay is a simple concept: it is extra money awarded for achieving predetermined results, scores, or goals.” — National Center on Performance Incentives, Research center studying performance incentives in education

The concept of rewarding employees based on their performance didn’t appear overnight. Merit pay emerged from specific historical and psychological foundations that continue to shape compensation systems today.

The original merit pay definition

Merit pay represents a fundamental shift in how organizations compensate their workforce. Merit pay (also called pay-for-performance) is a compensation strategy where employees receive additional financial rewards for meeting or exceeding specific performance criteria. What makes merit pay unique is that unlike standard raises based solely on tenure, it’s directly tied to an individual’s job performance, often measured against pre-established company goals or benchmarks.

The theoretical underpinnings of merit pay run deep. The concept has its roots in behavioral psychology and incentive theory. These theories operate on the principle that people are rational actors who respond to incentives, and that with the correct catalyst, you can increase performance. Essentially, merit pay systems assume that linking financial rewards to specific achievements will motivate employees to perform at higher levels.

Historical context and early adoption

Initially, the merit pay journey began in education. The earliest documented implementation of merit pay in the United States occurred in 1908 for teachers in Newton, Massachusetts. This initiative set a precedent for performance-based compensation that would eventually spread to various professional fields.

The evolution of merit pay followed a winding path. In the early 1800s, interest developed slowly as rural communities provided only room and board for teachers with minimal educational requirements. The early 1900s saw increasing urbanization and public interest in education, leading to the development of educational and certification requirements.

Following World War I, merit pay was introduced more broadly, though most plans disappeared during the Great Depression of the 1930s. During the first half of the 20th century, a teacher’s gender, race, and level of instruction were more likely to determine salary than equity or performance. By 1950, approximately 97% of school systems in the United States had adopted a single salary schedule.

The Russian launch of Sputnik in 1957 triggered renewed interest in merit pay as concerns about science education grew. Consequently, by the early 1960s, more than 10% of school systems were experimenting with some form of merit pay. Nevertheless, this momentum wasn’t sustained, and by 1972, half of these plans had been abandoned due to lack of interest and funding.

Why it gained popularity in education and sales

Merit pay experienced a significant revival following the 1983 publication of “A Nation at Risk,” which specifically recommended that teacher salaries be “professionally competitive, market-sensitive, and performance-based”. This report reignited interest in merit pay across educational systems nationwide.

The Teacher Advancement Program (TAP), created by the Milken Family Foundation in 1999, represents a prominent example of merit pay implementation. Currently, TAP operates in more than 180 schools throughout the United States. Under this program, salary increases depend on teacher performance measured through classroom observations and student test scores.

Federal support significantly bolstered merit pay adoption. In 2006, Congress established a $50 million federal grant program called the Teacher Incentive Plan (TIF). This program expanded in 2009 with additional funding from the American Recovery and Reinvestment Act. Furthermore, the federal government has awarded more than INR 168.76 billionacross more than 30 states to design and implement performance pay systems.

The appeal of merit pay extends beyond financial considerations. Schools implementing merit pay systems demonstrate an improved ability to attract qualified teachers, particularly in schools with lower socioeconomic status. Additionally, proponents argue that this approach aligns with private sector management principles and potentially leads to better educational outcomes.

Research has shown promising results. A RAND study found that 50% of schools with merit pay reforms outperformed control schools in math, while 47% showed better results in reading. These findings continue to fuel interest in merit pay across various sectors despite implementation challenges.

Where merit pay systems go wrong

“The result was that teachers and administrators became obsessed with financial rewards and punishments, and curriculums were narrowed to include only the testable basics.” — Boston Globe, Major American newspaper

Despite noble intentions, merit pay systems frequently fall short in practice. The gap between theory and implementation reveals several critical flaws that undermine their effectiveness.

Subjectivity in performance evaluations

The cornerstone of any merit pay system—performance evaluation—is inherently flawed. Most evaluations rely heavily on 90-day reviewfor new comers and otherwise, subjective judgments rather than concrete measurements. Surprisingly, 53% of employees believe their performance reviews are based on subjective opinions rather than objective data. This subjectivity occurs when clear criteria aren’t established, when evaluators lack proper training, or when personal factors influence the evaluation.

Even with the best intentions, we’re all susceptible to subjective biases. As one HR expert notes, “Even the most data-driven performance reviews are subject to bias”. This subjectivity creates a shaky foundation for compensation decisions that significantly impact employees’ livelihoods.

Favoritism and morale issues

When subjective evaluations determine financial rewards, perceptions of favoritism naturally emerge. Employees who receive less favorable merit increases often believe their managers favor other colleagues, regardless of actual performance assessments.

These perceptions poison workplace relationships. Merit pay plans frequently create problems in employee morale related to jealousy, fear, favoritism, undesirable competition, and job insecurity. Instead of motivating better performance, these systems can devastate team dynamics.

Ironically, merit pay programs tend to develop divisive and competitive attitudes rather than cooperation among employees. When employees compete for limited salary increase budgets, collaboration suffers. This competition between employees might directly contradict contemporary organizational design objectives of teamwork and cooperation.

Overemphasis on short-term results

Merit pay structures typically reward immediately measurable achievements. This focus creates an environment where employees prioritize short-term wins over long-term value creation. In companies with less positive cultures, the promise of merit pay may motivate employees to act selfishly rather than in the best interests of the organization.

Moreover, merit-based systems can inadvertently encourage employees to focus exclusively on measured metrics while neglecting equally important unmeasured aspects of performance. When compensation ties directly to specific metrics, people naturally orient their work toward those measurements—sometimes at the expense of overall organizational health.

Lack of transparency in criteria

Perhaps most troubling, nearly half (46%) of employees cite a lack of pay transparency as a major issue. Without clear understanding of how merit decisions are made, employees struggle to connect their efforts to rewards.

The transparency problem extends beyond process to outcomes. Only 54% of employees believe they are paid fairly. This perception gap is even wider among women (49%) compared to men (59%), highlighting ongoing concerns about pay equity.

When employees feel pay decisions are arbitrary, motivation suffers dramatically. The perceived fairness of the merit pay system is crucial—if employees believe the process is fair and transparent, engagement improves. Conversely, when they perceive it as biased or unfair, disengagement follows.

To address these problems, organizations must:

• Establish clear, measurable standards for performance evaluations
• Train managers to evaluate effectively and minimize bias
• Communicate the merit pay process transparently
• Balance individual and team performance measures

Without addressing these fundamental flaws, merit pay systems will continue to underdeliver on their promise of motivating higher performance through fair compensation.

Real-world examples of merit pay failures

Looking beyond theoretical problems, several high-profile cases illustrate how merit pay systems fail when implemented in real organizations.

The Veterans Health Administration scandal

Perhaps the most infamous merit pay failure occurred at the VA. In 2014, the department paid approximately INR 11982.02 million in bonuses despite ongoing scandals. The VA improperly awarded INR 911.31 million in critical skill incentives to 182 senior executives, with individual payments ranging from INR 3290837.58 to over INR 8438045.08 each.

Notably, an internal audit revealed more than 120,000 veterans were left waiting or never received care while schedulers manipulated waiting lists to meet performance targets tied to bonuses. This manipulation occurred with the knowledge of senior managers. Indeed, every one of the 470 senior executives received “fully successful” performance evaluations for four consecutive years.

The consequences were severe. By April 2014, the VA had paid approximately INR 16876.09 million for nearly 1,000 veterans’ wrongful deaths. In one stark example, VA regional director Michael Moreland received a bonus of approximately INR 5315968.40 despite a Legionnaires’ disease outbreak that killed six veterans.

Mixed results from the Teacher Incentive Fund

The Teacher Incentive Fund (TIF) was widely “viewed as a failure,” primarily because of poor implementation. Teachers frequently didn’t understand what they were being evaluated on or why they received extra pay. As one expert noted, “Schools would roll this out, but not communicate it well, so teachers had no understanding of what specifically they were being measured on”.

In reality, relying exclusively on specific measures of teacher quality sometimes backfired dramatically. In Colombia, a merit based pay system for teachers actually decreased students’ performance on high school exit exams by 8% of a standard deviation and reduced college enrollment and graduation by more than 10%, despite increasing pre-college test scores of teachers.

Corporate case studies with unintended consequences

Corporate merit pay systems often contain fatal flaws that guarantee failure. When merit increases alone won’t assure competitive pay, employee disappointment over perceived unfair treatment can lead to reduced morale, disengagement, and eventually separation.

Ironically, the merit pay process typically works well for one cycle but fails long-term. As one analysis concluded, “unless one gets promoted on a regular basis the ‘system’ actually works against you”. Management often touts these programs as effective while employees learn that “quitting and getting rehired is a sure way to get the money you deserve”.

To make matters worse, many organizations emphasize individual “superstar” performers at the expense of team contributors. This approach misses the subtle ways that certain employees help their colleagues shine without generating remarkable individual statistics themselves.

What makes a merit pay system actually work

Effective merit pay systems aren’t impossible—they just require thoughtful design and consistent execution. When implemented correctly, merit pay can boost motivation and align individual efforts with organizational success.

Clear and measurable performance standards

The foundation of any successful merit pay system begins with transparent benchmarks. Organizations must develop precise, quantifiable performance standards that employees can understand and strive toward. These criteria should be specific to each role and reflect both individual and team contributions. Beyond just setting standards, companies need to clarify what constitutes poor, adequate, and exceptional performance, with corresponding merit increases for each level. Subsequently, these standards must be documented in a formal merit pay policy that all employees can access.

Frequent and fair feedback loops

Annual reviews alone won’t support effective merit based pay. Instead, successful systems implement regular check-ins—weekly, monthly, or quarterly—to evaluate progress. This continuous feedback helps employees make real-time adjustments before formal evaluations. Hence, workers receive timely recognition for achievements and can address improvement areas promptly. This approach reduces bias by basing merit increases on performance over time rather than a single review.

Alignment with company-wide goals

For merit pay to truly work, individual performance standards must connect directly to organizational objectives. When companies tie compensation increases to accomplishing strategic goals, employees better understand what the organization values. Thus, abstract mission statements transform into actionable tasks with financial incentives. This alignment ensures employees recognize how their contributions affect the company’s success, fostering purpose and enabling more focused work.

Training managers to evaluate effectively

Managers need comprehensive training to implement merit pay fairly. This training should cover recognizing and avoiding personal biases, using objective criteria consistently, and communicating compensation decisions effectively. Moreover, organizations should conduct calibration meetings where managers review ratings across departments to ensure consistency and fairness. Primarily, this process helps identify and address pay equity issues before they become systemic problems.

How to design a better merit pay system in 2025

As we move toward 2025, designing an effective merit pay system requires embracing technological advancements and human-centered approaches. Companies facing compensation challenges need modern solutions that address traditional pitfalls.

Use of data and analytics for performance tracking

First and foremost, data analytics plays a crucial role in optimizing merit pay processes. Organizations using compensation management software experience 42% fewer compliance issues related to compensation practices. Likewise, companies leveraging predictive analytics can decrease employee attritionby up to 30%. Salesforce demonstrated this by analyzing performance metrics and market trends, resulting in a remarkable 30% decrease in turnover rates within one year.

For effective implementation:

• Track key metrics like employee retention rates, engagement levels, and productivity to measure program effectiveness
• Conduct regular market salary analyzes to understand compensation perceptions
• Utilize predictive modeling to prevent wage compression and align increases with market trends

Incorporating employee input into goal setting

Simultaneously, employee involvement creates buy-in. Approximately 70% of employees report feeling more valued when companies take a tailored approach to compensation. Above all, organizations should engage employees in developing performance criteria, fostering ownership and ensuring metrics reflect actual roles.

Balancing team and individual rewards

Team-based merit pay enables traditional organizations to move closer to innovative compensation structures. Through implementing team incentives alongside individual rewards, companies foster cooperation rather than unhealthy competition. This balanced approach helps align merit increases with both personal achievements and organizational objectives.

Ensuring legal and ethical compliance

Correspondingly, compliance remains non-negotiable. Research indicates 79% of organizations report challenges ensuring compliance with shifting regulations. Pay transparency laws continue expanding across states, creating compliance complexities for employers. In addition to legal requirements, ethical considerations demand that merit pay systems eliminate favoritism and evaluation inconsistencies through leveraging quantifiable data.

By addressing these four critical areas, organizations can transform merit pay from a problematic incentive into a powerful performance driver.

Conclusion

Merit pay stands at a crossroads as we approach 2025. Although the concept promises to reward top performers and drive organizational success, traditional implementations have frequently fallen short of expectations. Data clearly shows that subjective evaluations, perceptions of favoritism, and lack of transparency can transform well-intentioned merit pay systems into organizational liabilities rather than assets.

The Veterans Health Administration scandal serves as a stark reminder of what happens when merit pay incentivizes the wrong behaviors. Nevertheless, this doesn’t mean we should abandon merit pay entirely. Rather, organizations must reimagine these systems with both technological innovation and human psychology in mind.

Effective merit pay systems require four essential components. First, clear and measurable performance standards eliminate subjectivity. Second, frequent feedback loops ensure employees understand their progress throughout the year. Third, alignment with company goals connects individual efforts to broader organizational success. Finally, manager training prevents bias from undermining the entire system.

Looking toward 2025, companies must embrace data analytics to track performance objectively while simultaneously involving employees in goal-setting processes. This balanced approach addresses the fundamental tensions that have historically plagued merit pay implementations.

The ultimate question remains whether your organization will repeat past mistakes or design a merit system that genuinely drives performance. Merit pay can work—but only when built on fairness, transparency, and measurable outcomes. Organizations that master this challenge will undoubtedly gain significant competitive advantages through improved retention, engagement, and productivity in the years ahead.

FAQs

Q1. What are the expected merit pay increases for 2025? 

Merit pay increases are projected to be around 3.3% in 2025, which is consistent with the rate for 2024. This slight dip from previous years is attributed to a cooling labor market, with employers planning for more modest pay raises compared to recent years.

Q2. What are the main challenges associated with merit pay systems? 

The primary challenges of merit pay systems include subjectivity in performance evaluations, perceptions of favoritism among employees, overemphasis on short-term results, and lack of transparency in criteria. These issues can lead to decreased morale, unhealthy competition, and misalignment with long-term organizational goals.

Q3. How can organizations design an effective merit increase strategy? 

An effective merit increase strategy should include clear and measurable performance standards, frequent feedback loops, alignment with company-wide goals, and proper training for managers. It’s crucial to use data analytics for performance tracking, incorporate employee input in goal setting, and balance individual and team rewards.

Q4. Why do merit pay systems often fail to achieve their intended goals? 

Merit pay systems often fail due to subjective evaluations, lack of transparency, and poor communication. They can also create unintended consequences, such as fostering competition instead of collaboration, and may not accurately reflect an employee’s overall contribution to the organization.

Q5. How is technology changing the implementation of merit pay systems? 

Technology, particularly data analytics and compensation management software, is revolutionizing merit pay systems. These tools help in tracking performance objectively, predicting attrition, ensuring compliance, and aligning increases with market trends. They also enable more frequent and accurate performance assessments, leading to fairer and more transparent merit pay decisions.