What to Take Into Account When Giving Employees Raises

Filed under Managing the Workplace. Fact checked on May 24, 2012.

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Employers should review employee compensation on a regular basis and determine whether employee pay raises are warranted. Whether raises are the same across the board, performance-based or calculated using another method, a competitive compensation package is necessary to retain and attract the best employees.

A major part of attracting and retaining the best employees involves reviewing the compensation you are paying present employees and awarding raises as your business and the market demands. While there are as many ways of determining the amount of a raise as there are people determining it, the basic approaches to determine the amount of a raise is to give everybody the same percentage or dollar amount raise or give employees different raises based on equity between base wages or performance, also known as a merit system. Like most things, each approach has its pros and cons

The Same Raise Across the Board

Giving all your employees the same raise may seem like the simplest and least conflict-provoking method to use when granting raises. However, the fact that no one is singled out negatively also means that no one is recognized for outstanding work that goes above the bare minimum required of a position. Using this method may hurt morale and lead to a loss of inspiration in those employees that go the extra mile, in other words, the very employees you want to keep happy in your employ.

In addition, if you grant everybody the same raise based on a percentage, you can easily run into the same problems that occur when using wage bases to give raises, possibly resulting in poorly performing employees or newer ones getting much bigger raises than your star employees.

Using Base Wages to Give Raises

To make sure you stay competitive as an employer and retain your best employees, you can use base wages to determine employee raises. You'll have to keep on top of pay issues to make sure what you're paying is in line with the market for your area, your industry, and your job.

Work Smart

You can use methods similar to those used when determining pay for new hires.

Once you're convinced that your employees' pay is about what it should be for their occupation, if you have more than one employee, examine the pay equity within your business.

Pay compression. Do you have people who just joined the company that are making the same amount as people who have been there for years, but because of inflation the long-time employees' salaries did not keep pace with starting salaries of today? If this is the case, your company may be suffering from a problem common in business today called pay compression.

If senior employees find out that newcomers make as much as they do, you'll have problems with morale. Clearly, the only way around this problem is to make sure that long-term employees are paid more than newly-hired employees. If market conditions require that you give new employees more pay, you'll have to give older employees at least a little more as well.

Tip

Many business owners have the philosophy that raises should be linked strictly to the performance of the employee and that employee's contribution to the success of the business. If that's how you feel, you probably will not put as much credence in the idea that employees with more time in the business should make more than newcomers. In that case, focus on linking pay with performance.

Performance-Linked Raises

As a part of the process of coaching and motivating employees, most employers take some time every six months or every year to sit down with employees and discuss their performance. This practice is know as performance appraisal. In addition to talking with the employees about how they have been doing in performing their jobs, you can also use the performance appraisal to set goals for the employees for the period until the next time you evaluate performance.

How well the employees measure up to those goals can help you determine how much of a raise they deserve.

Pros and cons of linking pay and performance. Some experts say that linking pay and performance is not a good idea, and that pay should not be used to motivate employees to do a better job because they stop focusing on things like quality of work and how to improve their performance and start focusing on money and how much the raise is.

Others feel that pay for performance pits employees against one another in competition for the highest raises. That's why some businesses give the same, across-the-board raises to all employees. It eliminates competition and ensures that the whole workforce is working toward the same goal. But, if everyone gets the same raise, there is no motivation to exceed expectations and go the extra mile in the job. Only you can determine which approach will work best for your employees.

For better or worse, most companies use money to motivate employees in some form or fashion, whether it be by bonuses, commissions, cash awards, or bigger raises for good performance. The challenge for employers is coming up with a strategy that effectively links pay to performance.

Merit-Based Raises and Your Compensation Package

If you do decide to link pay with performance, the hard part is making the connection between how well someone has performed and how much of a raise you'll give to that employee. There are some basic steps to follow in making that link:

  • Know what your salary budget will be as a percentage of your total budget, considering your income or sales forecast for the coming year.
  • Decide what form the raises will take.
Example

Will you make raises a certain percentage of each employee's pay? Or will you work with actual dollar amounts?

If you use percentage points, it becomes easier to rank employees in terms of who gets what percentage. For example, your best performer could get 4 percent, while your average performer could get 3 percent, with no raise for your poor performer. Using this method simplifies the process of ranking, but it does not take into account what each employee is currently making. Using the example above, if the best performer makes $30,000 a year and the average performer makes $52,000 per year, then the best performer's raise will be $1,200 and the average performer's raise will be $1,560. Despite a higher percentage, the average performer still gets more money than the best performer.

If you use actual dollars, you can make sure that the person who performs the best get the most money. The problem becomes figuring out how to divide the money available for raises:

  • Do performance appraisals on all employees.
  • Rank employees based on their performance and the criteria that you set for them.
  • Divide the money up according to that ranking.
Example

If you use a percentage method and you have a set dollar amount in your budget for raises, decide how much each person is going to get and then calculate that back to a percentage of that individual employee's salary. For example, if you have $1,500 set aside for raises and two employees, and you decide that Andrew (who makes $30,000) will get $1,000 and that Benjamin (who makes $45,500) will get $500, the percentages for Andrew and Benjamin will be 3.3 percent ($1,000 ÷ 30,000) and 1.1 percent ($500 ÷ $45,500), respectively.

If you don't have a certain amount of money set aside for raises, just use percentages to rank your employees, with the best performers getting higher percentages and the poorer performers getting lower percentages.

If you calculate raises based on actual dollars rather than percentages, how do you divvy up the money? The simplest approach is to rank the employees and use this formula: take the amount of money you have and divide it by the number of employees. That would give you the amount of the average raise. Use that as a baseline and add and subtract from that number depending on where employees fall in your ranking. For example, if you had $5,000 set aside and five employees, the average raise would be $1,000 ($5,000 ÷ 5). Therefore, the employee in the middle of the ranking would get $1,000, while the two employees who were ranked above him or her would get more than $1,000, and the two below would get less than $1,000.

Reviewing Your Compensation Package

A common occurrence among busy small employers is to develop a compensation package and then, in effect, to put it in the back of the closet and forget about it. However, in order to keep your compensation package competitive and up-to-date, you'll need to periodically review it.

How often should you review your package? Here are a few suggestions you can consider:

  • Review your package at regular intervals, perhaps every year. The review doesn't have to be elaborate — it can consist merely of having your lawyer review it for legal compliance or getting some salary data to find out what other business are paying.
  • Review the benefits you're offering when benefit contracts come up for negotiation. When it's time to renew a benefit contract, check with other providers to see if they can quote you a better rate for the same coverage. See if the coverage you're offering is in line with what others offer. Too little coverage may mean you need to consider additional benefits and too much may mean that employees don't need all the coverage you're paying for.
  • Review your package if you notice a pattern beginning to emerge in which employees are leaving for better pay elsewhere. A constant flow of employees out the door may indicate that you're underpaying your employees. Get salary data to confirm your suspicions.

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