Pay, Compensation, and Performance, Psychology of

Joseph J Martocchio, University of Illinois at Urbana-Champaign, Champaign, IL, USA

Ó 2015 Elsevier Ltd. All rights reserved.
This article is a revision of the previous edition article by H. Thierry, volume 16, pp. 11130–11134, Ó 2001, Elsevier Ltd.

Abstract

Pay-for-performance stands for a variety of compensation practices that are designed to reinforce past performance and
encourage future performance. The purpose of this article is to review some of the more important issues pertaining to
pay-for-performance concepts and research. First, pay-for-performance concepts and practices are introduced in the
context of total compensation practices. Second, consideration is given to a longstanding vexing concern about whether
rewarding performance with tangible rewards may actually undermine performance. Third, job performance constructs in
the context of pay-for-performance are considered. Fourth, executive compensation determination and its implications for
pay-for-performance are reviewed. Finally, the importance of recognizing national culture in pay-for-performance research
is addressed.

The pay-for-performance topic is ubiquitous throughout featured only three sessions on compensation, among
all types of organizations. In recent decades, the role of hundreds devoted to other topics, at the 2012 annual meetings.
pay-for-performance was expanding beyond some of the In addition, they cited an analysis which revealed that of 111
traditional topics that have driven past psychological research. articles published in Personnel Psychology in 2003–07, only two
Questions such as ‘Are alternative pay-for-performance focused on compensation issues; the parallel proportion was
plans equally effective in influencing employee motivation seven of 457 in Journal of Applied Psychology (Cascio and
and job performance?’ were the focus. Increasingly the term Aguinis, 2008). For the period 2008–13, only three addi-
pay-for-performance was being used to convey a much tional articles on employee compensation were published in
broader and very different set of activities than it once did. For the Journal of Applied Psychology (of 602 total articles published
instance, researchers are asking questions such as ‘Are execu- in this period) and one article on employee compensation was
tives paid commensurately with organizational performance published in Personnel Psychology (of 153 articles). Research on
such as changes in stock prices?’ Whereas traditional research executive compensation is plentiful, and it appears in scholarly
focused largely on rank-and-file and managerial employee journals that publish strategic management research, including
categories, more recent research has focused on the chief Academy of Management Journal, Journal of Management, and
executive officers. The former question fits with traditional Strategic Management Journal.
pay-for-performance research that has been based in psycho-
logical theories of motivation; the latter represents a more
contemporary approach of compensation practices in a busi- Compensation Components
ness strategy context, often referred to as executive compen-
sation that has been largely based on theories in economics, Compensation represents both the intrinsic and extrinsic
finance, and sociology. (monetary) rewards or returns employees receive for per-
Compensation represents both the intrinsic and extrinsic forming their jobs, and compensation professionals typically
rewards employees receive for performing their jobs refer to both types of compensation as total compensation
(Martocchio, 2015). Together, both intrinsic and extrinsic (Martocchio, 2015). Intangible compensation includes
compensation describe an organization’s total compensation. recognition, status, employment security, challenging work,
In practice, organizations pay employees to perform the and unplanned learning opportunities. Tangible rewards
jobs for which they were hired. By the end of 2013, the US include pay (hourly wage or annual or annual salary) and
private sector labor force totaled, approximately 115 million employee benefits (such as paid time-off). Whereas organi-
individuals and the costs of pay, wages, and salaries have zational development professionals promote intrinsic
increased dramatically in recent years ($20.55 in hourly wages, compensation primarily through effective job design and
which increased 3.8% in an 18-month period through late employee feedback mechanisms, compensation professionals
2013). It would seem reasonable, then, to expect there to be are responsible for extrinsic compensation.
a strong continuing stream of research on topics such as
pay-for-performance to better understand how increasing wage
Intrinsic Compensation
and salary costs relate to employee productivity. However, this
has not been the case. Intrinsic compensation represents employees’ critical psycho-
According to Gupta and Shaw (2014), of more than 1200 logical states (that is, intrinsic motivation) that result from
sessions at the 2013 annual meetings of the Society for performing their jobs. Job characteristics theory (Hackman and
Industrial and Organizational Psychology, only three are Oldham, 1976) describes these critical psychological states.
related to compensation, rewards, or benefits. Similarly, the According to this job theory, employees experience enhanced
program of the HR division of the Academy of Management psychological states (that is, intrinsic compensation) when

International Encyclopedia of the Social & Behavioral Sciences, 2nd edition, Volume 17 http://dx.doi.org/10.1016/B978-0-08-097086-8.22012-6 611
612 Pay, Compensation, and Performance, Psychology of

their jobs rate high on five core job dimensions: skill variety, will see as making a meaningful change in compensation
task identity, task significance, autonomy, and feedback. (Krefting and Mahoney, 1977). The basic premise of this
concept is that a trivial pay increase for average or better
employees is not likely to reinforce their performance or to
Extrinsic Compensation
motivate enhanced future performance. Equity theory (Adams,
Extrinsic compensation includes both pay and employee 1963) tells us that individuals who judge that their pay or pay
benefits. Employees receive base pay, or money, for per- increases are commensurate with their inputs such as effort,
forming their jobs. Base pay is recurring; that is, employees skills, and knowledge that manifest in job performance, relative
continue to receive base pay as long as they remain in to the pay or pay increases of comparison others (coworkers)
their jobs. Organizations disburse base pay to employees as who perform similar or identical jobs. Perceptions of under-
hourly pay or (wage) as an annual salary. Employees earn payment inequity (Adams, 1965) may intensify because budget
hourly pay for each hour worked. They earn salaries for reductions make it more challenging to recognize differences in
performing their jobs, regardless of the actual number of employee performance. Exemplary performers may receive pay
hours worked. Organizations measure salary on an annual raises that are only slightly higher than average performers.
basis. The Fair Labor Standards Act established criteria for Also, overall lower pay increases may fall below the threshold
determining whether employees should be paid on an hourly of just-meaningful pay differences (Zedeck and Smith, 1968),
or salary basis for the purposes of determining who qualifies then, possibly exacerbating perceptions of inequity.
for overtime pay when working longer than the standard work Incentive pay is defined as compensation (other than base
week. In general, managerial, professional, and executive- wages or salaries) that fluctuates according to employees’
level jobs are exempt from the overtime pay provision while attainment of some standard based on a preestablished formula,
most other jobs are not exempt. individual or group goals, or organization earnings. Incentive
In either case, most organizations implement pay-for- pay or variable pay rewards employees for partially or
performance plans to determine whether pay increases completely attaining a predetermined work objective based on
should be awarded, and, if so, by how much. Organizations objective criteria such as sales volume, safety records, and team
embrace the importance of capital, which refers to the factors performance such as manufacturing quality.
that enable themselves to generate income and economic Effective incentive pay systems are based on three assump-
value. Human capital (Becker, 1975), as defined by econo- tions. First, individual employees and work teams differ in how
mists, refer to sets of collective skills, knowledge, and ability much they contribute to the organization, both in what they do
that employees can apply to create economic value for their as well as in how well they do it. Second, the organization’s
employers. There are a variety of different types of capital that overall performance depends to a large degree on the perfor-
organizations rely on to create value, including financial capital mance of individuals and groups within the organization.
(cash) and capital equipment (state-of-the-art robotics used in Third, to attract, retain, and motivate high performers and to be
manufacturing). Unlike other forms of capital, employers fair to all employees, an organization needs to reward
cannot own human capital. Organizations purchase the use of employees on the basis of their relative performance.
human capital by paying employees an hourly wage, salary, or Goal setting is a motivational technique that involves
bonuses and providing benefits such as paid vacation and employees’ participation in setting precise job performance
health insurance. Also, organizations help develop human goals for themselves. Locke (1968) first established the theo-
capital to their advantage by offering training programs aimed retical basis for how goal setting can impact motivation.
at further boosting employee productivity, and rewarding Latham and Yukl (1975) reviewed a multitude of goal setting
better performance increases with boosts to pay. research from which they created a theoretical framework for
how goal setting should be used in organizations to motivate
employee performance. Rewards are those tangible things (pay,
Pay-for-Performance benefits, recognition, promotion opportunities, and so forth)
that an organization provides to its employees in return for
Merit pay and incentive pay are the primary mechanisms for their performance.
providing performance-based pay. The intent of pay-for- Incentive pay augments employees’ base pay, but incentive
performance plans is to reward excellent job performance, pay appears as one-time payments. Employees usually receive
motivate future performance, and help employers retain valued a combination of recurring base pay and incentive pay, with
employees. Under merit pay, employees earn permanent base pay representing the greater portion of monetary
increases to base pay according to their performance. Most compensation. More employees are presently eligible for
often, an employee’s supervisor or manager provides an incentive pay than ever before, as organizations seek to
evaluation of past performance (oftentimes for periods ranging control costs and motivate employees continually to strive for
between 6 months and 1 year) based on subjective judgment. exemplary performance.
The amount of a merit pay increase should reflect prior job
performance levels according to the performance evaluation
Is Monetary Compensation a Nonstarter for Discussing
judgment and the amount ideally motivate employees toward
Employee Performance?
striving for exemplary performance. The pay raise amount
should be meaningful to employees in an absolute and relative Notwithstanding the ubiquity of pay-for-performance prac-
sense. In an absolute sense, the concept of just-meaningful pay tices, a body of literature has given pause to speculate whether
increase refers to the minimum pay increase that employees pay may diminish performance. Cognitive evaluation theory
 Pay, Compensation, and Performance, Psychology of 613

(CET) maintains that pay is likely to reduce an individual’s Ultimately, the body of evidence and thinking about the
interest in the job at hand. Consequently, reduced intrinsic influence of tangible rewards (pay) on motivation and subse-
motivation may be more likely to diminish job performance. quent job performance is mixed. Reasonably, there is some
At center stage is the concept of intrinsic motivation. Deci merit to both perspectives on theoretical rationale and
and Ryan (1985) describe intrinsic motivation as “based in evidence. Perhaps the issue is not whether pay undermines
the innate, organismic needs for competence and self- motivation, but, rather, the conditions that influence that
determination” (p. 33), and argue that it occurs in its purest relationship. Undoubtedly, continued research will help shed
form when “a person does an activity in the absence of a reward further light on this important matter.
contingency or control” (p. 35). In the CET framework, pay
undercuts intrinsic motivation because it exerts a governing
quality. Employers expect employees to work diligently when Job Performance
on the job. In rare instances, employees do have the freedom not
to perform their jobs whenever they desire if they expect to be According to Motowidlo (2003), job performance is defined as
paid. For most, pay provides for basic needs including food and the total expected value to the organization of the discrete
shelter without which individuals would not survive. According behavioral episodes that an individual carries out over a speci-
to Rynes et al. (2005), this perception of being controlled is fied time period. Those researchers emphasize two key issues in
assumed to be “demotivational” and to work against the this definition. First, performance is an aggregated property of
potential incentive effects of extrinsic rewards such as pay. multiple, discrete behaviors that occur over time. Second, the
The number of experiments on the effects of extrinsic property of behavior to which performance refers is its expected
rewards on intrinsic compensation is substantial; however, value to the organization.
strong evidence to support or disconfirm the main principle of Two performance criteria – mean performance and perfor-
CET is mixed. Two metaanalytic reviews did not clarify this mance variation – are among the most commonly studied
issue. For example, Eisenberger and Cameron (1996) examined indicators in pay-for-performance research. According to Reb
dozens of studies that compared a rewarded group (verbal or and Cropanzano (2007), average performance evens out
tangible rewards) with a no-reward control group on two employee’s contribution to an organization. Average perfor-
traditional measures of intrinsic interest: amount of free-time mance evens out variations from the mean that might be due to
devoted to a task when the tangible or verbal reward is passing influences outside the control of the employee.
subsequently withdrawn or self-reported attitude toward the Following this rationale, past research found that average
task (e.g., interest, enjoyment, or satisfaction). The results performance strongly predicts variance in pay and reward
revealed no significant effect of reward condition and free-time, allocation (Barnes and Morgeson, 2007; Zhou and Martocchio,
but did show that the relationship between reward condition 2001), largely because typical, or average, performance repre-
and task-related attitudes was actually positive, which is sents the dominant conceptualization of performance
inconsistent with CET. Deci et al. (1999) disagreed with the (Rushton et al., 1981). In the pay-for-performance context, it is
Eisenberger and Cameron (1996) conclusion and addressed eminently reasonable to expect that higher mean performance
them with a metaanalysis on the same issues. Still, they found will lead to positive changes in compensation level.
no overall effect for performance-contingent rewards on the Performance variation also plays a role in compensation
attitude measure of intrinsic interest (p. 644). award decisions. Sturman (2007) maintains that long-term or
Fang and Gerhart (2012) conducted a field examination of directional changes over time are differentiated from short-
CET to check whether Deci and Ryan (1985) may have focused term fluctuations, or unsystematic variation of performance.
too much on the potentially controlling aspects of rewards and Within-person performance variation can be due to a variety
not enough on the informational aspect. Consistent with this of factors, including affective state (Weiss and Cropanzano,
hypothesis, Fang and Gerhart (2012) found that employees 1996). Between persons, some individuals may show large
covered by pay-for-performance plans reported higher intrinsic variation in performance, that is, are inconsistent, whereas
interest than employees not covered by pay-for-performance others show little variation, that is, perform consistently
plans. Their finding is consistent with the fact that people around the mean level or a long-term trend.
often report pay as a motivator when it is perceived as recog- According to Barnes et al. (2012), there are several reasons
nition for good performance (Lawler, 1971). to expect that performance variation of greater magnitude is
As noted previously in this article, equity theory, and goal associated with smaller compensation. By definition, it is easier
setting theory help explain the motivational impact of pay-for- to predict the performance of employees who show little
performance practices. Expectancy theory also adds to the performance variability as compared to those who show high
discussion. According to expectancy theory, an individual will variability. Organizations tend to value predictability.
choose to behave in a particular manner because they are Employees performing inconsistently can create uncertainty
motivated to select a specific behavior rather other behavior. and disruptions for team members and other parties dependent
The choice is primarily based on the desirability or valence of on the employee, sometimes making it difficult to plan and
the outcome of the chosen behavior. Contrary to the premise of perform interactively. This increases the risk of performance
CET, a metaanalysis conducted by Locke et al. (1980) failures, coordination problems, and disrupted activities for
concluded: “Money is the crucial incentive . no other incen- other employees who are downstream in interdependencies.
tive or motivational technique comes even close to money with Moreover, inconsistent performance has been found to lead
respect to its instrumental value” (p. 379). Subsequent research to attributions of negative traits (Fox et al., 1995) such as
has continued to support their conclusion. undependable. The word undependable, which is one of the
614 Pay, Compensation, and Performance, Psychology of

hallmarks of the personality trait conscientiousness (Barrick Executive compensation consultants’ professional survival
and Mount, 1991), could be linked to high variability. may depend on recommending lucrative compensation
Empirically, at least one study has found high performance packages. Recommending the most lucrative compensation
variability to be associated with lower pay (Barnes and packages will quickly promote a favorable impression of the
Morgeson, 2007). Organizations may pay higher compensa- consultant among CEOs, leading to future consulting
tion to more consistent performers in an effort to reward and engagements.
retain these valued employees. Since 2008, the US Securities and Exchange Commission
rulings require organizations to include the identity of the
consulting firm in public disclosure statements. This ruling has
Executive Compensation created concerns about possible conflicts of interest for
consulting firms that also provide consulting services in other
From an economic standpoint, the chief executive officer areas (e.g., performance management and change manage-
(CEO) is the seller of his or her services, and the compensation ment) for the same client firms. Executive compensation
committee is the buyer of these services. Under classic consulting represents just one of many possible areas of
economic theory, a reasonable price is obtained through management consulting. The conflict potentially arises when a
negotiations that are at arm’s length between an informed consultant intentionally recommends a more-lucrative-than-
seller and an informed buyer. An awkward situation can result warranted executive compensation package in the hope of
when the CEO hires a professional compensation director or gaining management favor and additional other management
compensation consultant. In this case, the compensation consulting opportunities. Of course, compensation consulting
consultant who makes the recommendation to the compen- firms are concerned about the public image of possible conflicts
sation committee works for the CEO. In theory, the CEO of interest and have considered a variety of tactics to ensure the
hires the consultant to perform an objective analysis of the integrity of their recommendations to client firms. For example,
organization’s executive pay package and to make whatever there has been some speculation that executive consulting
recommendations the consultant feels are appropriate. This practices will be spun off into independent businesses. Many
relationship has the potential to promote a conflict of interest organizations are concerned about their own public image and
because of the perceived pressure for the consultant to protect have instituted policies to prevent compensation consultants
the CEO’s financial interests. The irony is that the consultant is from conducting other work for management.
often viewed as representing the shareholders’ interests. In The board of directors represents shareholders’ interests
a sense, the buyers of the CEO’s services are the shareholders by weighing the pros and cons of top executives’ decisions.
and their representatives, the compensation committee of the Boards of directors have approximately 15 members. These
board of directors. They tend to act upon the compensation members include CEOs and top executives of other successful
consultant’s recommendation (Walters et al., 1995). organizations, distinguished community leaders, well-regarded
Different individuals and groups participate in setting professionals (e.g., physicians and attorneys), and possibly
executive compensation. They include compensation consul- a few top-level executives of the organization.
tants, compensation committees, and boards of directors. Each Boards of directors give final approval of the compensation
plays a different role in setting executive compensation. committee’s recommendation. Some critics of executive
Executive compensation consultants usually propose compensation have argued that CEOs use compensation to
several recommendations for alternate pay packages. coopt board independence. CEOs often nominate candidates
Consultants make recommendations about what and how for board membership, and their nominations usually lead
much to include in executive compensation packages based on to candidates’ placement on the board. Board members
strategic analyses, which entail an examination of an organi- receive compensation for their service to the boards. It is not
zation’s external market context and internal factors. Examples uncommon for a board member to earn more than $50 000
of external market factors include industry profile, information per year plus a fee ($10 000 or more) for each board meeting
about competitors, and long-term growth prospects. Financial attended. Along with monetary and stock compensation,
condition is the most pertinent internal factor regarding exec- organizations are using such benefits as medical insurance,
utive compensation. Strategic analyses permit compensation life insurance, and retirement programs to attract top-notch
consultants to see where their client organization stands in the individuals to join boards of directors. In general, board
market based on external and internal factors. Strong organi- members’ failure to cooperate with CEOs may lead either to
zations should be able to devote more financial resources to fewer benefits or their removal. “The board determines the
fund lucrative executive compensation programs than weaker pay of the CEO. But who determines the pay of the outside
organizations. According to Crystal (1991), more often than directors? Here, a sort of formal Japanese Kabuki has devel-
not, executive compensation consultants find themselves in oped. The board of directors determines the pay of the CEO,
conflict-of-interest situations: “Ostensibly, compensation and for all practical purposes, the CEO determines the pay of
consultants were hired by the CEO to perform an objective the board of directors. Is it any accident, then, that there is
analysis of the organization’s executive pay package and to a statistical relationship between how highly the CEO is paid
make whatever recommendations the consultant felt were and how highly his outside directors are paid?” (Crystal, 1991:
appropriate. In reality, if those recommendations did not cause pp. 20–21).
the CEO to earn more money than he was earning before the Board of directors members within and outside the orga-
compensation consultant appeared on the scene, the latter was nization make up an organization’s compensation committee.
rapidly shown the door” (p. 12). Outside board members serve on compensation committees to
 Pay, Compensation, and Performance, Psychology of 615

minimize conflict of interest. Thus, outside directors usually are promotion to a higher rank signifies a win, and more lucrative
the committee’s membership majority. compensation (e.g., higher base pay, incentives, enhanced
Compensation committees perform three duties. First, benefits, and perks) represents the prize. The ultimate prize is
compensation committees review consultants’ alternate recom- promotion to CEO and a lucrative executive compensation
mendations for compensation packages. Second, compensation package. The chance of winning competitions decreases
committee members discuss the assets and liabilities of the dramatically as employees rise through the ranks: There are
recommendations. The complex tax laws require compensation fewer positions at higher levels in corporate hierarchical
committees to consult compensation experts, legal counsel, and structures.
tax advisors. Third, based on these deliberations, the committee
recommends the consultant’s best proposal to the board of
Social Comparison Theory
directors for its consideration.
Although pay-for-performance is the public rationale for According to social comparison theory, individuals need to
setting executive compensation, reality is often quite different. evaluate their accomplishments, and they do so by comparing
Three alternative theories explain the principles and processes themselves to similar individuals (Festinger, 1954). Demo-
for setting executive compensation: agency theory, tournament graphic characteristics (e.g., age or race) and occupation are
theory, and social comparison theory. common comparative bases. Individuals tend to select social
comparisons who are slightly better than themselves
(Festinger, 1954). Researchers have applied social comparison
Agency Theory
theory to explain the processes for setting executive compen-
Ownership is distributed among many thousands of share- sation (O’Reilly et al., 1988).
holders in large organizations such as Microsoft, General As we discussed earlier, compensation committees play an
Electric, and the International Business Machines Corporation important role in setting executive compensation, and
(IBM). For example, owning at least one share of stock in compensation committees often include CEOs from other
IBM bestows ownership rights in IBM. Each shareholder’s organizations of equal or greater stature. Based on social
ownership is quite small, with most owning far less than 1% of comparison theory, compensation committee members
the total shares. Inability to communicate frequently or face to probably rely on their own compensation packages and the
face to address business concerns is a major disadvantage of compensation packages of CEOs in organizations of equal or
thousands of shareholders. greater stature to determine executive compensation.
According to agency theory, shareholders delegate control to
top executives to represent their ownership interests; however,
top executives usually do not own majority shares of their National Culture as Context
organizations’ stocks. As a result, executives usually do not
share the same interests as the collective shareholders. These Cultural values are probably a key factor in the effectiveness of
features make it possible for executives to pursue activities that pay-for-performance systems, or, for that matter, whether
benefit themselves rather than the shareholders. The actions of pay-for-performance is even compatible in particular cultural
executives on behalf of their own self-interest are known as the contexts. Culture is defined as “the human-made part of the
agency problem (Jensen and Meckling, 1976). Executives may environment (Herskovits, 1955). It has both objective
specifically emphasize the attainment of short-term gains (e.g., elements- tools, roads, appliances- and subjective elements-
increasing market share through lower costs) at the expense of categories, associations, beliefs, attitudes, norms, roles, and
long-term objectives (e.g., product differentiation). Boards of values” (Triandis, 1994: p. 113). Cultural values shape work-
directors may be willing to provide executives generous annual related attitudes and behaviors (Triandis, 1994). Culture also
bonuses for attaining short-term gains. influences the domain of normative behavior (e.g., behavior
Shareholders negotiate executive employment contracts with that is desirable versus condemned for members of the
executives to minimize loss of control. Executive employment culture), defines roles for individuals in the social structure,
contracts define terms of employment pertaining to perfor- and prescribes guiding principles and values in one’s life. As
mance standards and compensation, specifically current and a result, culture specifies how things in the environment,
deferred compensation and benefits. The main shareholder including an organization’s practices, policies, and procedures,
objective is to protect the organization’s competitive interests. are to be evaluated and subsequent reactions to such proce-
Shareholders use compensation to align executives’ interests dures (Robert et al., 2000).
with shareholders’ interests. As discussed earlier, boards of These cultural values are apparent in compensation
directors award organization stock to align executives’ interests systems. The predominant bases for pay in the United States
with shareholders’ interests. are performance and knowledge, which represents equity
(Heneman and Werner, 2005). According to these cross-
national studies, there are three primary rules governing
Tournament Theory
individuals’ compensation award decisions: equity, equality,
Tournament theory casts lucrative executive compensation as the and need. The equity rule specifies that individuals should be
prize in a series of tournaments or contests among middle- and rewarded on the basis of their contributions such as task
top-level managers who aspire to become CEOs (Lazear and performance. The equality rule specifies that individuals
Rosen, 1981). Winners of the tournament at one level enter should be rewarded equally, regardless of their contributions
the next tournament level. In other words, an employee’s to the group or the organization. And the need rule states that
616 Pay, Compensation, and Performance, Psychology of

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