February 15, 2017 | By Wisconsin School of Business | Back to press releases

New research from Wisconsin School of Business shows bonuses are more motivating than raises

The idea of linking an employee’s pay to some measure of individual or organizational performance has been popular both in terms of management theory and in practice, as companies have sought to develop effective reward systems to boost productivity. Pay-for-performance (PFP) has usually taken the form of merit and or bonus pay, and it is estimated that more than 90% of firms utilize some sort of PFP program for most of their employees.

New research from the Wisconsin School of Business at the University of Wisconsin–Madison reveals that while both merit and bonus pay are positively associated with future job performance, bonus pay may have the strongest effect on future performance. Charlie O. Trevor, professor of management and human resources at the Wisconsin School of Business, together with Anthony J. Nyberg of the University of South Carolina and Jenna R. Pieper of the University of Nebraska-Lincoln, examined the impact of different PFP types on nearly 12,000 insurance company employees over a five-year period.

“There has been considerable discussion around the question of if pay-for-performance works and our findings suggest that the more appropriate question is one of when it works,” says Trevor of the Wisconsin School of Business. “Our research shows that some incentives work better than others. We found employees may be more motivated to improve performance when bonus pay is the carrot rather than a raise. That’s good news for companies looking to increase productivity because bonus pay doesn’t increase base salary costs and has the added benefit of providing more cash flow flexibility.”

As the two most prevalent types of PFP, merit pay and bonus pay are designed to reward past performance and set future expectations. Merit pay is an incremental increase in base salary, most commonly awarded on an annual basis and tied to yearly performance reviews. Bonus pay is usually awarded annually as well, in the form of a lump sum cash payment that doesn’t change an employee’s base salary.

While merit pay might be expected to be more effective because it generates a salary increase that will continue from year to year, the lump sum payment of a bonus was found to be a better motivator, in part because of the immediacy and perceived bigger windfall. For example, a $3,000 raise is only $115.38 per bi-weekly paycheck before taxes. However, a $3,000 bonus in one lump sum check on top of regular pay can feel much more substantial.

“Our research suggests that employees viewed the raise, which is typically spread out over 26 bi-weekly paychecks, as less motivating than getting one big bonus check,” says Trevor. “It may be the same reason why most lottery winners take the lump sum instead of the annuity. The lump sum bonus payout may feel more tangible and significant, which can be more motivating for employees to continue to work hard in the future.”

Bonus pay may also look particularly advantageous for companies trying to better manage spending during times of up and down business cycles. Using bonuses can be more cost efficient in terms of spurring productivity, while also controlling their investment in a PFP program.

But Trevor stressed that the findings do not mean that companies should abandon merit pay. “Firms that don’t offer merit pay may have problems attracting and retaining high quality employees,” he says. “No company wants to put itself at a competitive disadvantage and having a pay-for-performance program with both merit and bonus pay should be seen as a strong indicator of a commitment to rewarding, and thus securing, top talent.”

The paper, “Pay-for-Performance’s Effect on Future Employee Performance: Integrating Psychological and Economic Principles Toward a Contingency Perspective”, was published by the Journal of Management.