What is Incentive Compensation? Why Does It Matter?

Why do you reward your employees? It’s not a hard question to answer: You want to show your employees that you value them while motivating them to perform at a high level. An equally important question – and the key to a successful incentive compensation program: How do you reward your employees?

In this article, we’ll cover the ins and outs of incentive compensation and provide some key tips for developing a program that simultaneously rewards your employees and supports the growth of your business.

What you’ll learn:

• What is incentive compensation?
• How does incentive compensation management work?
• Why is incentive compensation management important?
• Long-term incentives vs. short-term incentives
• Specific types of incentive compensation
• Benefits of incentive compensation
• Drawbacks of incentive compensation
• Best practices for designing effective incentive compensation plans
• Incentive compensation management challenges
• Continuously fine-tune your incentive compensation strategy
• Frequently Asked Questions (FAQs)

Incentive compensation is a form of payment that rewards employees – often sales employees specifically – for achieving certain goals or objectives. It is often tied to individual or company performance and serves the purpose of motivating employees to work as effectively as possible and achieve better results.

Incentive compensation can take many forms, including bonuses, stock options, profit sharing, and commission-based pay structures.

Although incentive compensation is primarily used to compensate sales teams, it’s not uncommon for other roles to earn incentive pay. Employees who work in sales operations, customer success, recruiting, and marketing are often eligible for incentive compensation beyond their base salaries.

Incentive compensation management works by automating the calculation of commissions and bonuses. Earnings are tracked in real-time, giving sales reps visibility into progress and payouts. The right incentive compensation management tools should simplify the process of administering comp plans, including making adjustments and updates.

At a higher level, incentives need to be aligned with sales strategies and business goals. Compensation and incentives that aren’t part of the seller’s base pay – ie, variable compensation – can be determined by performance.

The software needed for incentive compensation management should, ideally, fully integrate into your sales CRM to access the necessary data needed to determine compensation, and to give reps visibility into how and why they’re being paid.

Incentive compensation management is important for a number of reasons.

• Aligns team behaviour with company objectives.
• Boosts morale and retention by providing transparent and fair compensation through real-time dashboards.
• Saves time and reduces errors by automating and standardising manual processes and disjointed data inputs.
• Supports recruitment of top talent by offering competitive, clear pay structures.
• Improves forecasting and financial planning through accurate incentive tracking.

Businesses that do not track compensation efficiently or accurately are likely to face a number of challenges, addressed below.

Incentive compensation typically falls into one of two categories – long-term incentives and short-term incentives.

Long-term incentives are awarded over several years or even decades. These incentives may include stock options, restricted stock units, performance shares, or other equity-based compensation that vests over time. Their purpose is to align the interests of the employee with the long-term success of the company, as the value of these incentives traditionally increases based on the company’s performance.

A recent EY Future of Pay survey found that with talent retention becoming increasingly challenging in a competitive economy, more and more Indian companies are turning to equity-based incentives such as Employee Stock Option Plans (ESOPs) and Restricted Stock Units (RSUs). ESOP adoption has grown to 75% in 2024 from 63% in 2020, making it the most widely used long-term retention tool.

Short-term incentives, on the other hand, are typically awarded and paid out within the current fiscal year, quarterly, or semi-annually. They are usually tied to specific performance goals or targets and may include bonuses, commission, or other performance-based rewards. Short-term incentives are used to drive short-term performance and provide immediate rewards to employees for achieving specific goals.

Let’s quickly break down some of the specific types of incentive compensation that an organisation might offer:

• Performance-based bonuses reward employees for achieving certain goals or targets related to their specific roles.
• Restricted stock units (RSUs) give employees shares of a company’s stock, which typically vest over time and are entirely owned by employees once vested. RSUs are typically offered by publicly traded companies that want to attract and retain their top performers.
• Profit-sharing bonuses distribute a percentage of the company’s profits to employees, usually on a quarterly or annual basis, incentivising them to work together to increase the company’s overall profitability.
• Commission-based pay provides a percentage of sales revenue to employees who generate sales.

Some organisations use only one type of incentive pay, while others use multiple types of incentive compensation to create a more well-rounded incentive compensation program.

You’ll also see each type of incentive plan leveraged differently. Some companies pay sales teams only in commission, for example, while others pair commission with a base salary. What works for one company might not work for another. Whether you are a family business, a rapidly scaling startup, or a thriving enterprise firm, it's best to test out different combinations of incentive offerings until you find what works best for your specific goals and objectives.

Incentive compensation can provide the following benefits to both employers and employees.

By tying compensation to specific sales goals, employees are motivated to work harder and achieve better results. When overall comp is based on their performance, employees have more incentive to achieve their goals.

Incentive compensation can align the interests of employees with high-level company strategies, encouraging them to work towards the company’s success.

Incentive compensation can help retain top-performing employees by providing rewards and recognition for their efforts.

Incentive compensation plans set clear goals and objectives for employees, which holds them accountable for their performance and rewards them for their productivity.

Incentive compensation can be customised to fit the unique needs and goals of the organisation as a whole as well as individual employees, enabling companies to offer the right compensation packages for their specific staff.

While its benefits are significant, incentive compensation can present the following risks if designed or distributed poorly.

When incentive compensation plans over-emphasise individual performance, they risk creating a culture that doesn’t place enough value on teamwork and collaboration.

Poorly designed incentive plans can inadvertently motivate the wrong types of behaviour. Without provisions like clawback clauses in place, employees might resort to unethical tactics or take a quantity-over-quality approach to selling. This can negatively impact sales results, morale, and overall productivity.

Incentive compensation can be costly for employers to administer and manage. Without the right resources, manual efforts to track and measure employee performance can be time-consuming and frustrating. The admin work alone can reduce an organisation’s profitability – as the overhead of managing an inefficient incentive program inhibits admins from spending time on more revenue-driving activities.

While there’s no set way to design an incentive compensation plan, there are a few key factors that will ensure you’re setting yourself up for success.

Define which teams will earn incentive compensation. Then consider the goals of each of these teams. Develop your plans around the factors directly within this team’s control, and pay close attention to the behaviours you want to incentivise.

For example, for an inbound SDR team, you’ll want to incentivise the activities that indicate high inbound SDR performance – things like lead response time and qualified opportunity generation. If you neglect these factors and only reward closed-won revenue, you’ll fail to incentivise inbound SDRs to perform their key responsibilities.

Make sure you are measuring the same core metrics consistently, over time. You need to have reliable data around sales metrics like closed-won revenue, demos booked, and qualified lead generation to determine how these specific results should be weighed in your incentive plans.

You also want to make sure your business is able to consistently deliver on the incentives you’ve promised to employees. If you fail to make accurate, consistent, and timely payouts, employee engagement, morale, and trust in leadership will suffer.

Your employees should be able to understand how their performance tracks to their goals, what specifically they’re getting paid for, and how to access and understand their incentive compensation statements.

If an incentive plan isn’t working out as intended (or at all), then it needs to be adjusted before it does more harm than good. We recommend reviewing your goals and KPIs at least quarterly in order to catch and resolve issues before they happen.

What systems or tools do you have in place to help you manage and maintain the manual work that often goes into managing an incentive program? Be sure you have the answer to this question before rolling out your plan. If you have a large team or limited bandwidth, you’ll want to explore incentive compensation management solutions that can help keep your program operating smoothly.

Before the adoption of tools like Salesforce for incentive compensation management, the people responsible typically relied on a mix of spreadsheets and manual processes in order to determine compensation. While organisations still rely on these outdated methods, others might rely on a disjointed mix of tools that lack the connectivity and unified data needed for seamless incentive compensation management.

Still, incentive compensation can be challenging. It requires a delicate balance of complexity and clarity, and the know-how needed to integrate systems from across the organisation to maintain data flow. It can be difficult to maintain and ensure regulatory compliance, though this can be made easier with integrated, automated tools. Similarly, with disjointed data and tools, reps might have difficulty with trust and transparency around earnings calculations. It can also be challenging to adapt plans to changing business priorities or market conditions.

For all of these reasons, choosing the right incentive compensation management software is extremely important in order to reduce administrative overhead, improve internal alignment, and optimise revenue growth.

Incentive compensation is too essential and multifaceted to exist as a set-it-and-forget-it program. Make sure that you’re regularly analysing your compensation strategy – from your overall philosophy down to the specifics of individual plans – so that you can identify areas for improvement and make adjustments that benefit your employees and promote high performance across the entire organisation.