How to Design an Effective Employee Incentive Plan

Are traditional financial rewards enough to motivate your team, or could the secret to unlocking peak performance lie in understanding the deeper, social value of non-cash incentives?

Incentive compensation has been one of the most studied topics in management, economics, and accounting.

Incentive theory emerged from motivation theories in the 1940s and 1950s, developed by behavioral psychologist B. F. Skinner. It was further established by Frederick W. Taylor, who discovered that professionals tend to make more of an effort when given extra rewards.

By now, the benefits of incentive programs are clear and well-established in the business world, yet understanding how to design and administer them still presents a challenge for organizations.

How do you structure them for maximum impact?

Who should be involved in the process?

What are the legal and ethical implications of using incentives?

In this article, we answer these questions and examine the steps to design an effective employee incentive plan.

What is an Annual Incentive Plan?

Incentive plans are compensation initiatives that companies use to motivate employees and increase productivity. Perhaps the most common and well-known incentive to employees is the annual incentive plan, which occurs with each performance review cycle.

So, what is an annual incentive plan?

An annual incentive plan (AIP) is a plan that is designed to reward employees for accomplishments of particular goals over a one-year period.

Rewards are usually linked to expected results that are set at the beginning of the performance cycle. Goals set for yearly programs are based on the role’s market prospects and the need to maintain fair pay within the company.

Unlike bonuses, the AIP is communicated upfront and is not entirely discretionary, but it may have a discretionary aspect.

A well-designed compensation plan will typically include annual performance incentives that support the company’s long-term business goals.

However, designing an employee incentive plan may create unintended challenges for employers. A poorly designed program can create inequalities for lower-paid employees, negatively impact staff morale, and strain budgets.

In addition, once financial rewards – even flawed ones – are set in place, it can be difficult to discontinue them.

For these reasons, employers need to carefully consider their incentive strategy before announcing their employee incentive plans.

How to Design an Effective Employee Incentive Plan?

Below we explore what steps must be taken to design an effective employee incentive plan.

Understanding Employee Motivation

When designing incentive plans, we must understand what drives human motivation.

Surprisingly, behavioral economics research shows that non-cash incentives have longer and more permanent changes in behavior than financial rewards.

A collaborative UC Berkeley and MIT study shows that people separate rewards into two main categories: those that bring social value, such as talking about them and showing off to friends, and those that bring monetary value, such as a cash reward or gift card.

In three separate experiments, people prioritized social value over money. Merchandized rewards, gift cards, and incentive travel fall under this category, making them effective motivators.

For these reasons, when considering rewards that provide monetary value, the potential rewards must be significant enough to inspire employees to act. A good measurement is whether the incentive would make a difference for employees if they did not receive it.

There are many criteria to think about when determining the amount of compensation.

Usually, the bigger the impact on business outcomes, the larger the compensation should be. Therefore, the incentive compensation should be substantial for executives and higher-ranking employees.

Ultimately, the best incentives are the achievable ones.

If they are not, they can have the opposite effect and make employees feel demotivated and frustrated.

Setting Clear Objectives

Before designing an incentive program, companies need to define what an engaged and motivated employee looks like in their specific business setting.

Is it a level of dedication, energy levels, or satisfaction levels?

In other words, define which specific behaviors and outcomes the company is trying to incentivize.

Once employers can clearly define what employee engagement looks like to their company, they can accurately measure it and set clear goals and objectives around it.

To start, organizations considering incentive plans for employees must define who will be eligible.

Standard criteria for eligibility include the following:

Type of position (like manufacturing or marketing)
Duration of employment and base salary
Job level (such as leadership or administrative)
Purpose of the reward
Criteria for evaluating employee achievements
Components of the compensation package (like bonuses, shares, or money)
Timing of the compensation distribution (such as annually or quarterly)
Overall expenses associated with the program

Types of Incentives

Examples of common financial short-term incentive plans include:

Annual Incentive Plan – Rewards employees for achieving specific goals set at the start of the year, based on expected outcomes
Discretionary Bonus Plan – Bonuses determined by management post-performance, without a set formula or guaranteed payouts
Spot Awards – Immediate recognition and rewards for exceptional contributions to specific tasks or projects
Profit-Sharing Plan – Employees receive a share of the company’s profits based on a predefined formula or management’s discretion
Team/Small-Group Incentives – Rewards based on the collective performance of a team
Retention Bonus – A financial incentive offered to key employees to remain with the company during critical periods
Project Bonus – Additional compensation for completing a project successfully within a specified timeline

Tailoring Incentives to Different Roles

When it comes to incentives, one size definitely doesn’t fit all.

Since most companies don’t have Silicon Valley budgets for bonuses, incentive dollars must be carefully allocated and customized for the people companies aim to motivate.

Employers must remember that different employee groups might get excited about different things. For example, some employees will be more motivated by monetary rewards, while extra time off work or public shout-outs might be more meaningful for others.

But how do you figure out what your team really wants?

One effective method is sending an anonymous email survey and getting feedback on popular incentive options. Analyzing the responses will provide valuable insights, making it easy to design a more targeted and effective incentive plan.

One thing to note is that people’s interests and priorities can shift, so check in with employees regularly. Keeping an incentive program updated and relevant keeps workers engaged and motivated.

Measuring Effectiveness

As mentioned before, an effective employee incentive plan must align with the company’s strategic goals by focusing on essential business outcomes and measuring the “right” key performance indicators (KPIs).

Often, though, programs fixate on immediate financial metrics like profit, productivity, and sales.

Yet, it’s crucial to also include softer, qualitative measures—things like risk management, compliance, customer happiness, and innovation—that fuel long-term success.

Moreover, as business priorities shift, so too should these performance metrics, ensuring they remain relevant, and employees can realistically achieve them.

For these reasons, it’s crucial to track and analyze the effectiveness of the incentive program after implementing it.

Is the business seeing the changes they hoped for? What insights can be gathered from the results to improve future incentive plans?

Continuously monitoring and evaluating the program’s outcomes allows for adjustments that keep it aligned with performance goals.

Hence, it’s advisable for every organization to periodically examine and adjust its incentive strategies to meet its objectives better.

Incorporating Feedback

The key to refining an incentive program is actively listening to the employees. Dedicating time to understanding their reception of current incentives and what they genuinely desire can make all the difference.

Companies can use the same approach and do regular follow-ups through engagement surveys to help gauge the success of any adaptations.

Tailoring incentive programs based on employee feedback sends a powerful message that their voices matter.

Moreover, leaders engaging directly with their teams to discuss survey outcomes and co-create action plans can further strengthen the initiative.

This collaborative approach not only keeps everyone aligned but also ensures the incentive programs are as effective and meaningful as possible.

Legal & Ethical Considerations

Incentives are designed to make choices more appealing by offering something valuable, aiming to be mutually beneficial. When incentives encourage voluntary actions beneficial to all involved, they are ethically sound.

However, complexities arise when multiple parties are involved, especially in positions of trust or legal duty, raising concerns about bribery and ethics.

Bribery, as defined by Cornell Law School, involves influencing someone in power through gifts or payments to act unethically or illegally, distinguishing it from legitimate incentives.

Ethical considerations are crucial when designing incentive programs in sectors like insurance, manufacturing for government use, and medical sales.

Legally, the US endorses incentives that promote societal benefits, such as hiring practices or energy efficiency, encouraging private firms to adopt ethical incentive frameworks.

For example, workplace safety incentives are supported as long as they don’t discourage reporting.

When creating an incentive program, especially in sensitive industries, it’s crucial to align with company values and avoid negative impacts on brand integrity or client interests.

The Benefits of Incentive Plans for Employees

Providing incentives to your team can offer many advantages for your business:

Reduced Employee Turnover – By giving rewards, you can help lower the chances of your staff wanting to leave
Boosted Enthusiasm – Rewards make employees feel valued and give them something concrete to aim for, enhancing their drive and preventing burnout
Better Work Environment – Introducing rewards can foster a workplace culture that’s all about motivation, productivity, and taking charge
Alignment with Company Goals – Rewards can be aligned with specific objectives, like improving sales or keeping staff, helping the overall growth strategy of your business
Better Collaboration – Incentive plans, whether they’re for the whole company or specific departments, can promote working together and strengthen team bonds

Conclusion

Ultimately, crafting an effective employee incentive plan is a dynamic process that requires understanding individual motivations and aligning them with organizational goals.

The right incentive plan can transform your workplace, driving not just productivity but also a deep sense of belonging and achievement among your employees.

Written by Ivana Radevska

Senior Content Writer at Shortlister

Sources

Employee Incentive Programs

Browse our curated list of vendors to find the best solution for your needs.

Stay Informed

Subscribe to our newsletter for the latest trends, expert tips, and workplace insights!