It could easily be argued that organizations are facing more new norms than ever. HR, people managers, and leaders need effective levers to pull in order to retain and engage top talent. One such lever is the merit increase.

A merit increase program is an essential compensation review component that should be evaluated yearly. However, it is commonly confused with pay raises that are not tied to performance. In this article, we'll unpack the importance of performance-based increases and how to establish a budget for them.

First, let’s talk about the different types of pay increases.

Promotion increases are mainly given when an employee’s job title changes and they take on more responsibilities. In the United States, the typical promotion increase is 10%, but this percentage can vary by country. For example, the promotion increase percentage for India is typically about 20%. A base salary increase isn't required when an employee receives a promotion, as the company could also leverage other compensation components like equity. However, employees getting promoted may be disappointed if they don’t receive a salary increase, especially if they are taking on a larger or more complex scope of work.

A market adjustment is when an employee is being paid below market and is given a raise to be more competitively aligned with the company's established compensation philosophy and compensation range for the employee's job, job level, and location. 

Cost of Living Adjustment (COLA) is frankly an antiquated practice and is a type of increase given to an employee to counteract any inflation for the location. A COLA may also be given if an employee moves to a lower or higher cost of living area (i.e., while some companies may decrease salaries if an employee moves to a lower cost of living area, this is highly discouraged since it’s pretty much guaranteed they will leave the organization). 

Merit increases are directly tied to the employee's performance during a certain time period. 

How to Create a Salary Increase Budget

To determine a salary increase budget (e.g., for the year), first, conduct job leveling across the organization. Then, each manager should complete performance reviews for their direct reports. Once job leveling and performance reviews are complete, you'll be ready to create guidelines for salary increases based on the employee's pay position against the market and performance. 

To determine each employee's market pay position, calculate their compa-ratio by dividing their base salary by the market midpoint of the job they're matched with. If their compa-ratio is at 100%, they're being paid exactly at the market rate for their job and job level. The competitive range is between 85% and 115% compa-ratio. 

Create salary increase guideline tables for each country your employees are in. Then flesh out the increase percentage based on each performance rating and compa-ratio range scenario (see example below).

		Base Salary Compa-Ratio
Performance Rating	Below Competitive <85%	Competitive 85-115%	Above Competitive >115%
1	0%	0%	0%
2	3.50%	3.00%	2.00%
3	5.00%	4.00%	2.50%
4	5.75%	4.50%	3.00%
5	6.50%	5.00%	3.50%

Then simply map each employee's performance rating and compa-ratio to these guidelines to calculate the estimated salary increase budget you'll need. Once this is calculated, you can compare it against Finance’s established budget (if any) to lower/increase the percentages as needed, to align with the available budget.  Don’t forget to also add a little extra (e.g., at least 1% of payroll) for promotions.

If you don’t know employees’ performance ratings at the time of budgeting, you can estimate the percentage of workforce you expect to have at each performance category. Here’s an example: 

Performance Rating	Percentage of workforce (estimate)	Salary Increase (% of base salary)	Payroll (estimate)	Estimated Annualized Cost (Salary Increase % X Payroll)
1 - Low	20%	0%	$2,000,000	$0
2 - Average	70%	4%	$7,000,000	$280,000
3 - High	10%	5%	$1,000,000	$50,000

Total payroll = $10,000,000 

Salary increase budget calculation = $330,000 (or 3.3% of payroll)

In the above example, the company should set aside at least 3.3% of their payroll (or $330,000), plus another 1% of payroll for promotions, for a total of 4.3% of payroll. It’s highly recommended to include a buffer (because you will need it), so round it up to 5.0% of payroll.

Once the guidelines are determined, the HR/People team can collaborate with managers in a compensation review process, where the managers propose base salary increases for their employees, factoring in various data points (i.e., performance, compa-ratio, tenure, budget). Involving the managers is crucial in this pay decision process, and it’s also imperative to equip them to communicate compensation decisions effectively to employees. 

About Kamsa

Kamsa's consultative approach, combined with our proprietary market compensation data, equips companies to budget and forecast salary increase budget and establish compensation strategies, painlessly. Features like our compensation review tool remove companies' heavy lifting and administrative burdens by automating routine compensation processes.