Bonuses and financial incentives are a form of variable pay based on lump-sum payments linked to individual, collective or organisational performance (or some combination of these). They are not consolidated into base pay, though in certain situations (such as due to cost constraints) they can be given as part of, or instead of, a pay rise. They are often paid in cash, but senior employees often receive some of these rewards in company shares.

It's important to draw a distinction between incentives and bonuses, although the two terms are interlinked and often used interchangeably.

• Incentives aim to influence future employee behaviour or performance, usually using targets: if a specific target is met, the employee will receive a payment.

• Bonuses can be discretionary or non-discretionary. Like incentives, they may be used to influence employee performance or behaviour to meet pre-set objectives, but they could also be used to reward past achievements.

It's also helpful to differentiate between:

• Non-cash incentives, sometimes called performance improvement plans, aim to affect employees’ future performance by awarding prizes or ‘gifts’, associated with some performance measure.

• Employee recognition schemes are retrospective as they recognise past performance rather than incentivising future efforts. They may be informal and discretionary. Such schemes may be linked with non-cash incentives.

Our report Show me the money! The behavioural science of reward examines recent thinking on how individuals can respond to various kinds of incentives.

The desire to incorporate bonus and incentive plans into reward packages has been driven in part by the ‘new pay’ philosophy. This advocates that ‘guaranteed’ remuneration (basic pay and benefits) should comprise a smaller proportion of the overall reward package, with a shift towards strategic reward linking employee performance and pay to the wider business strategy.

There's also been a move in certain sectors towards market-based pay, whereby an employee might only receive a pay rise if the market rate for the role had increased: in this scenario, individual contribution could be recognised via a bonus instead of a pay rise.

For the employee, the main benefits of bonuses/cash incentives over consolidated salary increases are:

• Greater control over their level of remuneration.
• Higher payments are potentially possible.
• The bonus can be received in one go.

But the downside for employees includes:

• Non-consolidated payments must be re-earned and may not count towards variable payments (such as overtime) or benefits (such as occupational sick pay).
• Payments may be unpredictable or lower than expected if targets cannot be met.

For the employer, the advantages include:

• Ongoing motivation as bonuses must be re-earned.
• Lack of impact on certain employer on-costs that are linked to basic salary levels, such as pension contributions.
• Capacity for maintaining market pay competitiveness without necessarily inflating the annual pay bill.
• Flexibility through, for example, the ability to reduce or even halt payments during economic downturns.

Financial-based bonus or incentive scheme must align with an organisation’s business objectives, corporate governance, and ethical standards as well as the views of key stakeholders. However, this can lead to a proliferation of checks and balances, such as malus or clawback, which may reduce the motivational impact.

The success of these schemes also depends on how effectively performance is defined, managed and ascribed, requiring effective communication and support for both line managers and employees.

Payment of bonuses and incentives is generally linked to the quality and/or quantity of work on an individual or collective basis, or to some measure of company performance such as profit levels (or both).

Schemes may be broadly divided into the following categories although definitions vary, may overlap or be linked.

• Individual-based - Payment of the bonus/incentive is calculated by some measure of individual performance.

• Schemes driven by business results - Company profit levels or customer satisfaction may be used to help determine bonuses.

• Team-based - Links the bonus with some measure of collective performance.

• Project-based - Might be used when a deadline is important.

• Department/site-based - Payments that could be used to reward workers who attain productivity improvements.

• Gainsharing - Employees share in financial gains achieved through improved performance (particularly enhanced productivity).

• Combination - Two or more of the above schemes, for example a scheme driven by a combination of both individual and team performance.

Our 2019 Reward management survey found that many employers use some form of cash-based bonus or incentive plan. However, such schemes are far more common in private sector than in the public or voluntary sectors. The most popular arrangements include individually based plans (for example, personal performance or commission), plans driven by business results (such as profit) and combination schemes.

CEO bonuses and incentives

Most FTSE 100 executives’ bonus and long-term incentive plans are weighted towards financial measures of company success. Non-financial measures, such as workforce ones, play a minor, albeit growing, role. See our CEO pay and the workforce report for more.

Levels of payments

To affect employee behaviour or performance, bonus or incentive payments need to be ‘worth having’. They must be set high enough to have an effect, and consider (though not be driven by) market practice. Setting bonuses at very high levels needs caution to avoid encouraging undesired behaviours or outcomes, such as taking on more risk or mis-selling.

Incentive calculation must be kept simple. Ideally, employees should be able to measure progress against targets and carry out the calculation themselves.

Employers need to decide how they'll set bonus payments, including whether to use a formula (typically for incentives) and how to express payments (for example, as a salary percentage or a flat-rate payment).

Information tracking specific breakdowns of UK bonus payments over time (by gender, for instance) can be found in the Office for National Statistics' Annual Survey of Hours and Earnings.

Concern around bonuses

Following the 2008 recession, bonuses in the UK became a concern. The Financial Services Authority (FSA) considered that remuneration practices were a ‘contributory factor to the market crisis’. A range of measures were introduced to regulate remuneration in the finance sector, particularly for senior pay. 

For incentives to work as intended and avoid distorted outcomes, employers should have an open and ethical culture in which staff are encouraged to do the right thing and feel able to challenge management decisions or targets they think are unethical. See more in our factsheet on ethical practice and the role of HR.

Because cash may not always be the most effective means of motivating employees, non-financial incentive schemes, based on the receipt of a gift or prize, could have greater impact.

Typically found in customer-facing industries, non-financial incentives may be a single prize won by the highest-performing employee or team, or a range of awards recognising different levels of achievement.

The benefits include:

• Affordability - They may be more cost-effective than cash bonuses.

• Simplicity - It's easy for a sales employee to understand that, say, selling so many phones will result in them receiving whatever the latest prize is.

• Psychological impact - It's more acceptable for employees to speak openly about winning gifts than about cash bonuses.

Drawbacks can include:

• Lack of credibility - Such prizes may not be taken as seriously as cash.

• Lack of employee awareness - Employees may be less conscious of the value of non-financial incentives over ‘hard cash’.

• Lack of value - People value the same non-financial reward, such as a trip to a sporting event, differently, so what might be an incentive to one person might not to another.

The incentivisation industry is more highly developed in the USA than in the UK where, according to our 2019 Reward management survey, only a minority of employers have non-financial incentive schemes.

Types of non-financial incentives

Non-financial incentives may be broadly divided into:

• Merchandise
• Activities/special events
• Travel
• Retail vouchers
• Awarding points that may be converted into a range of awards.

Incentive suppliers

Suppliers of non-cash incentives often provide other schemes such as recognition and team-building activities. There's more information in the journal Incentive and motivation.

Tax implications

Employers implementing a non-financial incentive scheme can be subject to income tax over a certain level. UK employers can pay any tax or national insurance owing on behalf of employees. Information on the UK tax implications of non-financial awards can be found in HM Revenue and Customs guidance.

The purpose of recognition

Recognition (non-monetary rewards) is given to acknowledge and reinforce employees' efforts, behaviour, or achievements. The climate of recognition in an organisation can be measured by asking employees how well recognised they feel by the organisation – for more see our report Incentives and Recognition: An evidence review. 

Do recognition schemes work?

Our 2019 Reward management survey finds significant use of individual or team-based non-financial recognition, especially in the public and voluntary sectors. This is also evident in our report Incentives and Recognition: An evidence review.

CIPD blog

One-off bonuses: are they the best way to support people through the cost-of-living crisis?

Books and reports

ARMSTRONG, M. (2019) Armstrong's handbook of reward management practice: improving performance though reward. 6th ed. London: Kogan Page.

COTTON, C., GIFFORD, J. and YOUNG, J. (2022) Incentives and recognition: an evidence review. Practice summary and recommendations. London: Chartered Institute of Personnel and Development.

PERKINS, S.J. and WHITE, G. (2020) Reward management: alternatives, consequences and context. 4th ed. London: Chartered Institute of Personnel and Development.

Visit the CIPD and Kogan Page Bookshop to see all our priced publications currently in print.

Journal articles

COTTON, C. (2020) CEO pay: complex solutions for complex problems. CIPD Voice. Issue 26. 16 November.

PARK, S. and STURMAN, M.C. (2012) How and what you pay matters: the relative effectiveness of merit pay, bonuses and long-term incentives on future job performance. Compensation and Benefits Review. Vol 44, No 2, March/April. pp80-85.

SHAW, J. and GUPTA, N. (2015) Let the evidence speak again! Financial incentives are more effective than we thought. Human Resource Management Journal. Vol 25 No 3, July. pp281-293.

TAYLOR, T. (2010) The challenge of project team incentives. Compensation and Benefits Review. Vol 42, No 5, September/October. pp411-419.

CIPD members can use our online journals to find articles from over 300 journal titles relevant to HR.

Members and People Management subscribers can see articles on the People Management website.