Working Paper | HBS Working Paper Series | 2010

The Psychological Costs of Pay-for-Performance: Implications for the Strategic Compensation of Employees

by Ian Larkin, Lamar Pierce and F. Gino

Abstract

Most research linking compensation to strategy relies on agency theory economics and focuses on executive pay. We instead focus on the strategic compensation of non-executive employees, arguing that while agency theory provides a useful framework for analyzing compensation, it fails to consider several psychological factors that increase costs from performance-based pay. We examine how psychological costs from social comparison and overconfidence reduce the efficacy of individual performance-based compensation, building a theoretical framework predicting more prominent use of team-based, seniority-based, and flatter compensation. We argue that compensation is strategic not only in motivating and attracting the worker being compensated, but also in its impact on peer workers and the firm's complementary activities. The paper discusses empirical implications and possible theoretical extensions of the proposed integrated theory.

Keywords: Compensation and Benefits; Employees; Recruitment; Performance Evaluation; Agency Theory; Motivation and Incentives; Corporate Strategy;

Citation:

Larkin, Ian, Lamar Pierce, and F. Gino. "The Psychological Costs of Pay-for-Performance: Implications for the Strategic Compensation of Employees." Harvard Business School Working Paper, No. 11–056, December 2010. (Revised July 2011.)