Merit Increase: How to Design, Fund, and Communicate Performance-Based Pay in 2025

Introduction

A merit increase is a permanent raise to an employee’s base salary awarded specifically to recognize and reward individual performance, achievements, or contributions toward organizational goals. This article is written for U.S.-based HR and compensation teams designing, updating, or refining merit programs in 2025—whether you’re building a merit increase process from scratch or modernizing an existing approach that relies on outdated survey data and spreadsheet workflows.

Merit increases matter more than ever in 2025. Tight labor markets mean top performers have options; inflation has reset employee expectations around pay raises; pay transparency laws are expanding across U.S. states; and pay equity regulations demand that compensation decisions be defensible and documented. In this environment, a well-designed merit pay program is essential to retain top talent, motivate employees, and align pay with both performance and market realities.

Direct answer: A merit increase is a pay-for-performance raise that permanently adjusts an employee’s base pay based on how well they performed against defined criteria—unlike cost-of-living adjustments (which offset inflation for everyone) or across-the-board raises (which are not tied to individual performance).

Scope of this article: You’ll learn what a merit increase is, how it differs from other pay actions, how to calculate and budget for merit raises, how to align increases with real-time market data, and how to communicate decisions to employees and managers. This content is designed for HR professionals and compensation teams—not for individual employees seeking personal negotiation advice.

By the end of this article, you will be able to:

Define and explain standard merit increase percentages for 2025 (including average merit budgets and typical ranges for high performers vs. average performers)
Build a defensible merit matrix using performance ratings and compa-ratio bands
Use real-time market data from tools like SalaryCube’s DataDive Pro to anchor merit decisions to current U.S. salary benchmarks
Navigate common challenges—budget constraints, pay equity risks, and manager discomfort—with practical solutions
Communicate merit decisions clearly so employees understand how their pay increase connects to their performance and the job market

Understanding Merit Increases

A merit increase is a permanent adjustment to an employee’s base salary, awarded as a direct response to that individual’s performance over a defined time period. Unlike a one-time payment (such as a bonus), a merit salary increase is baked into the employee’s annual salary going forward, affecting future pay, overtime calculations for non-exempt workers, and long-term compensation costs. Merit pay is a subset of pay-for-performance compensation strategies: it signals that rewarding outstanding performance is a core organizational value, not just a policy checkbox.

Merit increases are distinct from general pay raises, promotions, bonuses, and cost-of-living adjustments (COLA). A general or across-the-board raise may be granted for tenure, seniority, or structural reasons—not individual performance. A promotion involves a move to a new position with higher responsibilities and typically a larger pay bump aligned to a new salary range. Bonuses and incentive pay are variable, non-recurring financial rewards tied to events or targets, not permanent base pay changes. COLA is designed to maintain purchasing power against inflation, applied uniformly regardless of performance.

In U.S. organizations, merit increases are typically delivered annually as part of a focal review cycle, though some companies award off-cycle exceptional merit raises to retain high performers or respond to market shifts. For 2025, industry surveys suggest average merit increase budgets in the range of 3–4% of payroll, with top performers often receiving 5–6% and average performers receiving 2–3%.

Core Components of a Merit Increase Program

A robust merit increase process is built on several interconnected components:

Eligibility rules: Define which employees qualify for merit increases (e.g., minimum tenure, performance thresholds, status of employees on leaves or performance improvement plans).
Performance ratings: A structured scale (often 3-, 4-, or 5-point) that classifies each employee’s performance for the review period.
Salary ranges and compa-ratio bands: Job-level pay ranges with defined minimums, midpoints, and maximums; compa-ratio measures where an employee’s current salary sits relative to the range midpoint.
Merit pool/budget: The total percentage of payroll allocated for merit increases, set by HR and finance.
Merit matrix: A table that translates performance ratings and compa-ratios into recommended merit increase percentages.

These components interact as follows: performance ratings determine the target percentage range, compa-ratio adjusts that target up or down (accelerating pay growth for those below midpoint, moderating it for those above), and the merit budget caps the overall pool. Pre-defined criteria and documentation support consistency, auditability, and pay equity compliance.

Merit Increase vs. Other Types of Pay Changes

Understanding the distinctions between pay actions is critical for transparent communication and fair outcomes:

Pay Action	When to Use	Permanent or One-Time?	Example
Merit Increase	Rewarding individual performance against defined goals	Permanent	4% base pay raise for exceeding sales quota
General/Structural Raise	Tenure, seniority, or internal equity alignment	Permanent	2% increase for all employees with 5+ years of service
Cost-of-Living Adjustment (COLA)	Maintaining purchasing power against inflation	Permanent	2% across-the-board to offset CPI increase
Promotion	Moving to a new position with higher responsibilities	Permanent	10% increase for move from Senior Analyst to Manager
Variable Pay (Bonus/Incentive)	Recognizing project milestones, company results, or spot achievements	One-time payment	$5,000 bonus for successful product launch
Market Adjustment	Correcting pay below external market rates	Permanent	5% increase to align with current market data for the role
These pay actions can coexist in a single annual cycle. For example, an employee might receive a 2% COLA, a 3% merit increase for superior performance, and a market adjustment if SalaryCube data shows the role is paid below the 50th percentile. Separating these actions in communication builds employee trust and ensures transparency.

How Merit Increases Support Business Strategy

Merit increases are more than a reward mechanism—they’re a strategic lever for aligning individual contributions with company success. When employees understand that high performance leads to meaningful pay progression, organizations see stronger performance cultures, reduced regrettable turnover, and improved job satisfaction.

Data supports this connection: organizations that differentiate merit pay for top performers report higher engagement scores and lower attrition among critical roles. Merit-based pay also supports internal equity when tied to consistent, documented criteria—ensuring that employees performing at similar levels receive similar recognition.

Effective merit programs must be grounded in clear criteria and accurate market data, not ad hoc decisions or gut instinct. This connects directly to the next section: designing a merit framework that managers can apply reliably across the organization.

Designing a Merit Increase Framework

Once HR teams understand what a merit increase is and how it differs from other pay actions, the next step is to design a consistent framework. This framework should be written, shareable, and aligned with the organization’s compensation philosophy and pay transparency commitments. A clear framework reduces bias, speeds up manager decisions, and supports defensible pay equity outcomes.

Define Your Compensation and Merit Philosophy

A compensation philosophy is a documented statement of how the organization approaches pay—covering market positioning, the role of performance in pay progression, and the balance between base pay, variable pay, and equity. Merit practices flow directly from this philosophy.

Key decisions to articulate:

Pay positioning: Will you lead, match, or lag the market? For example, “We target the 60th percentile of U.S. market rates for critical technical roles.”
Performance differentiation: How much spread will you create between top performers and average performers? A meaningful gap (e.g., 5% vs. 2.5%) signals that rewarding outstanding performance is real, not symbolic.
Balance of pay elements: What proportion of total compensation comes from base salary vs. bonuses, incentive pay, or equity?

A written philosophy guides decisions on average merit budgets (e.g., 3% vs. 4%) and differentiation between performance ratings. Real-time benchmarking tools like SalaryCube’s DataDive Pro can validate whether merit increases are keeping pay within intended market ranges—preventing situations where even “good” merit bumps leave employees below market.

Set Eligibility Rules and Timing

Clear eligibility rules prevent confusion and grievances during the merit increase process. Without documented policies, managers and employees may have mismatched expectations, leading to frustration and perceived unfairness.

Key policy questions to address:

Minimum tenure: How long must an employee be in role before they’re eligible? (e.g., 6 months before the focal date)
Performance thresholds: Are employees on performance improvement plans (PIPs) eligible? What about those with “below expectations” ratings?
Leave and transfers: How do you handle employees returning from leave, or those recently transferred or promoted?
Geography and work arrangement: Will remote vs. on-site employees in different U.S. regions follow the same rules, or will geographic pay differentials apply?
Timing: Will you use an annual merit cycle or allow off-cycle exceptional merit awards for retention or exceptional performance?

Document these rules in manager guides and employee handbooks. Transparency ensures fairness and reduces the risk of legal or pay equity challenges.

Define Performance Rating Scales for Merit Decisions

Performance ratings are the foundation for merit decisions. A well-designed rating scale (e.g., 3-, 4-, or 5-point) classifies employee performance and directly informs merit percentage guidelines.

Best practices for rating scales:

Anchor each rating level with behavioral examples so managers and employees understand expectations (e.g., “Exceeds Expectations: Consistently goes the extra mile, delivers measurable results beyond goals, and contributes to team and organizational success”).
Calibrate ratings across teams and departments to avoid rating inflation or inconsistency—one manager’s “Exceeds” should mean the same as another’s.
Ensure top ratings receive meaningfully higher merit increases than solid performers, within budget limits. If the gap is too narrow (e.g., 3% vs. 2.5%), the incentive effect is lost.

Consistent, well-documented ratings help defend decisions in pay equity analyses and audits, demonstrating that merit pay is based on defined criteria, not subjective or biased judgments.

Incorporating Market Data Into Merit Planning

Pay decisions can’t be based solely on internal performance—they must also reflect external U.S. market data. If your salary ranges are built on outdated surveys, even a generous merit increase may leave employees below market, increasing turnover risk.

How to integrate market data:

Use real-time salary data (e.g., SalaryCube’s Bigfoot Live) to ensure ranges are aligned to current market conditions, not last year’s survey cycle.
Calculate compa-ratio (employee pay ÷ range midpoint) for every employee before the merit cycle. This shows whether an employee is low, mid, or high in their band.

Example: Consider two high performers in the same role. Employee A has a compa-ratio of 0.85 (well below midpoint); Employee B has a compa-ratio of 1.10 (above midpoint). Even if both receive “Exceeds Expectations” ratings, Employee A might receive a 5–6% merit increase to accelerate toward market, while Employee B might receive 2–3% or a one-time payment to avoid exceeding the range maximum.

With philosophy, ratings, and market data in place, HR can now build a practical merit matrix and calculation workflow.

Calculating Merit Increases and Building a Merit Matrix

This section turns concepts into numbers: how to move from budgets and ratings to specific, defensible merit amounts per employee. All examples use clear, round numbers and U.S. dollars.

Step-by-Step: How to Calculate a Merit Increase

This workflow applies whether you’re using spreadsheets or a modern compensation platform.

Determine the organization-wide merit budget as a percentage of total base payroll (e.g., 3.2% for FY 2025).
Assign each employee a current base salary and verified job range with midpoint (from tools like SalaryCube).
Confirm each employee’s performance rating from the latest review cycle.
Use the merit matrix (see next subsection) to find the recommended percentage for each rating/compa-ratio cell.
Calculate the raise: Current base × merit % = raise amount. (e.g., $80,000 × 4% = $3,200; new salary = $83,200)
Check the new salary against the range. If the increase would push the employee above the range maximum, consider splitting the award into a smaller base increase plus a one-time lump-sum payment.

Worked example:

Employee’s current salary: $70,000
Performance rating: Exceeds Expectations
Compa-ratio: 0.92 (below midpoint)
Merit matrix recommendation: 5%
Calculation: $70,000 × 5% = $3,500
New salary: $73,500

Designing a Merit Matrix (Ratings × Compa-Ratio)

A merit matrix is a table that suggests merit increase percentages based on performance rating (rows) and compa-ratio band (columns). This structure ensures that merit pay is both fair and budget-conscious.

Typical structure:

Performance Rating	<85% Compa-Ratio	85–100%	100–115%	>115%
Exceeds Expectations	6%	5%	3%	0–2%*
Meets Expectations	4%	3%	2%	0–1%*
Below Expectations	0%	0%	0%	0%
*Consider lump-sum payment for those above range max.

How to set the matrix:

Give higher percentages to high performers and lower percentages to low performers.
Give slightly higher percentages to employees lower in the range to accelerate them toward market; moderate increases for those well above midpoint.
Ensure the weighted average of all cells fits within the total merit budget.

SalaryCube’s DataDive Pro can export compa-ratios and support building and iterating on the matrix in minutes, replacing weeks of manual spreadsheet work.

Sample Merit Increase Scenarios for 2025

Scenario 1: Mid-Range, High Performer

Rating: Exceeds Expectations
Current salary: $90,000
Compa-ratio: 0.98
Merit matrix recommendation: 5%
New salary: $94,500
Rationale: Reward employee’s exceptional performance and move closer to market midpoint.

Scenario 2: Below-Midpoint, Solid Performer with Market Gap

Rating: Meets Expectations
Current salary: $65,000
Compa-ratio: 0.82
Merit matrix recommendation: 4%
Market adjustment (SalaryCube data shows role is 5% below market): additional 2%
Total increase: 6% ($3,900)
New salary: $68,900
Rationale: Merit plus market adjustment to close a documented market gap.

Scenario 3: Over-Range, Top Performer

Rating: Exceeds Expectations
Current salary: $115,000
Compa-ratio: 1.12 (above range midpoint)
Merit matrix recommendation: 2% base + $2,500 one-time lump-sum
New salary: $117,300 (base), plus $2,500 bonus
Rationale: Recognize superior performance without exceeding range maximum; preserve long-term range integrity.

Standardizing these scenarios in a matrix reduces bias, speeds manager decisions, and creates audit trails for pay equity compliance.

Implementing Merit Increases in Your Organization

Design and calculation are only half the work. Implementation requires governance, tools, and clear workflows. Repeatable, auditable processes support pay equity, compliance, and leadership confidence.

Building a Governance and Review Process

Effective governance ensures merit increases are consistent and defensible:

HR and compensation set guardrails: ranges, merit matrix, and budget.
Managers propose increases within guidelines, using performance data and compa-ratios.
HR and finance review aggregates vs. budget and equity metrics.
Leadership approval and lock dates finalize the cycle.

Calibration meetings normalize merit recommendations across teams and check for rating and pay disparities (e.g., by gender, race, tenure). SalaryCube’s reporting can quickly surface outliers by compa-ratio, range penetration, and demographic cuts—supporting both equity and efficiency.

Technology and Tools to Streamline Merit Cycles

Manual spreadsheets and static survey PDFs are increasingly insufficient for modern merit planning. They introduce errors, slow down cycles, and make it difficult to respond to market changes.

Capabilities HR teams should look for:

Real-time U.S. salary benchmarking integrated into planning (e.g., SalaryCube’s Bigfoot Live)
Built-in compa-ratio and range analytics to inform merit decisions
Unlimited, exportable reports (CSV/PDF/Excel) for managers and executives
Audit trails documenting who approved what, when, for compliance

Ready to see a full merit cycle configured end-to-end? Book a demo or watch interactive demos to experience SalaryCube’s workflows firsthand.

Integrating Merit Increases with Job Architecture and FLSA Compliance

Consistent merit decisions require clear job architecture—defined levels, families, and salary bands. Without this foundation, merit increases can create pay compression or push employees outside appropriate ranges for their roles.

Tools like SalaryCube’s Job Description Studio help define roles and tie them to market ranges and FLSA classification. A common pitfall: giving large merit increases that push a non-exempt role beyond typical non-exempt market rates without re-evaluating duties and FLSA classification. SalaryCube’s FLSA Classification Analysis Tool helps maintain audit-ready documentation while adjusting pay.

Even strong designs face real-world challenges—budget limits, equity concerns, and manager resistance. The next section addresses these directly.

Common Merit Increase Challenges and How to Solve Them

HR teams operating merit programs face predictable obstacles, especially during economic uncertainty. This section presents common problems and practical, HR-ready solutions.

Challenge 1: Limited Merit Budgets vs. Employee Expectations

With average merit budgets at 2.5–3% and employees expecting larger raises due to inflation and headlines, the gap between expectations and reality can erode trust.

Solutions:

Increase differentiation: allocate a larger share of the merit pool to high performers, rather than spreading thin across the board.
Use targeted market adjustments only where SalaryCube data shows true under-market pay—don’t use merit to fix market problems.
Communicate clearly about the difference between COLA, merit, and market adjustments so employees understand how their pay raise was determined.

Challenge 2: Pay Equity and Unintended Bias

Inconsistent merit decisions can widen existing pay gaps over time, creating legal and reputational risk.

Solutions:

Run pre- and post-cycle pay equity reviews using standardized analytics (pay vs. peers, by protected class where legal).
Use structured merit matrices and cap manager discretion within defined ranges.
Set exception-review processes where HR must sign off on out-of-band increases.

For more on defensible, data-based decisions, visit SalaryCube’s methodology and resources page.

Challenge 3: Manager Discomfort in Communicating Merit Decisions

Poorly handled conversations erode trust, even when the actual percentage is competitive.

Solutions:

Provide managers with scripts and talking points explaining how merit decisions were made (ratings, market data, budget).
Train managers to focus on performance, development, and future earning potential—not just the number.
Equip managers with simple visuals (e.g., where the employee sits in the range) generated through compensation tools.

Challenge 4: Hybrid and Blended Roles That Don’t Fit Legacy Surveys

Traditional survey-based pricing breaks down for modern hybrid roles (e.g., “Product Manager + Data Analyst”), complicating merit decisions.

Solutions:

Use real-time, role-matching tools (like SalaryCube’s DataDive Pro) that can price hybrid positions based on skill mix rather than outdated titles.
Adjust ranges and compa-ratios for blended roles before the merit cycle so increases are anchored to realistic market data.

Addressing these challenges turns merit increases into a strategic, not reactive, process.

Conclusion and Next Steps

A merit increase is a permanent, performance-based raise to base pay—one of the most powerful levers HR teams have for motivating employees, retaining top talent, and aligning compensation with organizational goals. In 2025, data-driven frameworks built on real-time market data, structured merit matrices, and transparent governance are essential to ensure fairness, speed, and defensibility.

Immediate next steps for HR teams:

Audit current salary ranges against real-time U.S. market data using a tool like SalaryCube.
Draft or update your merit matrix, aligning it with your compensation philosophy and current budget.
Review eligibility rules and performance rating scales for consistency and documentation.
Plan a manager training session on communicating merit decisions effectively.
Run a pre-cycle pay equity review to identify and address potential disparities.

Related strategic topics for further exploration:

Pay equity analysis: Ensure merit outcomes don’t widen pay gaps. Connects directly to merit matrix design and calibration.
Salary range design: Sound ranges are the foundation for compa-ratio-based merit decisions.
Job architecture: Clear levels and families support consistent merit allocation across roles.

If you want real-time, defensible salary data that HR and compensation teams can actually use for merit increases, book a demo with SalaryCube.

Additional Resources for Merit Increase Planning

This section provides optional but valuable reference material for HR and compensation teams who want to go deeper into calculations and tools.

Internal resources to reference:

Salary benchmarking and market pricing: SalaryCube Salary Benchmarking Product
Real-time market intelligence for merit cycles: Bigfoot Live
Free calculators to sanity-check merit decisions (e.g., compa-ratio calculator, wage raise calculator): SalaryCube Free Tools
Methodology and security documentation to support defensible, auditable merit decisions: SalaryCube Resources

Note: All SalaryCube data and guidance are focused on U.S. compensation, which is critical for compliance and accuracy.

If you want real-time, defensible salary data that HR and compensation teams can actually use for merit increases, book a demo with SalaryCube.