May 6, 2025

Merit Bonuses vs. Incentive Bonuses: Key Differences Explained

When it comes to rewarding employee performance, companies often choose between a merit bonus and an incentive bonus - or use both. Understanding the difference is essential to designing a compensation strategy that drives motivation, retains top talent, and aligns with business goals.

In this article, we’ll explore the definitions, purposes, and structures behind merit bonuses and incentive bonuses, explain key differences, along with practical examples and guidance on avoiding common pitfalls.

What Is a Merit Bonus?

A merit bonus is a reward given to employees based on individual performance evaluations. Unlike a salary increase, it’s a one-time payment recognizing past achievements rather than future goals.

These bonuses are typically determined through performance reviews, where employees who exceed expectations receive an additional reward. Companies often use key performance indicators (KPIs), manager evaluations, and peer feedback to assess merit-based awards. Merit bonuses work well in organizations that want to reinforce a culture of excellence and recognize top performers without committing to long-term salary increases.

Merit Bonus Meaning:

Reflects consistent, strong performance over time
Typically tied to manager evaluations and performance ratings
Paid annually or semi-annually
Does not require preset targets

Merit Bonus Examples:

Annual Performance Reviews: Many companies award merit bonuses following yearly performance evaluations, rewarding employees who exceed expectations.
Project-Based Recognition: Organizations may grant merit bonuses after the successful completion of high-impact projects.
Leadership and Initiative: Employees who take on extra responsibilities or drive innovation may receive merit-based rewards.

What Is an Incentive Bonus?

An incentive bonus is performance-driven and often tied to specific targets or results. Incentive bonuses are designed to encourage future performance by linking rewards to predefined goals. Unlike merit bonuses, which recognize past achievements, incentive bonuses are forward-looking and contingent on specific results.

These bonuses can be structured at the individual, team, or company level, and they often align with strategic objectives such as revenue growth, customer satisfaction, or operational efficiency. Incentive bonuses can be short-term (monthly or quarterly) or long-term (annual performance targets).

Incentive Bonus Meaning:

Forward-looking and tied to specific KPIs
Often linked to sales, productivity, or project completion
Can be individual, team-based, or company-wide

Bonus Incentive Program Examples:

Sales Commissions: Sales teams frequently receive incentive bonuses based on revenue generation or quota attainment.
Project Completion Bonuses: Employees may be rewarded for finishing a project ahead of schedule or under budget.
Company-Wide Profit Sharing: Some organizations distribute incentive bonuses when financial targets are met.
Team Bonus: A software team earns a LTI bonus (long-term incentive) for achieving 99.9% uptime for 12 months

Key Differences Between Merit and Incentive Bonuses

Feature	Merit Bonus	Incentive Bonus
Purpose	Recognize past performance	Motivate future performance
Timing	Awarded after performance reviews	Awarded upon meeting set targets
Criteria	Subjective manager evaluation	Objective KPIs and metrics
Frequency	Annual or semi-annual	Can be quarterly, annual, or project-based
Flexibility	More discretionary	Requires pre-defined bonus plans

When to Use Each Type of Bonus

Use Merit Bonuses When:

The goal is to recognize outstanding past performance.
The organization values long-term employee contributions.
Employee evaluation is based on subjective or qualitative measures (e.g., leadership, teamwork, or problem-solving).

Use Incentive Bonuses When:

The company wants to drive specific business outcomes in the future.
Performance can be measured objectively (e.g., revenue growth, cost savings, productivity increases).
Driving specific behaviors (e.g., sales, efficiency)
Aligning compensation with business results
A results-driven culture is a key component of the organization’s strategy.

Many organizations use both merit and bonus systems in tandem, tailoring rewards based on role and level.

Common Pitfalls and How to Avoid Them

While bonuses can be powerful motivators, poor implementation can lead to unintended consequences. Here are some challenges to watch for when structuring effective bonus programs.

For Merit Bonuses:

Subjectivity: Relying too heavily on manager discretion can introduce bias. Use standardized review frameworks.
Lack of clarity: Ensure employees understand how bonuses are determined.
Over-Reliance on Merit Bonuses: If only top performers receive bonuses, it may demotivate the broader workforce.

For Incentive Bonuses:

Unrealistic goals: If targets are too ambitious, they can demotivate rather than inspire.
Misaligned KPIs: Incentives should match company priorities, or they may encourage the wrong behaviors.
Lack of Transparency: Employees should clearly understand the criteria for earning a bonus.

Companies Using Both Bonus Types Effectively

Case Study: Tech Company

A SaaS firm uses merit bonuses for engineering roles and an incentive bonus plan for sales. Top engineers get annual LTI bonuses for innovation, while account managers receive monthly bonuses tied to new ARR.

Case Study: Healthcare Provider

Front-line staff receive STIP bonuses (Short-Term Incentive Plan) for night shifts and patient care metrics (incentive bonuses), while department heads receive merit based bonuses aligned with quality reviews.

Conclusion

Understanding the differences between merit bonuses and incentive bonuses allows businesses to reward employees in ways that are fair, strategic, and motivating. By blending both approaches—and avoiding common mistakes—companies can create bonus plans that support growth and performance.