The simple act of receiving a paycheck for one’s job is the result of many complex processes involved in the art and science of compensation. Compensation systems are designed to comply with a large number of organizational objectives, including serving as an exchange for hourly labor, motivating behavior, and accomplishing social objectives such as covering the cost of medical insurance. The design of compensation systems and methods for distributing pay and benefits is influenced by cultural traditions and legal requirements.

Within the organizational sciences, compensation has traditionally encompassed base pay, pay raises, pay systems, benefits, the psychology of pay, and legal issues. Recently, the area of compensation has expanded to include nontraditional conceptions of pay that are often captured under the term total compensation. Total compensation includes not only pay and benefits but also nonmonetary rewards, such as the value of positive job characteristics (e.g., having a creative job has a positive nonmonetary value that should be seen as part of total compensation). A second change that has occurred in the area of compensation over the last 20 years is an increased emphasis on at-risk pay, variable pay, or pay for performance. Despite the importance of these two recent trends, compensation will be treated here in its more traditional fashion, although brief mention will be made of total compensation and at-risk pay.

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Base Pay

Establishing the base pay, the basic annual salary or hourly wage, for a job can be a challenge. Organizations often rely on the market, which can be assessed through market surveys. However, the market can be unstable and unreliable. Industrial and organizational psychologists have made a significant contribution to the field of compensation through their work on job analysis and job evaluation systems. Job evaluation systems, particularly the point system, provide reliable, valid methods of measuring the compensable worth of jobs through the ratings of job characteristics such as skill, effort, responsibility, and working conditions. Job evaluation systems allow for the distribution or slotting of jobs into grades. Jobs within a grade receive the same base pay, although there can be fluctuations based on the step within the grade.

During the 1990s, the idea of broadbanding became more popular. Under a traditional system, there may be as many as 12 to 20 grades. Under a broadband system, there may be as few as 3 to 5 grades. Broadbanding systems are seen as allowing for greater managerial discretion and flexibility in the assignment of initial rates of base pay.

Pay Raises

In traditional pay systems, individuals start at a certain entry pay rate. Over time, they receive pay increases. In most systems, these increases are a function of both seniority and the cost of living. Pay raises may also depend on merit. Although merit may be based on some type of objective performance criteria, it is usually operationalized based on supervisor recommendations or ratings. Thus, the merit component is heavily dependent on the perceived fairness of the performance appraisal system. In addition to individual performance, pay raises may vary based on organizational performance, organizational productivity, or market conditions.

Pay Systems

Traditional pay systems rely on the payment of a fixed annual salary or hourly wage. This may be accompanied by periodic raises based on the cost of living or on merit. Over the last 40 years, however, this traditional view of pay has been challenged. For example, the new pay movement emphasizes paying workers for skills (i.e., skill- or competency-based pay) as opposed to the actual duties performed on the job.

The total compensation movement argues that pay should be conceived as being more than just salary and benefits, including as well the psychological benefits of the job. For example, having a good leader or having a lot of autonomy could be considered part of the total compensation package because these elements of the job represent a psychological benefit.

The variable or at-risk pay approach is based on the concept that pay is often seen as an entitlement and that more of an employee’s compensation dollar should be at risk and earned through effective performance. As a result, companies have begun to introduce a variety of pay-for-performance and incentive systems, including gain sharing, goal sharing, and profit sharing.


Relatively little psychological research has been conducted in the area of benefits. Benefits are important to pay satisfaction overall, but the overall value of benefits tends to vary as a function of the degree to which workers need benefits. For example, younger workers tend to be more aware of their maternity benefits, whereas older workers tend to be more aware of their retirement benefits. Thus, the value of benefits is likely to shift as a function of both the culture of the worker’s generation and the point in his or her career path.

Psychology of Pay

It may be somewhat surprising that industrial and organizational psychologists have not paid more attention to the psychology of pay. This lack of attention is partly a result of the humanistic-organizational movement of the 1950s and 1960s. Nevertheless, there are some theories aimed at explaining pay processes and pay satisfaction.

Three major theories attempt to explain satisfaction with distribution rules: equity theory, equality theory, and utility theory. In recent years, justice theory has also emerged as a major research framework. Justice theory argues that it is not just the fairness of the distribution that matters but also the fairness of the procedures used to make decisions. A major theoretical contribution to our understanding of executive pay is agency theory, which argues that stockholders use large incentives to motivate their agents (executives) to act in the best interest of the stockholders.

Major contributions have been made in the area of pay satisfaction measurement. The main facets of pay satisfaction are pay level, raises, benefits, and administration.

Legal Issues

As in most areas of human resources in the United States, federal and state laws have had a huge impact on the practical design of compensation systems and on the topics studied by researchers. Some of the laws that affect compensation in the United States include the Fair Labor Standards Act of 1938, the Equal Pay Act of 1963, and Title VII of the Civil Rights Acts of 1964 and 1991. Unions also have a major impact on pay systems.

During the 1970s, the issue of sex discrimination in pay was much debated. This debate, referred to as the pay equity or comparable worth debate, prompted a great deal of research by industrial and organizational psychologists on the psychometric properties of job evaluation systems and gender issues in pay systems.

Special Groups and Topics

Some groups, such as salespeople and executives, have special compensation systems. For example, some salespeople work on 100% commission based on their sales. Executive pay in the United States has become a controversial topic because of the large differences between worker and executive pay and the apparent disconnect between firm performance and executive pay.

The increased globalization of companies has also led to special compensation challenges. As with other types of pay, organizations have attempted to place limitations and controls on the amounts spent on expatriate pay.

One of the most interesting challenges to traditional compensation arose during the late 1990s as a result of the rise of virtual companies and e-jobs. A question that may have to be answered in the future is how to best compensate people working for virtual companies.


Pay is a complex process that is influenced by culture, society, and the law. At the individual level, pay satisfaction is important to job satisfaction, organizational commitment, and turnover intentions. Although individuals do not necessarily stay with an organization because of pay, it is clear that a major reason individuals leave organizations is the receipt of generous pay offers from other companies. Organizations continue to strive to develop pay systems that will give them a competitive advantage, although it is unclear whether pay satisfaction causes organizational financial performance or whether the financial performance of organizations leads to increased pay satisfaction.


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  2. Harvard Business Review. (2001). Harvard Business Review on compensation. Boston: Harvard Business School Press.
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