How to develop annual incentive plans that motivate employees

Every family has their favorite holiday movie — “It’s a Wonderful Life,” “Miracle on 34th Street,” “Elf.” But for my family, it’s National Lampoon’s “Christmas Vacation.”

Besides being side-splittingly funny, there’s even a powerful professional lesson to take away from this classic: screwing up annual employee incentive plans can have dire consequences.

In case you’re unfamiliar, here’s the summary: Clark Griswold, the ultimate family man, is counting on his anticipated annual bonus to install a backyard pool. He even writes a check he can’t cover until that bonus comes through. But when it finally arrives, it’s not the fat check he’s expecting—it’s a one-year membership to the jelly-of-the-month club.

Cue a profanity-laden rant for the ages against his boss.

Every HR team should take note: a poorly planned incentive plan doesn’t just miss the mark — it can cause an outright mutiny.

So, what works? What doesn’t? Let’s dive into the research and see what kinds of incentive plans will actually motivate your team.

What is an annual incentive plan?

Let’s start with an important distinction: an annual incentive plan is not a bonus.

• Annual incentive plan: A structured, performance-based compensation package designed to drive future behavior.

• Bonus: Typically discretionary, less structured, and used to reward past performance or celebrate company success.

Bonuses are like icing on the cake — a sweet extra at year’s end. Annual incentive plans, on the other hand, are strategic tools tied to team or individual performance against specific goals.

“A bonus is typically a one-time reward given after an achievement, such as meeting a sales goal or completing a successful project. Bonuses are often tied to short-term outcomes and are usually financial,” says Siobhan O’Leary, an HR expert with nearly four decades of experience in workforce management. “An employee incentive program, on the other hand, is a structured initiative designed to encourage ongoing performance and engagement.“

How do annual incentive plans work?

There’s no one-size-fits-all formula for annual incentive plans, but successful plans have a few things in common:

1. Clear goals: Managers define KPIs and goals for the year.

2. Firm deadlines: A set time frame for achieving these goals.

3. Budget alignment: Incentives are budgeted early.

4. Employee buy-in: Goals and incentives are communicated in writing.

5. Progress tracking: A system is in place for employees to monitor their progress.

6. Timely rewards: When goals are met, employees receive their promised incentives.

“Employees want to feel a sense of ownership driving the success and purpose of an organization,” explains O’Leary. “Frequent communication, measurable objectives, and consistent follow-up are critical.”

Examples of annual incentive plans

Profit-sharing

Profit-sharing is simple and effective. It aligns everyone’s efforts with the company’s success. Unlike role-specific plans, this approach rewards all employees equally, regardless of department or position.

However, profit-sharing may not address the nuances of roles where success is harder to quantify, like HR or marketing.

Academic research in the field generally shows neutral to positive results, so while the risk of a profit-sharing annual incentive plan is low, it’s also not a guaranteed home run.

Performance-based incentive plans

Performance-based plans tie rewards directly to measurable outcomes. For example:

• Sales teams: Goals could focus on revenue, units sold, or client retention.

• Customer support: Goals could include response times, satisfaction scores, or resolution rates.

• Tech teams: Goals could center on uptime, deployments, or product improvements.

The key here is specificity. The clearer the target, the more likely employees are to hit it.

Research backs this up: In a 2018 meta-analysis on incentive structures, former Council of Economic Advisers chairman Edward Lazear found that performance-based incentives significantly improved productivity when tied to clear, achievable metrics.

Team-based incentive plans

Team-based incentive plans are an attractive option for managers. In addition to motivating employees to push for company-wide goals, they can also help foster teamwork and camaraderie among employees. 

There’s a potential pitfall with this structure — the classic group project problem. Team-based incentives run the risk of creating an environment in which a select few high performers pull the weight for the team while employees who didn’t contribute still reap the same reward. In that same 2018 study, Lazear writes that team-based incentives often suffer from so-called free-rider effects when implemented in large group settings. However, studies have shown positive effects in smaller groups.

One such study followed a group of doctors incentivized to reduce healthcare costs by avoiding ordering unneeded tests or appointments. When paired in smaller groups, the providers significantly reduced patient costs. However, when placed in larger panels, some doctors didn’t try as hard because they figured others would make up the difference.

“Team-based incentives promote unity and tenacity,” says O’Leary. “In team incentives, there’s no giving up early, and they generally reduce unhealthy competition.”

Individual incentive plans

Individual plans are tailored to specific roles and goals. They’re a great way to recognize standout employees and reward them for their contributions.

However, for large organizations, managing individual plans for each employee can be a big logistical challenge. Incentive management programs may be a good investment to save time for your HR team while still reaping the benefits of an employee incentive plan catered to individual employees. 

“Individual incentive plans are often used to help retain top performers. Individual incentive plan helps ensure compensation is commensurate with employee contribution and skill set.”

How to Develop an Effective Annual Incentive Plan

HR experts suggest the following dos and don’ts when creating effective plans:

Do

• Keep it simple. A simple and easy-to-understand incentive is more likely to motivate employees. Employees should be able to easily track and check their progress towards their goal (and thus their incentive) throughout the year. If an incentive plan is overly complex, you run the risk of employees just giving up on it. “We want to make it easy for employees to see the connection between their efforts and rewards. A straightforward plan is easier to implement, track, and adjust as needed and cascade down,” says O'Leary.

• Allow flexibility. Business goals change. While you don’t want to completely change the rules of the game midstream, your plan should allow for a certain level of flexibility to account for changes to your industry’s landscape throughout the year. 

• Set achievable goals. While goals should encourage your team to aim high, a goal that is impossible to achieve only serves to demoralize team members. Make sure your goals are ambitious but within the realm of possibility.

Don't

• Go one-size-fits-all. Industry research shows that incentivizing smaller groups tends to be much more effective than large groups. A company-wide goal can work, but incentivizing small teams across your company can add fuel to the fire.

• Make it all-or-nothing. An incentive plan should have partial rewards to keep employees motivated, even if the ultimate goal feels out of reach. “Incentive plans that are all or nothing can demotivate employees who fall slightly short of goals. However, in an effort to be fiscally responsible, effective incident plans have a gatekeeper or a discretionary trigger for the other rewards to be activated,” explains O’Leary. “For example, achieving 80% of a target could result in a proportional reward, maintaining morale and drive.”

• Ignore feedback. Listen to employees about what’s working and what isn’t. According to O'Leary, “Feedback builds trust, drives engagement, and creates a sense of ownership over the program.”

Keep your employees engaged with annual incentives

Employee incentive plans are more than just a tool for driving performance — they’re an opportunity to build trust, foster collaboration, and celebrate your team’s successes.

Done right, they can transform your company culture and keep your employees motivated year-round.

Take the time to plan carefully, communicate clearly, and adapt based on feedback. Avoid your own Clark Griswold moment, and maybe next year’s incentive can cover that backyard pool.

Up next: Employee recognition: How employees want to be rewarded