See this write-up, somewat informational...

Introduction

It is very common to have once a year salary increments for all employees. Sometimes these are all done at once, alternatively they may be done on the anniversary date of the employee´s being hired. In either case, there is typically a set of rules to guide what increment an individual gets.

This article describes the most common way to give merit increments. There are all kinds of variations you can engineer. There are also some very different alternatives. You will almost certainly need to revise some elements of the method described here to better meet your specific situation.

In this article we are focusing on base salary increments, meaning increases to base salary that occur without a promotion.

Merit vs. Cost-of-Living Increases

Pay increases be cost-of-living increments reflecting inflation or merit increments reflecting the increased value of an employee to the firm. Usually firms bundle these two together so that an employee is told, "You get a 4% increase" rather than the more accurate "You get a 3% cost-of-living increase and 1% for merit."
Cost-of-living is not the most precise term to use. It is better for HR to use changes in labor market rates rather than the overall inflation rate. For example, general wage increases may be lower or higher than the overall rate of inflation. If wages are going up faster than inflation then a firm will need to follow the wage rate, not the inflation rate, in order to attract and retain employees. Similarly, if wage rates are falling behind inflation then there is no need to pay at the inflation (cost of living) rate.

Compa-Ratio

Compa-ratio is a useful concept in salary management. It is the person’s salary divided by the mid-point of the grade.
For example, assume Mr. X is in Grade C and is paid $11,000.
If the salary midpoint of Grade C is $10,000 then Mr. X´s compa-ratio is 1.1 ($11,000/$10,000).

Grade Maximum

In these examples I´ll assume that grades have salary ranges +/- 20% from the midpoint. This means someone with a compa-ratio of 1.2 is at the maximum of their grade. For example a Ms. Y in Grade C who is paid $12,000 would have a compa-ratio of 1.2 ($12,000/$10,000) and would be at the maximum of the grade ($10,000 +20%)

A Typical Salary Grid
Most firms use performance appraisals that give individuals ratings on a scale. I´ll assume a rating scale of 1 to 5.

Salary Increment
Compa-Ratio
Performance <.9 .9-1.0 1.0-1.1 1.1-1.2 >1.2
1-Excellent 12 10 8 4 0
2-Very Good 10 6 4 2 0
3-Good 6 4 2 0 0
4-Safisfactory 4 2 0 0 0
5- Poor 0 0 0 0 0

General Principles for Setting the Amounts in Each Cell

As you can see the general rule is that high performers get more than low performers and people high in the range (i.e. already paid highly for their job) get smaller increments than people lower in the range. People at or above the grade maximum (compa-ratio higher than 1.2 in this example) get no increment.

Managing The Budget

Typically there is a salary increment budget. HR needs to play with the increments so that the budget is not exceeded. Sophisticated compensation software can do this easily. Smaller firms typically do this calculation using spreadsheets. Here is a sample spreadsheet.

Solving the Problems (ha!)

The most important point to understand is that this (or any) approach will generate a lot of problems. Â There is no "solution" to the problems. Â Hence, your job is not so much to solve the problems or defend your solution as to get all the key people on-side by involving them in the decisions. Â Once people realize the trade-offs involved (which they´ll only do by being involved in the decision making) they will buy into the program.
In times of high inflation it is relatively easy to manage increments because everybody gets something. Â In times of low inflation it is more difficult.
Here are some of the problems you will encounter:

1) Not fair to give a lower increment to someone just because they are already paid higher in the grade.
The reasoning behind slowing down the increments is:
If you are above mid-point you are already being well-paid for good performance so they don´t deserve more.
Normally people start at the bottom of the pay range and quickly improve rapidly in the first few years as they learn the job. Â This scheme allows us to quickly get people up to mid-point in a way that accurately reflects their value.
People will eventually hit a maximum and this slows down the impact. Â If a very good performer got 10% a year, in a few years they´d hit the maximum of the grade and suddenly find their salary frozen. Â This method softens the impact.
Those are the reasons but companies can choose instead to just give everyone at a given performance level the same increment irrespective of compa-ratio.

2) A 2% increase is an insult.

Many people feel there is no point giving very small increments and it is better to give zero. This is a valid point, it all depends on culture and how the increment is communicated. This is an issue to be thrashed out with key managers.

3) There is not enough of a reward for high performance

Many people will argue that there is not enough of a reward for high performance: "Why did I knock myself out to get an excellent rating for a lousy 2% increment over ´very good´?"
There are various reasons for keeping the ratios small:
Appraisals are biased and unreliable hence it´s unfair to base substantial rewards on them.
Big increments provide permanent rewards for short term performance, hence it is better to provide a bonus rather than a big base salary increment.
It becomes too expensive to provide high rewards.
Very high increments rapidly push people to the maximum of the range at which point their salary is abruptly frozen.

4) It´s unfair to freeze salaries when they are at the max
When a good performer hits the salary maximum many feel it is unfair not to give a merit increment. Â In times of high inflation this issue is disguised by the high cost-of-living increments however in times of low inflation the problem is very visible.
There are various tactics people take:
Promotion: sometimes justified, sometimes not, people at the max are often promoted into a higher grade
Holding the Line: there is only so much you will pay for a given job. Â A truck driver will eventually hit a maximum at which point it doesn´t make any kind of sense to pay them more, even if they are a solid performer. Â At times companies have to hold the line.
Bending the Line: sometimes people at the max are allowed token increments.
5) Other
There are bound to be other criticisms not covered here. Â In all cases the issue is negotiating a consensus with key people rather than defending your decision. Â Look for compromises and alternatives rather than trying to win. Â Often people simply want to be heard and won´t demand any action.