The purpose of a good compensation philosophy is to attract, retain, and motivate good people. To accomplish these goals, companies use a mixture of the three main components of compensation: Base pay, also called salary; incentive pay, whether in the form of cash or non-cash award such as stock; and benefits, or non-financial rewards. A pay philosophy is a blend of all three, since the company must pay for whatever it delivers to employees.
For example, a company's pay philosophy might be to offer salaries that are competitive in the market, or it might favor pay that is structured to attract employees rather than pay that helps to retain them. But few companies can afford to attract, motivate, and retain via generous compensation. The challenge is to create a pay program that acknowledges all three goals without exhausting resources.
As an example, suppose a small company with moderate cash resources is establishing a pay philosophy. The philosophy might look something like this:
Pay a competitive base salary - not an aggressive one, but a salary comparable to what an employee could get somewhere else.
Offer equity in the company to all employees, so that they can reap the rewards of the company.
Be aggressive in total overall compensation through the use of the incentives. If, for example, an employee is below market by $20,000 in base pay, deliver market parity via a $5,000 signing bonus; a $5,000 retention bonus; and a $10,000 incentive. Incentive programs should be designed so that high-performance people get high compensation.