Merit Pay Adoption and Labor Productivity in South Korean Firms

ABSTRACT Merit pay is a compensation system that raises employees' base salaries, contingent on their prior performance. Despite its widespread use, the evidence regarding its impact on organizational performance remains inconclusive. In this research, we focus on the unique semi‐permanent and cumulative features of merit pay and draw on the compounding incentive effect and the collective sorting effect as complementary theoretic mechanisms to explain the organizational implications of merit pay adoption. Specifically, we argue that implementing merit pay is positively associated with labor productivity growth. Employing random coefficient growth modeling, we analyze a sample of 317 publicly listed firms in South Korea. Our findings reveal that although firms adopting merit pay did not exhibit higher labor productivity levels after 1 year (short‐term performance), they demonstrated significantly higher linear productivity growth over time following adoption (long‐term performance). We discuss the theoretical and practical implications of these findings.