It's a classic dilemma for all CEOs: The economy is in the grip of a growth recession, the future looks tense; and yet, you have to pay enough to retain critical talent.

Most companies these days are moving to variable pay as a better way to attract, retain and motivate employees -- at least the ones they want to stay on. There is nothing new with the concept, but the difference now is that companies are getting stricter with variable pay too, so that there are not too many 'top performers' and very few 'low performers.'

So don't be surprised if your supervisor is giving you 'Grade B' this time against 'Grade A' for the same level of performance last year. Companies such as Infosys [Get Quote] are doing just that: Performance appraisals are getting that much stricter as there is very little money to pay. So it's better to serve jam to a few rather than spread peanuts and make everyone unhappy.

According to a study done by Hewitt, 30 per cent of organisations surveyed have increased performance linkages to counter fixed pay increases.

Indian companies, however, still have a long way to go as the variable component in salaries in US companies has gone up to an average of 75 per cent. But quite a few are making up for lost time -- in many cases, this has moved up to 50 per cent. This was just around 5 per cent five years ago.

Take the example of Hindustan Unilever, India's largest consumer goods company. The company has increased the variable pay component sharply and one of the key performance parameters is how externally-oriented an employee is -- the accent being on the speed at which a trend is spotted.

A recent Mercer study says companies are also increasingly resorting to performance-driven employee stack-ranking where they qualify the top performers at one end and the underperformers (those in the bottom quartile) at the other to have a clearer view of the impact of talent on business performance.

While variable pay is here to stay, the point is not everything is hunky dory as implementation can often be extremely complex. For example, a problem with pure pay incentives is that it raises the risk of employees driving corporate growth for the sake of the personal reward it brings, rather than for what is best for the company. Another question which arises from this strategy is what should the company be measuring -- effort or performance; the individual or the team?

Sometimes, variable pay motivates employees to focus excessively on doing what they need to do to gain rewards, sometimes this is at the expense of doing other things that would help the organisation.

If, for example, a company introduces variable pay but lacks an effective performance management system to measure and reward, things will fall apart. For proof, read the following example.

The CEO of a company got everyone excited about working across functions to help the business grow. The sales team tracked down every last lead, and the orders poured in. The production team worked overtime to keep up the flow of goods and the business achieved record growth for the year.

It was great teamwork, everybody thought. But when the incentives were announced, the camaraderie faded. The sales team members got huge benefits, based on the number of orders they had booked.

But the production team's incentive was calculated on the basis of how well they had managed costs against output, and all that overtime had dragged their numbers down. This meant, the entire organisation's 'team work' took a nosedive.

There are many other examples of how variable pay plans can backfire if they don't consider worker motivation in a realistic fashion. Indian companies would do well to read this example from the Harvard Business Review. In her celebrated piece, 'Pay for performance doesn't always pay off,' Martha Lagace gives Hewlett Packard's example of how the best-intentioned variable pay plans can go wrong if not thought through properly.

Managers at one of the HP units launched a programme of team goals coupled with team-based pay with three possible levels of reward. The scheme worked well initially, but the complaints started to pour in soon. The teams were frustrated as factors such as the delivery of parts affected their work and went out of their control.

The high-performance teams often refused to admit people whom they thought were below their level of expertise, leading to disparities among the teams. Mobility between teams was reduced, preventing the transfer of learning across teams. The lifestyle of employees now revolved around higher pay scales, and this led to anger when they could not achieve it consistently.