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How Pay Compression Develops
When the market moves faster than your merit cycle
The most common cause of compression is a labor market that moves faster than your organization's merit budget. If the market for Senior Engineers increases by 8 percent in a year and your merit budget is 3.5 percent, engineers hired at market rate two or three years ago are now paid significantly below the market rate for new hires in the same role. Within a few hiring cycles, the gap between tenured employees and new hires in the same grade becomes visible.
When new hires enter above midpoint
When a competitive hiring market requires bringing new hires in at 100 to 110 percent of band midpoint to close offers, those hires immediately earn more than tenured colleagues who were hired at 85 to 90 percent of a previous, lower midpoint. The compression is immediate and visible to the tenured employee within their first shared performance cycle.
When merit increases do not differentiate by pay position
A flat merit increase applied uniformly to all employees in a grade preserves compression rather than resolving it. An employee at 82 percent of midpoint receiving a 3.5 percent increase moves to 84.9 percent. An employee at 105 percent receiving the same increase moves to 108.7 percent. The gap between the two does not close; in absolute dollar terms it widens.
How to Identify Pay Compression in Your Organization
Running a compa-ratio analysis by tenure cohort
The fastest way to identify compression is to sort employees within a grade by tenure cohort (0-12 months, 1-3 years, 3-5 years, 5+ years) and calculate the average compa-ratio for each cohort. If the average compa-ratio for the 0-12 month cohort is higher than the 3-5 year cohort within the same grade, you have compression. This analysis should be run before every merit cycle.
Identifying specific compressed pairs
Beyond cohort analysis, identify specific cases where a less-tenured employee in the same grade is paid equal to or more than a more-tenured employee with a stronger performance history. These specific cases represent the highest retention risk because the affected employee typically becomes aware of the disparity and may have already been approached by competitors.
How to Fix Pay Compression
Equity adjustments separate from the merit cycle
The merit cycle is designed to differentiate based on performance. Pay compression is a structural equity issue that should be corrected through a separate equity adjustment program rather than through inflated merit increases that distort the merit matrix. An equity adjustment is a documented, off-cycle base salary adjustment specifically to correct a compression or equity gap, separate from any merit or promotional increase.
Using the merit matrix to slow future compression
A merit matrix that allocates larger percentage increases to employees at lower compa-ratios (below midpoint) naturally decelerates compression by directing more budget toward underpaid employees. Configuring the merit matrix with a compression-aware structure before the cycle opens is the most effective prevention strategy for future cycles.
Updating salary bands when the market moves significantly
If your salary bands are 18 to 24 months old and the market has moved substantially, the bands themselves may be the source of the compression signal. A new hire brought in at 95 percent of the current market midpoint will appear at 110 percent of an outdated band midpoint, triggering false compression alerts while the underlying issue is actually a stale band. Running an annual market pricing review and updating bands accordingly prevents this type of structural confusion.
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