Incentive Compensation in Nonprofits? Yes!
By Frank A. Monti, CPA

Frank Monti-2012
Frank Monti
Incentive compensation is as desirable in the nonprofit sector as in the for-profit world, but, unlike the latter, which bases incentive payments on organizational profitability, nonprofits need to structure their systems on other performance measures.

The first question many nonprofits ask is if they are allowed to offer incentive compensation. The answer is “yes.”

However, the incentive compensation arrangement cannot be based on organizational profitability, commonly called a surplus in nonprofits, i.e., the amount by which revenue exceeds expenses in a given year. That’s because the purpose of a nonprofit is to achieve its charitable mission as opposed to generating a surplus.

The concern nonprofits face is that if they pay for performance, is the performer benefiting inappropriately from the performance of the charity? Someone benefiting inappropriately from the charity’s performance could violate IRS regulations that nonprofits cannot be organized or operated for the benefit of private interests.

There are two schools of thought regarding incentive compensation. One is based on pay for performance, which holds that that financial incentives are the most powerful motivator of performance. The other focuses on intrinsic motivation, whereby performance of the task is its own reward.

(Behavioral psychologists disagree on which approach is better. Some argue that intrinsic motivation is far superior to pay-for-performance motivators, which frequently become addictive with diminishing results. Many also believe that intrinsic motivation is inherent to and consistent with the mission-oriented nature of nonprofits.)

The fact that better performance improves the financial results of a nonprofit organization is irrelevant to the propriety of the incentive compensation arrangement. What is essential is that the nonprofit clearly specify—in advance of implementing the plan—the performance measures against which individual performance will be measured.

Documentation Is Important
Therefore, documenting the mission-based reason for increased performance is important, for two reasons: 1) Documenting all policies is good practice for nonprofits in general, as doing so helps managers manage; 2) In this case, documentation serves as a reference point in case the IRS questions the basis for the incentive plan.

Successfully designing and implementing an incentive compensation system that achieves the desired results takes work, and the first order of business is to tie incentives to the achievement of measures that advance your organization’s tax-exempt mission.
Example: In an organization that has a clinical counseling component it is often a challenge for the organization to avoid excessive missed counseling appointments. When a client fails to show for their scheduled appointment, the organization does not realize the third-party payment that is linked to that counseling session while still incurring costs relating to the counselor and the physical space that goes unused. In such a situation, it is entirely appropriate to incent the clinician to devise procedures that will result in reduced no-shows.

Organizations that are not funded on a fee-for-service basis, but instead rely on grants and other donations, may also implement an incentive compensation system. However, determining the appropriate incentives will not entail determining the amount of additional revenue the nonprofit will realize from improved individual performance. Rather, the increased compensation expense related to that improvement is merely a variable cost of conducting the activity.
Example: If a charity has a fixed contract to provide services to the community and wants to incent its social workers to increase the number of consumer contacts they have each day, thereby providing more services to the community, an incentive compensation program could be developed aimed at rewarding performance above the baseline. Since no additional funding will be received by the charity based on the increased level of services, the charity needs to accurately predict its total salary costs (regular salary plus incentive pay). For instance, 90% of the salary and benefits budget may be dedicated to regular salaries and 10% reserved for incentive pay. That way, the organization has budgeted for compensation pay although its exact distribution is not known in advance.

Most importantly, the amount of incentive pay to be awarded should be high enough to instill motivation, but not be greater than the organization’s ability to pay for it.

Frank Monti manages the nonprofit practice at the accounting firm of Kahn, Litwin, Renza & Co., Ltd. Email him at or call 781-547-8800.
June 2012