By Thomas Flannery and David Hofrichter
Source: July/August 2007 issue of Trustee Magazine

A properly designed and implemented incentive compensation program is a powerful tool that links an organization's strategic and operational plans to the rewards it provides to executives. Health care organizations have been adopting incentive compensation as part of their executive pay package since the mid-1980s, and it is a rare health care organization today that does not have one. Despite this, trustees and executives continue to struggle with incentive compensation. Why are incentive compensation programs so problematic for health care organizations? Discussing the following six key questions can provide insight and guidance for trustees and executives as they adopt or update an executive incentive plan.

All Compensation Must be Reasonable

Q: How can we determine whether an executive compensation package is "reasonable," when we do not know how much executives will earn in the first place?

A: "Reasonable" means that any amount paid to an executive must be for "like services by like enterprises under like circumstances," according to the Internal Revenue Service code. In making this determination, both taxable and nontaxable entities can be considered in defining "like," and the maximum compensation that could be earned is what has to be established as "reasonable." So if the compensation committee approves a package that includes a maximum incentive opportunity of, for instance, 50 percent of base salary, the compensation committee assumes the executive could earn his or her base salary plus 50 percent. It also assumes that this total amount is "reasonable."

Committee Action Guidance: First, we advise compensation committees to use a "tally sheet" approach when approving executive compensation. The tally sheet sets forth all elements of compensation, including the maximum earnings under an incentive program, base salary and deferred compensation.

Second, when approving the executive compensation package, compensation committees should look at the compensation twice. The first time is at the inception of the entire program, when the board first approves total remuneration up to the maximum potential earnings under the incentive compensation program. The second examination comes when the board approves the actual incentive payment, which it does after determining an executive's actual performance level achieved under the plan and his or her corresponding incentive awards.

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