Until a few years ago, the terms "compensation" and "compensation and benefits" were commonly used. However, more recently these terms have been replaced by "rewards" and "total rewards". A compensation system is a set of mechanisms for distributing both tangible and intangible benefits in the context of an employment relationship.

An employee's tangible returns include cash compensation (e.g., base salary, cost-of-living and performance bonuses, short-term and long-term incentives) and benefits (e.g., income protection, tuition reimbursement). In addition, employees also receive intangible or relational returns, including recognition and status, job security, challenging work, and learning opportunities. Not all types of returns are directly related to performance management systems. Some returns are based on tenure rather than performance.

Base salary is paid to employees for work performed. Base salary, which usually includes a range of values, focuses on the position and tasks performed rather than an individual's contribution. Base salary is usually the same for all employees with similar tasks. Cost of living adjustments (CoLa) provide the same percentage increase to all employees regardless of their individual performance. CoLa are granted to combat the effects of inflation and preserve employee purchasing power.

Short-term incentives, sometimes called variable pay, are one-time payments given based on past performance. Incentives are not added to base salary, but are simply temporary salary adjustments based on the review period. Long-term incentives, on the other hand, seek to influence future performance over a longer period of time. Typically, they take the form of stock ownership or options to buy stock at a predetermined price. This investment is expected to translate into sustained high levels of performance.

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