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Chapter 21 - Performance-Based Contracting and Service Level Agreements

21.8 Developing performance incentives

Performance incentives should be incorporated into the contract to encourage suppliers to increase efficiency and maximize performance. These incentives should be applied selectively and correspond to the specific performance standards in the QASP and be capable of objective measurement. Incentives should apply to the most important aspects of the work, rather than every individual task. Fixed-price contracts are generally appropriate for services that can be defined objectively and for which the risk of performance is manageable. Incentives are not penalties, but should be developed and used to encourage superior performance in areas of particular importance or to motivate supplier efforts that might not otherwise be emphasized.

Performance incentives may be positive or negative and may be monetary or non-monetary; i.e., based on cost control, quality, responsiveness or customer satisfaction. Care must be taken to ensure that the incentive structure reflects both the value to the agency of the various performance levels and a meaningful incentive to the supplier. Performance incentives should be challenging, yet reasonably attainable. The goal is to reward suppliers for outstanding work with a positive incentive for the supplier's benefit, and equitably, a negative incentive for the customer's benefit, when supplier performance does not meet the contractual schedule, quality standards or service levels. The incentive amount should correspond to the difficulty of the task required, but should not exceed the value of the benefits the agency receives. Agencies need to monitor to ensure that desired results are realized; i.e., that incentives actually encourage good performance and discourage unsatisfactory performance.

Where negative incentives are used, the deduction should represent as close as possible the value of the service lost. Negative incentives are deductions for failure to perform a required task up to required quality levels or for failure to timely meet a time-sensitive deliverable or milestone. Negative incentives generally represent a percentage price reduction tied to the magnitude that performance fails to meet the AQL. For example, if a given task represents 10 percent of the contract costs, then 10 percent will be the potential maximum deduction in the event of task failure.

Similarly, if a task is not performed to the AQL stated in the quality standards of the contract, deductions are computed based upon tables or formulas designed to reflect the value of substandard output. For instance, the AQL may require the supplier to perform a task correctly 95 percent of the time. Rather than withhold contract payment for anything less than 95 percent performance, the contract could provide that for every percent that performance falls below 95 percent, payment for the task will be reduced by 20 percent. Incentives, both positive and negative, can be a powerful tool to ensure superior contract performance results.

Verifying and validating the effectiveness of the contractual incentives used is important. Agencies need to monitor the effectiveness of incentives throughout the course of the contract to ensure that the incentives are resulting in enhanced performance or discouraging unsatisfactory performance. Incentive payments should be selectively applied. Remember that in a PBC situation, the agency should have already built in an incentive for successful performance by basing contract payments on achieving an acceptable or minimum level of quality or meeting certain deliverables and/or milestones.

The table below provides information on various types of incentives:

Type of incentive



Relate profit or fee to results achieved by the supplier in relation to identified cost-based targets.

Award fee

Allows suppliers to earn a portion (if not all) of an award fee pool established at the beginning of an evaluation period.


Supplier pays for developing an end item and is compensated from the savings it generates. Established baseline of costs is extremely important.


Generates additional revenue enhancements; compensation based on sharing formula.

Balanced scorecard

Used when performance is less tangible, i.e., quality of lead personnel or communication and resolution of issues.

Past performance

Information used as part of the decision process to exercise contract options or to make contract awards.

Non-performance Incentives

Specified procedures for reductions in payment when services are not performed or do not meet contract requirements.