Adjust compensation to the employee's performance (stack ranking)
For most organizations, it is difficult to determine who are the best employees in the company, who are the worst, and those that are in the middle of the pack. Without identifying who these are, it's hard to adjust compensation accordingly.
Valve uses a "stack ranking" to rank each employee against his or her peers. They do this ranking once per year. The goal of this ranking is to identify who is providing the most value to the company, and thus adjust each employee's compensation to the real value they have for the company. Valve wants to pay each employee their "correct" salary, what they are worth, according to the opinions of their peers.
Set a stack ranking system
Ask each employee to rank the peers he or she has worked with in teams during the year. Employees cannot rank themselves, they can only evaluate the peers they have worked with in project/product groups, in the most unbiased way possible.
Extrapolate the information to the whole company
Now, employees need to be ranked against the workers of the entire company in order to be able to adjust their salaries according to where they stand in the employees ranking.
Adjust the employees' compensation according to the stack ranking
The employees that rank high in the ranking should get a pay raise, and those that rank low should get paid less than those that rank considerably higher than them. It is important to clarify that the contracts have a minimum pay in them, and what varies is the bonus-based pay. However, the bonuses can end up being much higher than the sum of the basic wage.
Those that are the worst performers, according to the ranking made by their peers, participate in meetings and evaluations to try to find ways to improve. The workers that stand the lowest in the ranking are not fired immediately, as this is very costly for the company. Instead, they have many opportunities to turn things around.