(FORTUNE Magazine) – Pay--the subject's enough to make even the most macho manager cringe. No matter how you handle this sensitive issue, you wind up making some, if not most, of your employees angry and confused. Many managers unintentionally short-change their stars and overpay their sluggards. Or they design pay plans that send employees the wrong message or a mixed message or no message at all.

I know. I've spent two decades as a manager, a teacher, and a consultant. When it comes to pay, I've seen almost every mis-take that can be made, and I've seen--and tried--a host of solutions. To find what works best, I looked at compensation practices at 75 companies. The good news is that I've found a few principles and practices that make sense. The even better news is that you can probably do most of these things at your firm without spending much money. Really.

Most of us know instinctively how to motivate and reward people. We do it with our kids or with the guy who mows our lawn or the gal who cuts our hair. When it comes to our jobs, though, we tend to get distracted by a blizzard of ideas with jargony names, offered by high-priced consultants. Does your daughter Jenny want to ride her bike with her new friend Claire? If you tell her she can, but only after she cleans her room, you've just put into place an "operationally defined, cost-neutral, performance-contingent reward system." Got it?

Where, then, to start. If your company's pay program is broken--and it probably is--don't fix it! Not yet. You've got two other issues to address before you even think about rewards: goals and measurements.

First, you need to tell people exactly what's expected of them. Not some vague mumbo jumbo about making the company or the division the best and biggest in the world, but what role you, Mr. Salesman or Ms. Engineer, are supposed to play in this great enterprise. Here's an exercise I used when I taught executive education classes at the University of Michigan. I asked all the students to write down their company's mission statements, as well as the amount of senior management time it took to develop them. I put all the notes in a shoebox, then picked one out at random. Whose finely crafted credo is this, I asked the class? Inevitably, five or six hands would go up, as managers from airlines, pharmaceutical companies, and plumbing-supply manufacturers all claimed the statement as their own.

Though it can take hundreds of hours to devise these declarations, many top managers can't distinguish their own slogans from those of their neighbors. If executives can't clearly articulate their company's reason for being, how can we expect line workers or supervisors to know their roles?

At General Electric's leadership development center in Crotonville, New York (where I work), we try to get managers to bring those lofty mission statements down to earth. Imagine you're at a party a year from now, we tell them. You're celebrating the successful completion of a big project in your division. How exactly did your leaders, peers, and subordinates change their behavior to reach this goal? We don't accept imprecise answers. What do you mean your people have become empowered? Do they participate more in meetings? Do they feel free to constructively criticize their superiors? Did they find a solution that boosted sales or improved quality or cut costs?

Once you know specifically what you want your employees to be doing in the future, then you need to measure it. Even seemingly fuzzy stuff, like how well a manager satisfies customers or delegates authority or gets along with colleagues, can be measured through 360-degree evaluations--where an employee is rated by people above and below him in the organization-- and through one-on-one interviews. The key is to ask not only the right questions but also the right people--customers, coworkers, and bosses.

People, though, aren't likely to change their behavior unless you reward them for it. Companies typically hand out bonuses or stock options as recognition for past performance. Great job landing that account, Judy, here's $2,000. But the real purpose of that award should be to induce Judy to perform even better in the future. Studies show that to truly motivate people, you have to offer them an award that's at least 10% to 12% above their base salary. In practice, companies pay out much less than that. Variable compensation--including bonuses, stock options, and profit sharing--accounts on average for only 7.5% of compensation.

So a key principle of compensation is to link more of it directly to performance. Sounds obvious, doesn't it? But consider the way we currently pay people. The two factors that usually carry the most weight are an employee's title and length of service. When you reward employees according to seniority or you give everyone on the staff the same annual percentage increase, you've turned compensation into an entitlement, not an incentive. You're giving your weakest performers a free ride. And you're encouraging your best employees to polish their resumes and look elsewhere.

Okay, so you've defined exactly what people should do to make your company flourish; you've figured out how to measure their activities; and you've committed your company to actually paying for performance. Now, you have to execute. To make things easier, keep these guidelines in mind:

RULE 1. Don't tie pay to power. In the halcyon days of the 1950s and 1960s, when companies had umpteen layers of management, it was fine to tell every subaltern with a college degree and a starched white shirt that he could aspire to fatter paychecks and juicier perks as he climbed each rung on the ladder. But in these days of downsizing, we've got a bulging cohort of baby-boomers chasing a shrinking number of slots in the hierarchy. If you continue to link rewards to rank, you're likely to create an army of malcontents. Popos is what the experts call them: "passed over and pissed off."

At GE we've tried to get away from the idea that you have to move up to make more. We cut from 29 to six the number of different salary grades--a technique known as "broad banding." This gives people more opportunities to get a raise without a promotion. We've also sharply increased the number of employees eligible for stock options, and we're experimenting with programs that reward managers for what they know, not for how many workers they supervise or how long they've been on the job.

RULE 2. Make compensation comprehensible. A Detroit auto supplier I worked with a few years ago was stunned to learn that some of its best factory workers were taking jobs at a rival company offering inferior pay packages. The competitor paid higher hourly wages, but when you added in the fringes--like health, dental, and life insurance--there was no contest between the two companies. The trouble was that the auto supplier's benefits department communicated in such abstruse actuarial double talk that workers didn't have a clue what their total compensation was worth. The company solved the problem by creating a clearly written booklet, complete with cartoon drawings, that explained all the perks.

RULE 3. Start spreading the news. When you give a deserving worker a reward, broadcast it! If you hand out a $1,000 spot bonus, but no one knows it except you and the recipient, the total number of people you've motivated is somewhere between zero and one.

Yes, paychecks are supposed to be private. That's ingrained in our corporate culture. Only the top guys disclose their comp packages, and that's only because the SEC requires them to. But when employees don't have real information, they spread rumors. And surveys invariably show that folks underestimate how well they're being paid in relation to their peers. If you posted everyone's salary and bonus on the bulletin board, the dominant reaction might well be a sigh of relief.

A couple of caveats: Don't talk about other people's money unless you're sure your measurement system works. If you aren't prepared to explain and defend your decisions--why Joe got only a $2,500 bonus while Sam in the next cubicle got $3,000--then it's better to be discreet. Also, not all workers like being singled out for praise. Some employees come from cultures like Japan that consider public commendation of an individual an affront to the harmony of the group.

RULE 4. Forget about the calendar. A reward delayed is almost as bad as a reward denied. If a rat in a cage pulls a lever and nine months later (on the anniversary of his arrival in the laboratory) you give him a cube of sugar, he's not likely to connect cause with effect. Time and again I run into companies that review people in May, then reward them the following January. Some firms require so many layers of managerial sign-offs that by the time an extra lump sum shows up in a worker's paycheck, she may be left scratching her head, trying to remember just what she did to deserve it.

At GE we invite employees to assess--and reward--their peers on the spot. A program called Quick Thanks!, used by GE Medical Systems, lets an employee nominate any colleague (even one in another department) to receive a $25 gift certificate from certain restaurants and stores in appreciation of an exemplary job done. (Over the last year GE has given out 10,000 such awards.) The employee himself often hands out the award to his deserving co-worker. And guess what? Peers are often a whole lot tougher than bosses in dishing out praise. For the recipient, it's the approbation of a colleague, not the $25, that matters most.

That's not to say instant gratification should always prevail. I once saw a chief executive give only a perfunctory "thank you" after receiving a briefing from a midlevel manager. But the next day he telephoned to say, "I really appreciated your contribution yesterday." In this instance, the theatrical pause enhanced the value of the recognition.

RULE 5. Make rewards reversible. It's no good pretending you have perfect judgment. Some of the compensation decisions you make are going to be bad ones. Also, let's face it, business conditions can change. So give yourself an out. It's virtually impossible to take back a raise. You have to deal with mountains of paperwork and endless appeals. But if you give an employee a bonus, as opposed to an increase in base pay, you don't have to live with your decision forever. He knows he'll get another bonus next year only if he keeps performing.

But be careful. For variable compensation to work, it really has to be, well, variable. At some companies, bonuses have become so routine that employees look at them as wages by another name, as just another entitlement. And be mindful of what your competitors are doing. If your employees need to collect a bonus just to bring their compensation up to the going rate, chances are you're not paying enough base salary to begin with.

RULE 6. You can't always give what you want. But you can still, to paraphrase Mick Jagger, give what you need. I've seen companies with minuscule salary pools spend hundreds of management hours rating, ranking, and grading every single employee. But everyone gets such a small piece of the pie that virtually no one is happy. If you don't have enough cash in the kitty, try some nonfinancial incentives. Don't get me wrong. Money, when used properly, is a great motivator. But nonmonetary rewards pack potent advantages:

--They're reversible (see Rule 5). It's easier to cut back someone's authority or to stop giving someone opportunities to participate in plum projects than it is to reclaim a 6% raise.

--You can create your own supply. If you give $1,000 to Employee A, you have $1,000 less to give to Employee B. With nonmonetary awards there are fewer constraints. You can give Employee C more interesting assignments, a mention in the in-house newsletter, and a chance to make a presentation to the division head today, and then you can give the same things to Employee D tomorrow. Of course, if you create too much supply you end up debasing the currency. A nonmonetary reward quickly loses its value if it's overused.

RULE 7. Don't be a compensation chauvinist. If you're operating overseas, be aware that some cultures are not big on the idea of incentive pay. Once, after I lectured an executive education class on the need for more performance-based pay, a Japanese manager rose in protest: "You shouldn't bribe your children to do their homework, you shouldn't bribe your wife to prepare dinner, and you shouldn't bribe your employees to work for the company." In some countries, the objections to bonuses are more fiscal than philosophical. Instead of cash, employees would rather have more leisure time, access to vacation villages, or anything the tax man can't get his hands on. I'm not suggesting that you abandon your principles, but do modify them to account for cultural differences.

RULE 8. Cheer up! If your company is breaking most of rules 1 to 7, don't despair. Your competitors' compensation practices are probably at least as messed-up as your own. You've got a wonderful opportunity to gain an edge over your rivals without necessarily having to invest more cash. In how many aspects of business is that ever the case? When it comes to rewarding employees, the key is not how much more you have to give. It's how well you give what you already have.

STEVEN KERR, chief learning officer at GE, runs the company's Crotonville, New York, leadership center.

REPORTER ASSOCIATE Erin Davies