The term merit increase refers to the growth in an employee's wages which is awarded based on an objective measure of their past performance. Merit increases are not based on time in position, as is usually the case with unionized employees.
Also known as pay for performance, merit increases are provided to employees based on their ability to achieve certain results or complete goals. This form of pay for performance is normally a component of a larger process, which starts its annual cycle with the formation of a budget for the organization's increase in wages.
Generally, companies will first establish a merit pool, which is the budget line item that supports pay increases across the entire organization. For example, a company might establish a merit pool that supports an average increase of 3.5%. Managers then have the ability to distribute the dollars in this pool to individuals based on a combination of factors such as their contribution to the organization's success and their salary relative to the target salary for the position they hold.
Employees that exceed performance expectations will receive higher merit increases than employees management considers as underperforming. In the same manner, an employee that is "underpaid" relative to their job value will tend to receive a higher increase if they're performance is acceptable. Continuing with the example above, an employee that exceeds expectations, and is below their target salary, might receive a merit increase of 7.0%, while an underperforming employee that is paid more than their target salary might not receive a merit increase.