Merit pay systems work differently in different specific companies, but the basic idea of merit pay is the same in all companies. The general idea of merit pay is that employers identify certain metrics by which they grade their various employees. The employers then give different amounts of pay to people who achieve at different levels.
In a merit pay system, the firm needs to determine how they will tell good employees from bad employees. This is not always as easy as it sounds. There are many jobs for which it is hard to measure production in any very objective way. However, this is what firms must try to do. They let employees know the basis on which merit will be decided. They employees then do their work. Employees who achieve better results on the metrics that the firm uses get paid more than employees who achieve lesser results. Thus, the firm can pay higher salaries to those workers who are more productive.