In almost every company I've been to, pay is decided by a yearly review using feedback garnered from colleagues.
This has a lot of negatives associated with it. People save feedback until the year end, instead of giving it regularly. They end up only asking friends for feedback to get "good marks". The review itself inevitably ends up focusing on people's weaknesses instead of their strengths. There's a lot of data to show that tying reviews and feedback to pay is a really, really bad idea.
What alternatives exist?
Edit: I'm really looking for alternatives to reviews, not better ways to do performance reviews or better ways to tie pay to it. I pretty much share Esther Derby's feelings about formal review processes, and am looking for different ways to manage pay scales. It's possible to create environments in which feedback is given freely and informally. In that situation, a review process is irrelevant and harmful... except that I don't then know what to do about the pay. This is why I'm asking. I would prefer even to have pay not tied to individual performance at all. What alternatives out there exist? Has anyone tried anything different?
For reference, Joel Spolsky's article, "Incentive Pay considered Harmful", in which he quotes HBR:
... at least two dozen studies over the last three decades have conclusively shown that people who expect to receive a reward for completing a task or for doing that task successfully simply do not perform as well as those who expect no reward at all.