A primary goal of military compensation is to enable the military to meet its manning objectives for force size, composition, and wartime capability. To attain these objectives, compensation must be appropriately structured to attract, retain, and motivate personnel at a reasonable cost, even when national security goals are changing. A key question facing military manpower and compensation managers is, How should military compensation be structured? Although past studies have narrowly focused on the relationship between compensation and retention, less attention has been paid to whether the military compensation system induces the best individuals to stay and seek advancements, and whether it motivates effective work. This highly technical report addresses the issue of how military compensation should be designed in light of these considerations. It presents research that aids us to develop a model of compensation in a large, hierarchical organization such as the military, a model that permits an analysis of the issues surrounding the design of military compensation. The report reaches four conclusions: (1) In a hierarchical system, pay spreads need to rise with rank to provide personnel with continuing incentives to work hard and seek promotion, and to induce the most able personnel to stay; (2) intragrade pay should be somewhat contingent upon performance and not be provided lockstep with seniority; (3) up-or-out rules are necessary to induce the separation of unpromotable personnel when pay is set administratively; and (4) retired pay may be offered for a number of reasons. The report also begins to evaluate the current military compensation system in light of the model, finding that the system appears more aimed at attracting and retaining personnel than at providing them with effective incentives to work hard and seek advancement.