This chapter considers the design of incentive pay systems for teachers and principals and the challenges facing policy makers who seek to design them. The author argues that policy makers must direct the efforts of teachers and principals toward schools' mission--the acquisition of skills and knowledge among children--and must find ways to link the compensation of teachers and principals to the value of the educational services provided by their schools. However, the nature of the educational process creates at least three important challenges for those who design incentive systems for educators. Even when reliable measures of student achievement are available, it is difficult to value the outputs of schools and also difficult to identify whom within different schools is responsible for the observed variation in the outputs of schools. Further, the process of assessing achievement under high-stakes may create undesirable re-allocations of resources among various types of learning activities within schools. The author's goal is to explain and analyze how these challenges affect the design of incentive systems for teachers and principals. (Contains 1 table and 19 footnotes.)