Twenty years ago the dead went unburied, the bins stood unemptied and the country was plunged into sporadic bouts of darkness. The mounting frustration of public sector workers over their rates of pay sparked the Winter of Discontent, and when the strikes came they were bitter. Tony Blair believes that the industrial action of 1979 did not just wreck James Callaghan's chances of winning the next general election, it was a turning point in Labour's relationship with the British people.

In Mr Blair's reading of history, it took a total reinvention of the party for it to win power again. This is why the pay awards to doctors, nurses, teachers and civil servants - which will be announced tomorrow - are so symbolic. They are not just about percentage points and perks, they are about confronting New Labour's Old ghosts.

This is an issue much closer to the Labour Party's heart than it ever was to the Conservatives'. Those on the left argue that taxes should be put up to fund substantial increases in public sector pay; they question why Carol Vorderman should have received a pounds 5m pay package - about 90 times that of a nurse. Those on the right say wage increases must be restrained in order to control inflation. The Prime Minister is balancing his desire to keep on side the workers, Labour's traditional constituency, with his determination that the party should not be perceived to be in the pocket of the unions. Not surprisingly, perhaps, the result is a Third Way-style compromise. As Gordon Brown told the Cabinet on Thursday, this year's pay awards will be both "affordable and right" - in other words both prudent and just.

BUT THERE are much bigger reforms afoot. The whole way in which government- funded salaries are structured is about to be changed. Mr Blair said last week he wanted to tackle the "sacred cows" in public services. Alongside waffle about peerages for dinner ladies, he asked his audience of public sector employees: "Do we need greater differentials within the public sector? Should we decentralise pay more? What are the lessons of performance pay and where else should we be using it?"

These questions may sound tentative, but the New Labour strategy is already in place and will be clearly visible this week. The aim is to introduce elitism into the pay structures, to reward excellence rather than just long service, to target increases more carefully. And this will be far more controversial than the size of pay rises in any one particular year.

The Government has decided that salary increases should go to particularly needy groups, rather than be handed out evenly across the board. The newspapers trumpeted last week that nurses would get pay rises of up to 11 per cent - in fact only around 27,000 of the most junior ones, 5 per cent of the total number, will do so well. The vast majority will receive more like 4.7 per cent. Similarly, primary school headteachers will get generous awards of up to 9 per cent while their colleagues in the classroom are expected to get less than 4 per cent. Other public sector workers are heading for just 3.5 per cent, with senior civil servants, MPs and ministers likely to receive 2.8 per cent.

On the surface, this is clever - the Government gets the headlines about pay rises for nurses and teachers without having to fork out the cash. But the unions are warning that the targeting strategy will fuel discontent among the unlucky majority and over time could increase pressure for industrial action.

Christine Hancock, head of the Royal College Nursing, talks dismissively of the "so-called" 11 per cent rise for nurses. Jack Dromey, national secretary of the Transport and General Workers' Union, warns that the rises will "arouse expectations and create a sense of grievance on the part of support staff". John Edmonds, general secretary of the GMB, dismisses the whole package for NHS staff as a "wasted opportunity" which might tackle the problems of recruitment in the short term but will do nothing to stop nurses leaving in the end.

"Tony Blair praised public sector workers last week but we don't just need the warm words - people in the health service have mortgages to pay," he says. "A lot of people voted Labour because they thought there would be a substantial change in the approach to public sector workers and people are discouraged that there hasn't been the change they expected."

What nobody has realised is how far-reaching the changes will in fact be. In future, the Government intends to aim its money far more narrowly at the best and brightest public sector workers. There will be super-teachers and super-nurses, elevated above their peers in salary and status. There will be super-schools and super-hospitals, given bonuses for achieving targets on reducing class sizes or waiting lists. Super-dinner ladies and super- dustbin men cannot be far behind. "We need to reward excellence and performance," a Downing Street source says. "Some people aren't going to like that. But the idea that some workers are going to do better than others shouldn't be a break on trying to put new systems in place."

The teaching unions are up in arms about the Education Secretary David Blunkett's proposals to introduce performance-related pay into schools. They are not much happier about plans to set up a new fast-track system for high-flying graduates. The National Union of Teachers is threatening to go on strike if the Government forces through the "nightmare" of payment by results. The National Association of Schoolmasters Union of Women Teachers is willing to consider an element of appraisal, but rejects the idea of performance-related pay. "You must assess input not output," says Nigel de Gruchy, its head. "How can you relate pay to exam results which have as much to do with family background as the quality of teaching?"

THE HEALTH SERVICE is next on the hit list for more assessment of results. Ministers are examining plans to give bonuses to hospitals that have the best success rates in reducing waiting lists or carrying out operations. The Government will also announce shortly that it believes there must be a huge shake-up of the way in which nurses and midwives are paid. Frank Dobson, the Health Secretary, wants the old system of increments and grades, through which employees progress year on year, to be replaced with a more flexible structure in which the best people can be rapidly promoted. "Instead of relating pay to length of service we want to relate it to achievement," a government source says. "We want to get people into pay scales which accord to their responsibilities and performance."

This is a principle that the Prime Minister is determined to impose in every area. In Blairite jargon, there may be equality of opportunity for all public sector workers but there will certainly not be equality of outcome. There is just one group that has so far escaped scrutiny. It is not doing well at reaching targets of satisfying the public, reducing expenditure or improving productivity. But then how would you set about measuring the performance of politicians?