Royal Bank of Scotland today said it would cut this year's staff cash bonus by more than 90 per cent to £175 million.
The bank, which is now nearly 70 per cent owned by the taxpayer, said there would be "no reward for failure" as it announced the cuts and confirmed no discretionary cash bonuses would be made for last year.
The news came as Chancellor Alistair Darling insisted bonuses at the bank would be slashed to the "absolute legal minimum".
The bank also announced a pay freeze this year for senior and US staff, as well as those in its investment banking arm, the division that has been largely responsible for mammoth losses at the group.
Other staff will on average receive below inflation pay rises, added RBS.
It has also introduced an option to "clawback" any of the non-cash awards made to staff for 2008 if losses arise from their activities.
The bank is now conducting a review of its pay and incentive policies, with more details due in its forthcoming annual report.
Sir Philip Hampton, RBS group chairman, said: "A fundamental reform to pay and reward is needed to reflect the reality of the situation the company is in."
He added: "We fully recognise, as a company, that we have to change materially not just the business we do but also the way we do business.
"Our overarching aim is to restore the standalone health of the Group as soon as is practicable."
Mr Darling said the new system of bonuses represented a "cultural change" within the bank.
"We have had the opportunity now to open the books, to go through what RBS has been doing," he said.
"A huge amount of change has to take place in this bank and what you are now seeing is a cultural change in the way in which payments are made."
The Government has been facing intense pressure to halt all bonuses at RBS and Lloyds Banking Group - the two banks bailed out by the taxpayer.
MPs across the political spectrum have argued that it is wrong for the banks which have taken public money to make bonus payments.
Giving evidence last week to the Commons Treasury Committee, RBS chief executive Stephen Hester said they could not ignore obligations as well as the need to retain their best staff.
The announcement will now put pressure on Lloyds - which includes the loss-making HBOS - to cut back its bonuses to the minimum.
Derek Simpson, joint leader of Unite, said: "Unite welcomes the acknowledgement from the Government that staff at RBS, and across the financial services sector, are not the culprits of the financial crisis and must not face cuts in their pay packets in a desperate attempt to satisfy the hunger of the pack.
"To punish workers for the actions of senior bankers represents a demand for a pound of flesh from the wrong people.
"Staff are among the victims, not the culprits of the financial crisis. Our members at RBS are not, as is often suggested, the executives earning hundreds of thousands of pounds in bonuses.
"Many of the staff on the frontline of the financial services sector earn salaries as little as £12,000 per year.
"They are not those in the City of London earning mega bonuses. Union members rely upon the small annual bonus payment they have been promised to supplement their low income and pay their family debts.
"RBS employees are hard working and their ongoing dedication, despite the continued difficulties in the financial services sector, reflects the professionalism of the workers at the bank."
RBS paid out around £2.5 billion in bonuses across the group last year.
But it has been one of the banks worst hit by the global financial crisis, recently warning its losses for 2008 could hit as much £28 billion, which would mark the biggest loss yet in UK corporate history.
Mr Darling said in future payouts from the taxpayer-controlled bank would take the form of "capital" rather than cash.
The Government has pumped billions of pounds into RBS under its bank rescue plans.
The bank is now 68 per cent owned by the State.
It said today it would hand out deferred awards for 2008 performance only to those staff who are "essential to the bank's recovery and who might otherwise be at serious risk of leaving".
Sir Philip added that while it needed to overhaul its pay practices, the bank needed to ensure staff stayed motivated.
"Our staff have had to contend with significant anxiety over recent weeks and months over a situation that the vast majority bore no responsibility for creating," he said.
"We have tried, wherever possible, to focus the worst impact of the changes on our more senior staff and, in particular, those in the concentrated areas of our business responsible for the major losses recorded in 2008."