A psychological contract, a concept developed in contemporary research by organizational scholar Denise Rousseau, represents the mutual beliefs, perceptions, and informal obligations between an employer and an employee. It sets the dynamics for the relationship and defines the detailed practicality of the work to be done. It is distinguishable from the formal written contract of employment which, for the most part, only identifies mutual duties and responsibilities in a generalized form.
Although Rousseau's 1989 article as highlighted by Coyle-Shapiro "was very influential in guiding contemporary research", the concept of psychological contract was first introduced by Argyris (1960) - "Since the foremen realize the employees in this system will tend to produce optimally under passive leadership, and since the employees agree, a relationship may be hypothesized to evolve between the employees and the foremen which might be called the "psychological work contract." The employee will maintain the high production, low grievances, etc., if the foremen guarantee and respect the norms of the employee informal culture (i.e., let the employees alone, make certain they make adequate wages, and have secure jobs)".
Psychological contracts are defined by the relationship between an employer and an employee where there are unwritten mutual expectations for each side. A psychological contract is rather defined as a philosophy, not a formula or devised plan. Characterizing a psychological contract through qualities like respect, compassion, objectivity, and trust. Psychological contracts are formed by beliefs about exchange agreements and may arise in a large variety of situations that are not necessary employer-employee. However, it is most significant in its function as defining the workplace relationship between employer and employee. In this capacity, the psychological contract is an essential, yet implicit agreement that defines employer-employee relationships. These contracts can cause virtuous and vicious circles in some circumstances. Multiple scholars define the psychological contract as a perceived exchange of agreement between an individual and another party. The psychological contract is a type of social exchange relationship. Parallels are drawn between the psychological contract and social exchange theory because the relationship's worth is defined through a cost-benefit analysis. The implicit nature of the psychological contract makes it difficult to define, although there is some general consensus on its nature. This consensus identifies psychological contracts as "promissory, implicit, reciprocal, perceptual, and based on expectations." 
These psychological contracts can be impacted by many things like mutual or conflicting morals and values between employer and employee, external forces like the nudge theory, and relative forces like the Adams' equity theory.
The psychological contract came to be identified in 1960 by Argyris. However, only within the last ten to fifteen years has it become more popular and more research been done on the subject. As studies in industrial relations developed and grew more complex, it was revealed that employees are more likely to perform better in certain work environments. The early works of Frederick Winslow Taylor focused on how to enhance worker efficiency. Building upon this, Douglas McGregor developed Theory X and Theory Y to define two contrasting types of management styles that were each effective in attaining a certain goal. These differing management types hold different psychological contracts between employer and employee, as described in more detail under "formation of the psychological contract."
Works by Denise M. Rousseau and later went more in-depth on the details and perspectives of the psychological contract. Sandra L. Robinson indicated employees commonly reported a breach of the psychological contract within several years of beginning their position, and that the effects of contract breach negatively effected employee productivity and retention.
Maslach, Schaufeli and Leiter stated in 2001:
Psychological contract formation is a process whereby the employer and the employee or prospective employee develop and refine their mental maps of one another. According to the outline of phases of psychological contract formation, the contracting process begins before the employment itself, and develops throughout the course of employment. As the employment relationship grows the psychological contract also grows and is reinforced over time. However, the psychological contract is effective only if it is consented to on a voluntary basis. It is also useful in revealing what incentives workers may expect to receive in return for their employment. There are two types of contracts depending on the nature. These are relational psychological contracts and transactional psychological contracts.
The content of psychological contracts varies widely depending on several factors including management style as discussed earlier. It also depends on the type of profession and differs widely based on stage in career; for example, between graduates and managers. Denise Rousseau is credited with outlining these 5 phases of contract formation:
The employment relationship emerges through the interpersonal relationships formed in the workplace. How employers, supervisors and managers behave on a day-to-day basis is not determined by the legal contract. Employees slowly negotiate what they must do to satisfy their side of the bargain, and what they can expect in return. This negotiation is sometimes explicit, e.g. in appraisal or performance review sessions, but it more often takes the form of behavioral action and reaction through which parties explore and draw the boundaries of mutual expectation. Hence, the psychological contract determines what the parties will, or will not do and how it will be done. When the parties' expectations match each other, performance is likely to be good and satisfaction levels will be high. So long as the values and loyalty persist, trust and commitment will be maintained. The map followed by the parties is the development of an individualized career path that makes only reasonable demands on the employee, with adequate support from managers and co-workers, for a level of remuneration that is demonstrably fair for a person of that age, educational background, and experience. Motivation and commitment will be enhanced if transfers and promotions follow the agreed path in a timely fashion.
The psychological contract changes over time. Since an employee's level of work changes as they advance in their career, the psychological contract that was established when they first began their career changes, too. As an employee is promoted throughout their career they expect more from their psychological contract because they are putting more of themselves into their work. Each stage of a career creates another editing process to the contract. The stages include apprentice, colleague, mentor, sponsor, exploration, establishment, maintenance, and disengagement. The details of each step are as follows:
Studies from Canadian adjunct professor and psychology researcher Yani Likongo demonstrated that sometimes in organizations an idiosyncratic psychological contract is built between the employee and his direct supervisor in order to create an "informal deal" regarding work-life balance. These "deals" support the idea of a constructivist approach including both the employer and the employee, based on a give-and-take situation for both of them. Similarities are drawn between the psychological contract and social exchange theory in that the relationship's worth is defined through a cost-benefit analysis. The employee's attitude toward changes in the company which lead to changes in the psychological contract . An employee's attitude toward change in the job is directly linked to the employee's psychological contract with the manager or employer. An employee's attitude and mindset about what changes could benefit them in what ways could affect the psychological contract they have with the manager.
If managed effectively, the relationship will foster mutual trust between the parties, matching the objectives and commitments of the organization to those of their employees. But a negative psychological contract can result in employees becoming disenchanted, demotivated and resentful of authoritarianism within the organization. This will result in an increasingly inefficient workforce whose objectives no longer correspond to the organization they work for. The main cause of disappointment tends to be that middle managers are protective of their status and security in the eyes of their superiors, and this can introduce conflicts of interest when they are required to fulfill their obligations to their subordinates.
Psychological Contracts are largely reliant on promises between the employer and employee, with trust being the basis for the social exchange. A breach in the Psychological Contract occur if employees perceive that their firm, or its agents, have failed to deliver on what they perceive was promised, or vice versa. Employees or employers who perceive a breach are likely to respond negatively as it may oftentimes result in an immediate response of mistrust from the other side. Responses may occur in the form of reduced loyalty, commitment, and organizational citizenship behaviors. These feelings typically increase negative tension in the environment. Perceptions that once psychological contract has been breached may arise shortly after the employee joins the company or even after years of satisfactory service. A breach in the contract may occur when the organizational changes are not necessarily beneficial for employees because of extenuating factors such as globalization and fast-changing markets. The impact may be localized and contained, but if morale is more generally affected, the performance of the organization may be diminished. The risk for breach may be reduced when the organization knows and respects the contracts of the employees. Further, if the activities of the organization are perceived as being unjust or immoral, e.g. aggressive downsizing or outsourcing causing significant unemployment, its public reputation and brand image may also be damaged.