Firms face significant constraints in their ability to differentiate pay by worker productivity. We show how these internal equity constraints generate a quantity-quality trade-off in hiring: firms which offer higher wages attract higher skilled workers, but cannot profitably employ lower skilled workers. In equilibrium, this mechanism leads to workplace segregation and pay dispersion even among ex-ante identical firms. Unlike in a conventional monopsony model, firms use higher pay to improve hiring quality, even at the cost of lower quantity. Our framework provides a novel interpretation of the (empirically successful) log additive AKM wage model, and shows how log additivity can be reconciled with sorting of high-skilled workers to high-paying firms. It can also rationalize a novel hump-shaped relationship between firm size and firm pay (which we document using Israeli data) and, by implication, the negligible wage return to firm size. Finally, our model provides new insights into aggregate-level and regional changes in worker-firm sorting and earnings inequality, firms’ location choices, and public-private sector wage differentials—which we explore empirically.