How to delete from source using MERGE command in SQL Server 2008?

You can use the output clause to capture the modified/inserted rows to a table variable and use that with a delete statement after the merge.

DECLARE @T TABLE(EmployeeID INT);

MERGE Target1 AS T
USING Source1 AS S
ON (T.EmployeeID = S.EmployeeID) 
WHEN NOT MATCHED BY TARGET AND S.EmployeeName LIKE 'S%' 
    THEN INSERT(EmployeeID, EmployeeName) VALUES(S.EmployeeID, S.EmployeeName)
WHEN MATCHED 
    THEN UPDATE SET T.EmployeeName = S.EmployeeName
WHEN NOT MATCHED BY SOURCE AND T.EmployeeName LIKE 'S%'
    THEN DELETE  
OUTPUT S.EmployeeID INTO @T;

DELETE Source1
WHERE EmployeeID in (SELECT EmployeeID
                     FROM @T);