Because God is just and righteous, He could not simply "dish out mercy". The mercy we received came at a price! The cost of our punishment had to be paid. Jesus chose to take our punishment upon Himself, and in doing so, we could freely receive God's mercy.
Mercy:
According to the Bible, we have all sinned (Ecclesiastes 7:20; Romans 3:23; 1 John 1:8). As a result of that sin, we all deserve the judgement of death (Romans 6:23) and to be destroyed in the lake of fire (Revelation 20:12-15). With that in mind, every day we live is an act of God's mercy. If God gave us all what we deserve, we would all be, right now, condemned for eternity. A simple definition would be that mercy is deliverance from judgment. In essence, mercy is God not punishing us as our sins deserve.
Grace:
We deserve nothing from God. God does not owe us anything. Anything good that we experience is a result of the grace of God (Ephesians 2:5). Grace is simply defined as unmerited favour. God favours, or gives us good things that we do not deserve and could never earn.
In Summary:
Mercy is being rescued from the fires of hell where grace, going beyond mercy, is the kindness from God to receive blessing and favour we certainly don't deserve. Another view on this is to say that, rescued from judgment by God's mercy, grace is anything and everything we receive beyond that mercy (Romans 3:24).
Mercy is not sending us to hell (ie: leaving us in our current state no matter how good or bad that state is)! On top of this mercy are the blessing of God, given to us in unmerited favour. Examples of this grace are (1) salvation, (2) forgiveness of sins, (3) abundant life and blessings (John 10:10), (4) protection and (5) an eternity in Heaven, to name but a few.
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