What Is Severance Pay?

What You Need to Know About Severance Pay

A recently laid-off worker sits on steps beside a cardboard box filled with her belongings.

Witthaya Prasongsin / Getty Images

Severance pay is money that an employer may extend to a laid-off or terminated employee. Although there are no federal laws requiring severance pay, many employers offer it, typically in consideration for signing a release waiving the right to file future legal claims.

An effective severance pay policy can protect your organization against lawsuits, build your employer brand, and foster a positive company culture.

What Is Severance Pay?

Severance pay is compensation that companies offer to employees who are terminated for various reasons. An employer might choose to offer severance pay to employees who lose their jobs during a layoff, for example, or they might extend severance to employees who lose their jobs for any reason.

When employers choose to offer severance pay, the amount is usually determined by the length of employee tenure, typically one or two weeks per year of service.

Senior executives sometimes negotiate severance pay as part of their employment contract.

Federal Laws 

The Fair Labor Standards Act doesn’t require employers to give employees severance pay. It’s a matter of agreement between the employer and employee, or it may be part of a union contract. 

If you are closing a plant or doing a mass layoff, you must comply with the federal Worker Adjustment and Retraining Notification (WARN) Act to give employees advance notice. The law doesn’t specifically mention severance pay, but it does discuss the concept of pay in lieu of notice. 

If you have a health plan for employees, and have 20 or more employees, you must give terminated employees notice explaining their rights to have COBRA coverage. This plan gives terminated workers the right to continue group health benefits (at their own cost) for a limited time. 

Be sure that your severance pay benefits do not discriminate against any employees. You’ll need to consider age discrimination (employees over 40), equal pay (non-discrimination on the basis of sex), and other anti-discrimination laws. 

State Laws

A few states and territories have laws requiring severance pay for employees who are not terminated for cause. For example, Puerto Rico law requires that employees discharged without cause must receive an amount of severance pay based on years of service.

Check your state’s labor office website to see if it has severance pay requirements. 

Severance Pay and Taxable Income

Severance pay and unemployment benefits are both taxable to the employee. Be sure to withhold both federal income tax and FICA (Social Security/Medicare) tax from severance paychecks. If the employee chooses to take a lower amount of severance pay to receive outplacement services, the full amount of the severance is still taxable. 

How Does Severance Pay Work?

If you decide to give employees severance pay, you should develop a policy for these payments and include it in your employee policies and procedures manual

1. Determine Eligibility

Decide which employees are eligible to receive benefits. For example, you can say that only full-time employees would receive severance pay, as long as you treat all employees in that category equally. 

You may also want to list eligible termination reasons for giving severance pay. You can also exclude employees who resign voluntarily, are fired for misconduct, or fail to return from a leave of absence.

Be sure to specifically define the actions included in the term “misconduct.” 

2. Set a Pay Schedule

Your policy should include a pay schedule, including: 

  • Ranges (less than one year, one to three years, etc.)
  • Page grade or salary levels
  • Amount

For example, all employees in your company's "executive" pay level with one to three years of service could receive nine months of severance pay. 

3. Consider Other Benefits 

You can extend health benefits for a time period or just let employees know about COBRA coverage (described above).

As mentioned earlier, you may also want to offer employees the option for outplacement services to help them find another job. But remember, the full amount of the severance is still taxable even if the employee takes less money because of the services.

Also, be sure to explain that severance isn’t affected by payments for accrued or unused vacation, or commissions. 

4. Prepare a Severance Pay Agreement

As you talk to each employee at the time of the firing or layoff, you should have a severance pay agreement ready for the person to sign. Having a written agreement spells out the terms that both parties are agreeing to, so there’s no misunderstanding later. The agreement also gives notice to the employee of actions they can’t take after termination.

The severance pay agreement should include: 

  • The effective date of the termination and the agreement 
  • The amount of severance pay, how it will be paid, and when 
  • Whether accrued vacation pay or other payments due (like commissions) are being paid and the amount 
  • What health plan benefits will continue (not required), or a notice explaining COBRA coverage
  • What happens to other benefits, like life insurance or vesting in a retirement plan
  • Return of confidential information, keys, computers, and other company property

Be sure to include a release stating that the employee agrees not to bring a lawsuit for any claims against the company. 

Depending on the employee’s job description, you may want the person to sign additional agreements restricting their actions as a former employee. These agreements, called restrictive covenants, might include: 

  • A non-solicitation agreement to keep the former employee from soliciting your customers or other employees 
  • A non-disclosure (confidentiality) agreement to keep the former employee from disclosing your company’s trade secrets 
  • A non-compete agreement to keep the former employee from setting up or working for a business in competition with your company 

Key Takeaways

  • Severance pay is money that employers pay laid-off or terminated employees.
  • A severance pay policy ensures that all employees are treated equitably and protects the employer from legal exposure.
  • Be sure to check state and federal laws to ensure that you are in compliance.
  • Consider working with an attorney when drafting a severance pay policy for your business.