May 13, 2024

What is Severance Pay? Employers Guide to Severance Packages

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Tags: HR

Key takeaways

  • Severance pay is any compensation or benefits employers provide employees following termination.
  • Several factors influence severance pay calculation, including length of employment, the employee’s role, termination reason, and your established policies.
  • Offering a severance package builds employee loyalty, allows employees exit gracefully, and reduces the negative impact on employees during layoffs.

May 13, 2024: Irene Casucian refined the page’s layout to improve the visual flow of information. She also added more insights on calculating severance pay to provide the best answer to our readers. She also provided examples of software solutions that can help draft severance agreements.

What is severance pay?

Severance pay is compensation or other benefits employers provide employees following termination. It can help keep an employee’s relationship amicable while offering them a way to pay for expenses as they look for a new job.

In exchange for severance pay, employers often require employees to sign a general release of claims to deter employees from filing lawsuits against the company. As such, severance pay is often one aspect of a larger severance package employers negotiate with their employees upon their departure. 

Typically, an employer will offer severance pay if one of the following scenarios occurs:

  • Employee layoff.
  • Reduction in force (RIF).
  • Mutual separation agreement between employer and employee.
  • Special circumstances, such as cutting ties with low performers.

Learn how to help low performers course correct and succeed in their roles with a performance improvement plan. 

Elements of a severance package

At a minimum, severance pay usually includes salary continuation for a set number of weeks, either paid all at once or over a set period. You can also include benefits continuation, unemployment insurance, compensation for unused paid time off, retirement benefits, outplacement services, and other miscellaneous benefits in their severance package.

If you’re a qualifying employer, you must offer health insurance continuation under COBRA; however, you may offer to continue to pay their portion of insurance premiums for a set time. You can also continue to pay for other benefits, such as life insurance, stock options, or retirement plans.

In the severance documents, you can agree not to protest an employee’s claim for unemployment benefits. This gives employees a better chance of receiving unemployment benefits following termination.

You can pay the employee for unused time as part of the severance agreement. This could include any accrued paid vacation, sick time, or other paid time off. However, in some states, employers may already be required to pay employees for all unused vacation upon termination.

Severance pay and retirement benefits are separate components. Handling retirement benefits depends on the retirement plan’s rules and is not typically merged with a severance package. Nonetheless, the employee is entitled to all accrued benefits up to the point of termination. Here are the possible scenarios: 

  • The employee can receive their benefits as a lump sum payment.
  • The employee can purchase an annuity. 
  • Retirement benefits can be rolled over into another IRA or a new employer’s 401(k) plan.

The last option allows for continued tax deferral and potential growth of retirement funds.

This includes any assistance you can provide to departing employees to find a new job, such as recommendation letters, reference checks, résumé help, or time-off flexibility to apply or interview for a position.

Employers may decide to provide other unique benefits to the employee as part of their severance package. For example, allowing an employee to keep company equipment, such as a company cell phone or computer, or maintain other perks, like gym memberships, for a set timeframe.

How is severance pay calculated? 

Several variables affect the calculation of severance pay like tenure, seniority, existing company policies, and reason for termination.

Some companies provide one week’s salary for every year of tenure:

Severance pay = (weekly salary) x (year(s) of service)

So, if an employee has been with the company for exactly three years and earns $800 per week, the severance pay will amount to $2,400:

Severance pay = $800 x 3 years of service = $2,400

You might also consider providing a higher severance rate for key employees. Instead of one week’s salary for each year of service, you may offer these employees a month’s salary for every year.

Severance pay = (monthly salary) x (year(s) of service)

For example, an executive who has worked for five years and earns $25,000 a month will receive $125,000 as severance pay:

Severance pay = $25,000 x 5 years of service = $125,000

Some companies state their severance pay formulas as policies in their employee handbooks or employment contracts. While doing so provides transparency, clear expectations, and consistency, it also makes you legally obligated, under employment law, to follow through with these expectations.

Another possible underlying factor that may affect severance pay calculation is the employee’s reason for leaving. Companies don’t usually offer severance pay for reasons like voluntary resignation or discharge for cause.

However, as mentioned above, there are special circumstances outside the employee’s control that can result in their employment being terminated. In these situations, many companies tend to offer generous packages to ease the burdens that come with involuntary termination.

Learn best practices for managing tough transitions: How to Fire an Employee (and Stay Out of Trouble)

Severance pay best practices

Suppose you decide to put a severance agreement policy in place. In that case, you must put the agreement in writing, make sure it’s legally compliant, provide time for the employee to review it, follow through on its commitments, and remain consistent with all employees in the same situation.

Put it in writing

It is critical employers put your severance pay agreements in writing. This provides a record that both parties, you and the employee, agreed to the terms of the severance package in case of a lawsuit. You may also consider outlining a general severance pay policy in your employee handbook indicating what circumstances qualify employees for severance pay agreements. 

To craft an effective severance pay agreement, you should consider the following questions: 

  • Why is the employee receiving a severance package? 
  • What is included in the severance package?
  • How is/are the severance payment(s) calculated? 
  • If benefits will continue, how will the payments be handled?
  • How are unemployment insurance benefits handled? 
  • How will the employee receive their severance pay?
  • When will the employee receive their severance payment(s)?
  • Will the employee be required to sign a release of claims before receiving pay?
  • How long does the employee have to review the severance agreement?
  • Is there an appeal process? If so, what are the steps?

After collecting the answers to the above, employers should prepare a clearly defined severance agreement with them. You can use Rippling’s customizable workflow recipe to automatically notify payroll whenever an employee is laid off involuntarily. This will alert them to prepare and calculate the severance package.

This Rippling workflow recipe will automatically notify the employee, manager, and admin department once an employee is involuntarily fired.
Rippling’s workflow recipe streamlines the process that needs to take place once an employee is involuntarily terminated. Source: Rippling

Also, Bambee can help you draft a legally compliant severance agreement that considers both the employer’s and employee’s best interests by providing access to HR experts who understand the nuances of employment law. Their expertise can ensure that all terms in the severance agreement are both fair and equitable.

Include relevant waivers and clauses

If you want the employees to sign a waiver of discrimination claims in the severance agreement, you must make sure the claims are legal and enforceable. In particular, employers must comply with the requirements of the Age Discrimination in Employment Act (ADEA) and the Older Workers Benefit Protection Act (OWBPA).

Under the ADEA and the OWBPA, workers 40 years of age or older must have at least 21 days or 45 days to accept the severance agreement, depending on the termination reason. Even if the worker is younger than 40, employers should provide adequate time for the employee to review the severance agreement before making a decision.

Additionally, a revocation clause — a section indicating how long an employee has to revoke a severance agreement signature — is another measure employers can take to strengthen their severance agreements. For instance, it shows employers provided plenty of time for employees to decide on the terms of their severance agreement, making it harder for employees to dispute the agreement later. 

Consult legal experts

Severance agreements can be difficult to draft, and even the best HR teams should consider getting theirs checked by legal experts before presenting them to their employees. You could save time and money from future lawsuits by investing in a professional employer organization (PEO) to review severance agreements beforehand. 

Small businesses with no dedicated HR department, especially, should have an employment law attorney construct the severance agreement on their behalf so they can dedicate their time to matters of higher priority while remaining compliant. For example, ADP TotalSource is a PEO that allows small businesses to outsource specific HR needs, which includes handling severance agreements. ADP TotalSource can act as the employer of record and oversee several aspects of employee terminations, including severance agreements.

A screenshot of ADP TotalSource displaying a message with instructions regarding Roger Kiney’s SSN compliance.
ADP TotalSource can provide professional advice in benefits administration, hiring, payroll, compliance, and reporting. Source: ADP

Present the agreement to the employee

Severance agreement in hand, it’s time to present it to the employee. You should not be surprised if the employee attempts to negotiate the terms of the severance agreement.

Depending on the circumstances, the employer may not want to negotiate with the employee. However, you should update any changes to the agreement and then provide the allotted time for employees to accept or decline the offer. Employees should then sign the agreement whether they disagree or agree with the terms for the employer’s records.

Follow through on severance obligations

If the employee accepts the severance pay agreement, you should ensure they uphold their end of the bargain.

  • Your payroll department should know how and when the separated employee will receive their severance pay. 
  • Benefits administrators should send out any necessary COBRA paperwork and continue paying the employer’s portion of premium payments if applicable. 
  • Managers should avoid protesting unemployment claims for the employee after they’ve received their severance pay. 
  • HR teams should also double-check that the severance agreement is administered appropriately by all departments on an ongoing basis. 

By providing a smooth severance pay experience, employers demonstrate a willingness to support their employees’ well-being, even after they are gone. 

Enforce severance policies consistently

Consistency is important. It shows employees that you are dedicated to treating everyone in the same situation fairly and equitably. Even offering severance pay to an employee under special circumstances, outside their usual cadence, could set a precedent. To avoid this and remain consistent, employers should keep track of what was included in their severance packages and who received them for future reference.

FAQs

There are many advantages to offering a severance package to departing employees. Specifically, severance pay policies help HR teams in the following ways: 

  • Builds employee loyalty: Making severance packages a standard procedure for terminations instills faith that the company treats its employees fairly, even when the employee life cycle comes to an end.
  • Allows underperformers to exit the company gracefully: Instead of risking rigorous PIPs or drawn-out termination, underperforming employees may opt for a severance package that provides some financial stability as they look for a new job. 
  • Reduces the chance of employment-related lawsuits: Most employment legislation, including the FLSA, does not allow employees to waive their rights to sue; however, requiring employees to sign a release in a severance agreement can dramatically discourage the possibility and reduce risk.
  • Softens the blow for employees during layoffs: While no employee likes being laid off, providing a severance agreement package can ensure employees have the time and money to get back on their feet. 

There are also reasons why severance packages may not be a good choice:

  • Adds to financial strain: If you are at risk of bankruptcy or unable to pay labor costs, offering severance packages could worsen your financial situation.
  • Increases administrative burden: Severance packages often require negotiations with employees, documentation, and ongoing administrative upkeep, which may be too time-consuming for companies with small HR teams.
  • Delays employee exits: You may choose to forego severance instead of negotiating the details of the severance package, which can prolong an already unpleasant situation. 
  • Increases legal risks: Deviating from severance agreement procedures could lead to discrimination lawsuits.
  • Promotes employee attrition: Depending on severance pay policies, it may encourage employees to leave knowing they’ll receive a payout, hurting your retention efforts.

Yes, employers must withhold all payroll taxes, including federal, state, and local taxes, from employees’ severance check(s). In addition, employers must also pay their portions of federal unemployment, state unemployment (if applicable), Medicare, and Social Security taxes on the severance checks. 

Depending on how the employer provides the employee their severance, the amount withheld for taxes may differ. For example, a lump sum severance pay could place the employee in a higher tax bracket and result in the withdrawal of more taxes than usual. To avoid surprises, employers should let their employees know how the taxes will affect their severance pay during negotiations.

Private employers are not required to provide severance pay under the Fair Labor Standards Act (FLSA). Therefore, it is usually up to the company whether or not they want to offer severance pay to its employees.

However, there are circumstances when employers have to offer severance pay to their employees. Here are some examples: 

  • You are in a WARN Act state: Employers may be required to offer severance pay under the Workers Adjustment and Retraining Notification Act (WARN Act) and other state equivalents. Typically, this occurs if a business does not provide adequate notice to affected employees before a business closure or mass layoff.
  • You have an employment contractor or collective bargaining agreement (CBA): Certain employment contracts and collective bargaining agreements require employers to provide severance pay to employees. In these cases, employers must comply with the Employee Retirement Income Security Act (ERISA) as with any other employer-provided health or retirement plans.

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