Severance Pay: An Employer’s Guide to Payments and Policy

Disclaimer: This article is not intended as legal advice. Please seek counsel from an employment law attorney for specific situations.

Severance pay can serve several functions: one, to help employees financially following layoffs or termination; and two, to mitigate the risk of wrongful terminations against the company. In a notable Ford example, employers can even offer severance pay instead of performance improvement plans (PIPs) or termination to manage underperforming employees.

Nevertheless, severance pay policies can be challenging to navigate and companies should research whether their advantages outweigh their disadvantages before implementing them in their business. Offering a severance package is either a step toward improving overall company retention or a financial burden for companies struggling with high turnover during economic downturns.

Creating a severance pay policy and sticking to it can be difficult. Check out our Payroll Software or HR Software Guides for solutions to simplify the process. 

What is severance pay?

Severance pay is compensation or other benefits employers provide employees following termination. Severance pay can help keep the relationship with an employee 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 exit. 

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.

Do companies have to pay severance?

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.

There are circumstances, however, when employers have to offer severance pay to their employees. For example, 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.

Additionally, 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.

Is severance pay taxable?

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 payment 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.

Related: How to Avoid These 3 Costly Payroll Mistakes

What does severance pay typically include?

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. Additionally, employers can include benefits continuation, unemployment insurance, compensation for unused paid time off, outplacement services, and other miscellaneous benefits in their severance package.

Benefits continuation

Qualifying employers must offer health insurance continuation under COBRA; however, employers may offer to continue to pay their portion of insurance premiums for a set time. Employers can also continue to pay for other benefits, such as life insurance, stock options, or retirement plans. 

Unemployment insurance benefits 

Employers can agree not to protest an employee’s claim for unemployment benefits. This gives employees a better chance of receiving unemployment benefits following termination.

Unused paid time off

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

Outplacement services

This includes any assistance an employer provides 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.

Miscellaneous benefits

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.  

Should I give employees severance pay?

Before committing to a standardized severance pay policy, employers should carefully weigh the benefits and drawbacks to determine whether it is suitable for their business.

Advantages

Although severance pay is not mandatory for the most part, 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 outside of discharges for cause or voluntary resignations can foster goodwill toward the company as employees are more likely to remain loyal, even in economically challenging times.
• Allows underperformers to exit the company gracefully: Instead of risking rigorous PIPs or future termination, poor-performing employees may appreciate the option of a severance package that keeps them financially stable as they look for a new job. 
• Reduces the chance of employment-related lawsuits: Although not all regulations, such as the FLSA, allow employees to waive their rights to sue, requiring employees to sign a release in a severance agreement can dramatically discourage the possibility and keep the company safe.
• 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 after an event outside their control.

Disadvantages

There are also circumstances where severance packages may not be the best option for employers. They include: 

• Adds to financial strain: For businesses at risk of bankruptcy or unable to pay labor costs, offering severance packages could worsen their financial situation.
• Increases administrative burden: Severance packages require negotiations with employees, documentation, and ongoing administrative upkeep, which may be too time-consuming for small businesses or companies with limited HR teams to maintain effectively.
• Delays employee exits: Employers may choose to forgo severance instead of negotiating the severance package details and prolonging an already unpleasant situation. 
• Increases legal risks: Deviating from severance agreement procedures could lead to discrimination lawsuits.

Severance pay best practices

If an employer decides to put a severance agreement policy in place, they 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 their severance agreements in writing. This provides a record that both parties, the employer and the employee, agreed to the terms of the severance package in case of a lawsuit. In addition, employers can outline a general severance pay policy in their employee handbooks indicating what circumstances qualify employees for severance pay agreements. Still, employers should always write an individual agreement between themselves and the employee receiving the severance package. 

To craft an effective severance pay agreement, employers 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 are the payments 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 the severance agreement with them clearly defined. 

Include relevant waivers and clauses

If employers want employees to sign a waiver of discrimination claims in the severance agreement, employers 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 reason for termination (layoff or reduction in force). 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 that 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. In addition, it gives employees another chance to back out of the agreement should they decide it’s not right for them.

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. Employers could save time and money from future lawsuits by paying a few hundred dollars to have their severance agreements reviewed 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.

Present the agreement to the employee

Severance agreement in hand, it’s time to present it to the employee. Employers 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, employers 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, employers should ensure they uphold their end of the bargain. Payroll 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 long after they are gone. 

Enforce severance policies consistently

Consistency is important. It shows employees that employers are dedicated to treating everyone in the same situation fairly and equitably. Additionally, it prevents employees from lawsuits for discrimination. 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 their what was included in their severance packages and who received them for future reference. 

Severance pay supports healthy employee offboarding

Companies that make it a standardized practice to offer severance pay to laid-off employees set themselves apart from their competition and mitigate their risk of potential employment-related lawsuits. But, more importantly, offering severance pay provides employees with a financial cushion following events outside of their control and forms the foundation of strong and effective employee offboarding procedures. 

Nevertheless, implementing a severance pay policy can be time-consuming and costly and may not make sense for every business. Therefore, employers should carefully consider the advantages and disadvantages of severance pay and choose the route that best supports the future of their company and employees overall.

Drafting effective severance agreements can be difficult and time-consuming. Check out our HR Software Guide for tools to help in the process.