Severance pay: Definition and guidance for HR professionals

Ever wonder about all the ins and outs of severance pay? If the answer is yes, you’re in the right place.

What exactly is severance pay? When – if ever – are employees entitled to it? What’s included in a typical severance package? What are some of the legal issues that can arise?

Here’s a look at the answers to those questions – and more.

Disclaimer alert: We’ll give you plenty of useful information about severance pay here, but it’s not a substitute for legal advice. For that, you’ll need competent legal counsel who knows both the subject-matter area and the specific rules that apply in your unique situation.

What is severance pay?

In a nutshell, severance pay is compensation paid to an employee upon separation from employment – above and beyond what the employee has earned in wages.

Severance pay can include a lump-sum monetary payment and payment in the form of continuation of salary for a set period of time. We can also think of severance “pay” as including an agreement to extend an employee’s benefits after they leave, such as providing an extension of health care benefits.

When employers and departing employees enter into a severance agreement, the employer pays the terminated employees something extra – and usually gets something back in return in the form of a release.

We’ll get into more details about those releases in just a bit, but getting a release is one of the biggest reasons why employers offer severance pay. Those releases are primarily designed to block future lawsuits by the departing employee, and gaining that insulation from liability – or just the cost of defending a suit – is important for employers.

Severance pay also serves the purpose of making the separation a little (and sometimes a lot) easier for employees to handle. It can also help avoid bad press, preserve and promote employee morale, and protect proprietary company information.

Federal law does not require employers to pay departing employees any amount of severance pay. Instead, the payment of severance is generally dependent on the existence of some type of agreement between the employer and employee.

This agreement may be reached by way of a pre-existing direct contract between an employer and employee, such as one that was entered into when the employee started working. It can also derive from a provision in a collective bargaining agreement. An employment handbook section that provides for the payment of severance benefits may also serve as a basis for a right to a severance package.

In a 2023 survey, only a quarter of U.S.-based employer respondents said they offered severance to all employees.

Separate special rules apply to federal employees when it comes to severance pay.

How severance pay is calculated

In the typical case, severance pay calculations are made with reference to the departing employee’s years of service. In other words, the amount of severance pay usually increases in proportion to the employee’s length of service.

An employee’s base salary is typically used to calculate severance pay. In addition, specific severance pay calculations may be dictated by established company policy or the existence of a contractual agreement.

The amount of severance pay may also vary depending on the departing employee’s position. A senior executive may receive a higher amount of severance pay per year of service than a lower-level employee might receive.

For example, a departing senior executive might receive three weeks of severance pay per year of service, whereas a departing low-level employee at the same company might receive something closer to two weeks of severance pay per year of service.

In addition, at some companies only higher-level employees get any severance at all.

You get the point by now: There’s no set rule on this, and no law specifically sets how much (if any) severance is to be paid. It all depends on whether a prior agreement or policy requires severance pay. Of course, employers are also free to provide severance pay even if they are not obligated to do so.

Key components of a severance package

One popular option for severance pay is for the employer to make a single lump sum payment. Lump sum severance pay simply means that a one-time payment is made at or soon after separation from employment.

Another common way to pay severance is to continue the employee’s salary for a set period of time, such as six months.

The manner of payment is negotiable.

Lump sum vs. salary continuation

Each of these payment methods carries implications with respect to unemployment benefits and taxes.

Precisely how severance pay impacts an employee’s ability to collect unemployment benefits depends on state law. Receiving payment over the course of time may limit access to unemployment benefits. On the other hand, receiving the payment as a lump sum may provide employees with the advantage of gaining full access to unemployment benefits more quickly.

Let’s say that a particular severance package calls for an employee to receive the exact same benefits they were getting while working, over an extended period of time. In that case, the payment of the severance benefits may make them ineligible for unemployment benefits until the severance payments stop.

Tax implications also come into play with respect to the payment of severance benefits. Severance pay is taxable in the year it is received. Receiving severance pay in installments rather than as a one-time lump sum may cause the payments to be taxed at a lower rate.

In some states, unused vacation time is earned wages that must be paid at separation regardless of whether there is a severance pay package being offered. In others, unused vacation time may be paid as part of a severance package.

Spreading payments out over time may increase the chances that the employer will extend the provision of health insurance coverage for the departing employee.

Benefits continuation

A severance package can include components in addition to monetary payments. Example: A severance package may extend an employee’s insurance benefits, such as healthcare coverage, or contributions to a retirement fund.

These other components can be very valuable. As to healthcare coverage, for example, a separated employee may stay on an employer’s health insurance plan for up to 18 months under a federal law known as the Consolidated Omnibus Budget Reconciliation Act, more commonly known as the COBRA law. But under COBRA, the employee is responsible for the entire premium. Employers typically pay a significant portion of the health insurance premiums of their current employees.

The duration and extent of benefits continuation will vary depending on the applicable company policies and any relevant agreements.

It’s particularly important for employees’ planning purposes to know exactly which benefits (if any) will continue after the date of separation – and for how long.

Non-compete and non-disclosure clauses

A severance agreement offered to an employee may include a non-compete clause that seeks to limit what job the departing employee may go to next.

These agreements generally restrict the former employee from working for a competitor for a set time period after departure, and they usually include a geographic range.

Example: The non-compete agreement bans the departing employee from working for a direct competitor that is located within five miles of the employer for a period of 12 months.

The enforceability of these agreements varies from state to state. In states that generally allow them, the restrictions they impose with respect to scope and duration must be reasonable.

Though they are still generally valid in many states, there is a clear trend that disfavors these non-compete pacts. In fact, the Federal Trade Commission has proposed that they be banned.

Non-compete provisions in severance agreements need to be carefully evaluated by both sides with careful attention to the law of the jurisdiction where they are located.

A severance agreement may also include a provision relating to non-disclosure.

A big question regarding the validity of non-disclosure provisions: Exactly what kind of disclosures are they trying to ban?

A non-disclosure provision that seeks to block the departing employee from discussing any labor issue, or from revealing even an unlawful provision within the overall severance agreement, may cross the legal line. In fact, the National Labor Relations Board has specifically ruled such broad non-disparagement and confidentiality provisions violate the National Labor Relations Act. Although this ruling applied only to non-supervisory employees, it serves as a warning about the limitations applicable to non-disclosure provisions.

This doesn’t mean non-disclosure provisions need to be avoided altogether.

But severance agreements should include a clear statement that nothing in the agreement should be construed to prevent the employee from exercising their rights under the National Labor Relations Act.

In addition, they should say that the agreement does not stop them from filing an administrative charge of unlawful bias.

Employers are free to include non-disclosure provisions that are designed to stop a former employee from divulging sensitive information, such as trade secrets or other proprietary information.

Finally, employers need to know that some states have limited the use of non-disclosure agreements.

Federal regulations on severance pay

There is no federal law mandating the distribution of severance pay when workers leave their jobs.

Just don’t confuse that general lack of a severance pay requirement with the fact that federal employees do get severance pay if they meet certain requirements.

Also remember that federal law can affect severance agreements more peripherally, such as by disallowing the presence of certain clauses within them. For example, an overly broad non-disclosure provision may be deemed to violate federal law by unduly interfering with an employee’s rights under the National Labor Relations Act.

Another way to think of it: Though federal law does not directly regulate severance pay, employers can still run afoul of federal law in connection with the administration of severance agreements.

WARN Act (Worker Adjustment and Retraining Notification Act)

Requirements

Under a federal law known as the Worker Adjustment and Retraining Act, which is more commonly referred to as the WARN Act, most employers with at least 100 employees must provide employees at least 60 days of advance notice in the event of a plant closing or mass layoff.

A plant closing means the shutdown of a facility that causes the layoff of at least 50 full-time employees, while a mass layoff is defined to include either 1) the layoff of between 50 and 499 employees, if the number of employees laid off is at least a third of the full-time workers at the site, or 2) the layoff of at least 500 employees at a single site.

The purpose of the required advance notice requirement is to give employees time to adjust in the event of plant closures and mass layoffs.

The notice may be provided in connection with the provision of outplacement services.

A person does not count as an employee under the WARN Act if they have worked for the employer for less than six months or have worked less than 20 hours per week.

If an employer violates the act, affected employees are entitled to an amount equal to back pay and benefits for the period of the violation, up to 60 days.

The federal Department of Labor has advised that a covered employer may provide a severance package in place of the generally required WARN Act notice in two different situations. First, the payment of severance benefits may be conditioned on waiving claims that might otherwise be available under the act. Second, a severance package may offset the WARN Act. In the latter case, pay is essentially provided in lieu of notice.

Coverage and exceptions

Generally, the WARN Act applies to employers with at least 100 employees. Workers who have worked for fewer than six of the last 12 months or who work less than 20 hours a week are not counted toward the total.

The law covers private, for-profit and nonprofit employers. It also applies to public and quasi-public entities that operate commercially and are organized apart from regular government.

It does not cover regular federal, state and local government entities that provide public services.

There are some exceptions to WARN Act notice requirements, such as closings that occur due to unforeseen business circumstances or natural disasters. In those cases, employers need to provide as much advance notice as possible.

Several states have their own versions of the federal WARN Act. These state laws may give employees more protection than their federal counterpart, such as longer notice periods and greater damages.

ERISA (Employee Retirement Income Security Act)

A federal law known as the Employee Retirement Income Security Act, or ERISA, is a federal law that sets standards for retirement and health plans. Among other things, it requires plans to provide participants with relevant information and gives plan participants the right to sue for benefits and breaches of fiduciary duty.

Impact on severance pay

If a severance agreement involves an ongoing administrative scheme that the employer administers, then it may be subject to ERISA requirements.

If ERISA applies, the employer must make sure the plan is in writing and include a claims procedure. All covered employers must also provide participants with a summary plan description. In addition, plans with at least 100 participants must file a specified form on an annual basis.

The federal Department of Labor has created a safe harbor rule that says a severance benefits arrangement will not be treated as an ERISA plan so long as specified requirements are met, including that the payments are not contingent on a requirement that the employee retire.

ERISA is intended to protect employee rights and ensure fairness with respect to severance practices.

Compliance requirements

If ERISA applies to employers offering severance pay, the requirements relating to claims procedures, summary plan descriptions and reporting kick in.

Penalties for violating applicable ERISA requirements can be steep. For example, a covered employer may be penalized up to $110 per day if it does not provide a summary plan description to a participant upon request. That number jumps all the way up to a maximum of $1,100 a day for covered employers that do not meet applicable reporting requirements. If a violation is deemed to be willful, criminal penalties may also apply.

IRS regulations

It is important for employers and employees to be aware of how severance pay is treated for tax purposes.

Tax treatment of severance pay

Tax implications also come into play with respect to the payment of severance benefits. Severance pay is taxable in the year it is received. Receiving severance pay in installments rather than as a one-time lump sum may cause the payments to be taxed at a lower rate.

Severance pay is subject to Medicare and Social Security tax. It is essentially taxed in the same way as regular wages.

Some states have their own rules relating to exemptions and deductions for severance pay.

Reporting and withholding requirements

Employers usually withhold federal income tax at a rate of 22%. Severance pay may also be withheld at an employee’s regular withholding rate if the severance pay is combined with regular wages.

If the severance pay is being paid to an individual who qualifies as an employee, then the payment is to be reported on Form W-2. If it is paid to a non-employee such as an independent contractor, it is to be reported on Form 1099.

Penalties for inaccuracies on these forms can run into the millions.

Severance pay FAQs

Is severance pay taxable?

Yes. For employees, severance pay is taxable in the year that it is received.

Does an employee get severance pay if they’re fired?

Whether an employee gets severance pay depends on whether there is a pre-existing agreement or obligation to pay it. The fact that an employee was fired does not absolutely ban the receipt of severance pay in all cases, but fired employees are less likely to get severance pay — especially if they were fired for willful misconduct.

What happens if severance pay is denied?

If there is a valid agreement in place to pay severance and it is not paid, employees may seek to recover the severance pay by asserting a violation of a contractual obligation to make the payment.

Can severance pay affect unemployment benefits?

Yes. Receiving severance pay over the course of time may limit access to unemployment benefits. On the other hand, receiving the payment as a lump sum may provide employees with the advantage of gaining full access to unemployment benefits more quickly.

The bottom line

The payment of severance is generally dependent on the existence of some type of agreement between the employer and employee. Severance pay can provide important benefits to employers and employees alike. The administration of a severance plan comes with some significant pitfalls that employers can avoid by familiarizing themselves with applicable requirements and by seeking specific guidance from a qualified legal professional.