Businesses sometimes have to make difficult decisions about their staffing and employees. In cases of downsizing, layoff, or terminations, companies often provide benefits for departing employees, including severance pay.
In this article, we will discuss severance pay, legal requirements, tax implications, and best practices for severance packages and severance agreements. While you should always check with your legal counsel to ensure you are following all laws and regulations, this guide can provide a general overview of severance pay.
What Is Severance Pay?
Severance pay is compensation an employer pays when employment is terminated. Typically, severance pay is offered due to layoffs or downsizing, although severance pay can be offered for any type of separation.
Severance packages can include pay in a lump sum or be spread out over time. It can also include other types of benefits beyond pay. Severance pay goes beyond what employers owe their employees for hours worked and is not legally mandated by the federal government.
While employers must pay employees for all hours worked, there is no requirement for employers to offer severance pay in the Fair Labor Standards Act (FSLA).1,2 However, some states have more specific requirements regarding situations where facilities are closing or a large number of employees are being laid off. For example, the Worker Adjustment and Retaining Notification (WARN) requires advance notification of job elimination, and some states have specific compliance regulations for severance.3
Severance pay may be required in cases where there are specific requirements included in union contracts or employment agreements.
In most instances, severance packages include releases where employees waive their right to sue in exchange for a severance package. If employees want to accept the severance as offered, they can waive their rights, although they are not required to sign.
However, some rights cannot be waived, including:4
- Workers’ compensation claims
- Minimum wage and overtime claims
- Unemployment insurance claims
- Discrimination claims with the Equal Employment Opportunity Commission (EEOC)5
There are also special requirements for employees over the age of 40. The Older Workers Benefit Protection Act (OWBPA) requires most companies to give employees up to 21 days to consider a severance offer.6 Upon signing, employees also have up to seven days to rescind their signature. Terminations involving layoffs of multiple employees may require longer periods.
Tax Implications of Severance Packages
Severance pay is taxable in the same way wages are in the year it is earned. Employers record any payments and include them in year-end W-2 forms.
Depending on the amount of the payment, it may be taxed as supplemental wages instead of normal wages and subject to a flat withholding rate.7
Why Businesses Offer Severance Pay
If businesses are not required to provide severance pay, why do they do it? There are several reasons.
Mitigate Potential Legal Risks
Anytime you dismiss an employee, whether it’s a termination for cause, without causes, reduction in force (RIF), or any other reason, you need to consider the potential legal risks. While severance pay does not stop employees from taking legal action against your company, it can help. Employees that are getting severance pay may be less likely to pursue legal options.
When employees leave your company, you should always be concerned about the potential impact it can have on the employees who remain. If you treat departing employees fairly and with compassion, it demonstrates a commitment to your team. Regardless of the reason employees leave your company, they should be treated with respect.
A severance package can provide a financial cushion for departing employees and show that you care about your team members.
Maintaining Employer Reputation
Layoffs or downsizing can hurt a company’s reputation and have a ripple effect across employees inside the company, job applicants, and customers. Offering a severance package can help protect a company’s reputation and any resulting negative publicity.
How to Decide the Amount of Severance Pay
Organizations have a great deal of latitude in deciding what to include in severance packages. Companies should consult with their legal advisors and HR experts to ensure they are meeting all legal requirements. Other factors that impact the amount of severance pay typically include:
- Length of employment. While companies may have different approaches, a common example is to pay one or two weeks’ pay for each year of service.
- Employee positions. Some companies offer senior executives or employees with specialized skills a higher level of severance since such workers may have more difficulty finding employment elsewhere.
- Industry benchmarks. When setting severance pay policies, businesses may want to examine what others in their industry offer to make similar benefits available.
While severance pay is most often covered in an employee handbook, employment contract, or collective bargaining agreement, employers can negotiate a severance agreement. Depending on the circumstances, employers may offer additional benefits that go beyond pay. For example, with large layoffs, employers often offer outplacement services to help terminated employees find new jobs.
Other Forms of Severance Packages
Besides outplacement services, other items are often included to help employees as they transition out of the company.
Some companies offer extended benefits, such as keeping employees on a company’s health insurance for a period. They may also offer additional benefits, such as:
- Providing letters of recommendation
- Reimbursement for moving expenses
- Ability to keep company cell phones or equipment
- Retention of pension plans or defined-benefits plans
- Agreement not to contest unemployment compensation
- Tuition reimbursement for retraining
- Severance Pay Best Practices
- Ending any non-compete agreements
When designing a severance pay package or severance agreement, companies should seek legal help or get advice from HR experts. Failing to do so can have serious consequences. What we’re discussing in this article should not be construed as legal advice, and your particular situation may have additional legal requirements beyond what has been covered.
Here are other best practices regarding severance pay:
Staying Up to Date on Labor Laws
Organizations should also stay on top of any federal, state, and local labor laws. Labor laws and regulations are also updated regularly.
For example, California requires any employees that were terminated involuntarily to receive their final pay immediately upon termination, although severance pay may be extended over time.8 In 2023, New Jersey amended its state WARN Act to require employers with more than 50 employees located anywhere in the state to provide one week of severance pay for each year of service. 9 Thus, be sure you’re up to date on any labor changes to protect your business.
Different jurisdictions also have laws that impact the enforceability of certain clauses in severance agreements, such as non-disparagement or non-compete clauses.
Have a Written Severance Plan
Having a clear policy and criteria for severance can help avoid confusion and legal implications. Written policies should include who is eligible for severance and under what conditions severance is paid. It should also include how severance pay is calculated, such as the number of weeks of pay given for each year of employment.
Policies should also include the conditions and obligations. Employees should know that they must sign a release of claims or waive other rights to receive severance pay.
Severance agreements should include:
- Consideration. Consideration is what employers are offering employees in exchange for signing a severance agreement. Consideration cannot be something that employees are entitled to, such as payment for hours already worked.
- Timelines. Employees should know how long they have to sign the document and any rights they have to rescind their signature (if applicable).
- Payment Terms. Organizations should also detail how severance pay will be given. For example, will it be paid in a lump sum upon signing, or will it be paid out over time?
- Benefits. Severance agreements should specify any other benefits an employee may receive (if any) and how long they will last.
Best practices for severance agreements are also to let employees know that they should have the agreement reviewed by their advisors or attorney. This encourages employees to seek legal advice if they are unsure of anything in the agreement. It also helps to mitigate claims that they did not know the contents of the agreement.
Create Fair and Reasonable Policies
Severance plans should be consistent with industry standards and market conditions to help attract and retain a quality workforce. Especially during an uncertain labor market or economic downturn, job seekers may pay closer attention to what happens in case they lose their job due to layoffs or downsizing.
Review Severance Policies Regularly
Make sure your severance policies conform with any applicable regulations and reflect your current strategy.
Work with a Professional Services Organization
You may want to consider working with a Professional Employer Organization (PEO) to help create and review your policies. An annual review with HR specialists can help make sure everything is correct.
Resourcing Edge is an industry leader in human capital management solutions and can help you with just about any aspect of your HR, payroll, or benefits, including severance pay. To discuss your needs, contact the HR experts at Resourcing Edge today.
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