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What is Severance Pay?

Topics: Comp Strategy

Severance pay is compensation an employer may pay an employee after departing from the company. While severance pay is common and can establish good will among employees, it is not required by law.

Severance packages are most commonly offered for layoffs, involuntary job elimination, retirement, or mutual agreement of departure between parties. Sometimes, employers will provide severance for employees who resign or who are fired.

The past year informed many organizational leaders that they can never be too prepared for large economic and workplace shifts, especially involving highly sensitive matters such as employee layoffs. This article will inform common aspects to take into account regarding severance pay during both employee onboarding and departure.

How is severance pay determined?

Severance policy details should be written into employee contracts at the start of employment, including the conditions in which an employee receives severance (e.g. involuntary job elimination), and how severance will be paid (e.g. lump sum vs. payments).

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Severance pay is not required by law, though there are other employment separation laws to protect employee welfare. Currently, the Fair Labor Standards Act only requires an employer to pay remaining wages and accrued vacation time. Under the Consolidated Omnibus Budget Reconciliation Act of 1995 (COBRA), employees are entitled to continue under an employer’s existing medical plan for up to 18 months.

There are certain circumstances in which severance pay is required. The Working Adjustment and Retraining Notification Act requires that an employer with 100 employees or more provides a 60 day notice for a mass layoff, as we saw in 2020, or alternatively pays employee salary and benefits for 60 days. Further, it is also typical for union contracts to require severance payouts.

💡 Outside of employee contracts, employers are also legally required to provide severance if it is mentioned in employee handbooks or is verbally mentioned. It is important to establish clear severance policies for employees across communication channels.

Why Offer Severance?

Absent a requirement or obligation, an employer may decide to offer severance to establish good will, protect against competition, or avoid lawsuits. For example, upon signing a severance or separation agreement, an employee may be asked to sign various confidentiality forms that protect a company beyond termination.

💡 A termination of any kind can be a difficult process. Severance offerings can lessen the emotional hardship as employees are in search of another job.

To employees: You got fired… what next?

Losing a job in any capacity can be a difficult experience, but there are always next steps. If you are fired, review your employment contract and the severance policy conditions and circumstances, if listed. It is possible under the circumstances in which you were fired, you are eligible for severance pay or to negotiate for severance pay. Employers and Human Resource managers should also be prepared to hold immediate conversations.

Who is eligible to receive severance pay?

The severance policy will determine who is eligible to receive severance pay. In general, if a company has a severance pay or package policy, large layoffs, involuntary job elimination, and retirement will fall within eligibility. Policies should list circumstances in which severance pay will be withheld, such as with termination for cause.

As mentioned, employers may pay the same amount to all employees, or they may establish a calculation based on tenure or seniority.

💡 If employers are dishonest and less than equal in how they distribute severance pay, they are not only subject to bad will amongst remaining employees but are also subject to lawsuits based on discrimination.

How much is an employer required to pay?

It is typical for employers to pay the calculation of a week’s salary for the duration of weeks equivalent to the number of years worked at the company. Some companies may decide upon a flat rate for all separated employees. Ultimately, the calculation of severance is up to the employer.

When provided, severance is paid in one of two ways:

  • One lump sum
  • Payments over time

If payments are spread out over time, it may accompany additional benefits within a severance package (more on this to come), including health insurance coverage.

💡 When paying an employee severance over a series of weeks, it affects unemployment eligibility. A former employee cannot receive full unemployment until severance payments have discontinued. This is an important consideration when calculating severance pay.

Know the difference: Severance pay vs. separation pay

Severance pay and separation pay are often confused, as their differences are only subtle, but important nonetheless. Both severance and separation pay outline the conditions of a dissolved relationship between employer and employee, including circumstances, dates, monetary amounts, and legal agreements.

Separation pay is part of a separation agreement, determined upon termination and involving specific legal agreements and a fixed payment amount. Alternatively, severance pay is brought to light and signed during the hiring process, often as an additional perk for candidates, and informs the circumstances under which employees will receive additional benefits.

What to include in your severance package for employees

As mentioned, companies will often offer a full severance package for employees, which includes additional benefits outside of a lump monetary payment. A severance package may include the following:

  • Insurance or benefits: Some companies will offer continued healthcare coverage, or if they provide coverage for their employees, are required by law under the COBRA Act of 1995 to offer coverage. Some state laws also mandate health benefits, which is important to clarify within employee contracts.
  • Outplacement services: Oftentimes employers will provide structure and services to assist terminated employees in landing another job. Some employees may find this helpful, especially if they have not job searched in some time.
  • Stock options: If an employer provides stock options during employment, they may provide detail into the stock’s current value.

💡 Employees are permitted to negotiate severance package terms, which is entirely normal and always worth a conversation. As an employer, it is important to align on company values, budget and strategic goals as a foundational compass in any severance negotiation.

Last note: Information on severance taxes

Severance payments will also be deemed W-2 wages by the IRS and state tax authorities, and thus are taxed payments. Employers are required to withhold payroll taxes and pay employer payroll taxes.


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