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Should You Offer Severance Pay?

Max Freedman
Max Freedman

Depending on your reason for terminating an employee, you may be inclined to offer them severance pay to help them bridge the financial gap until they can find new employment.

  • Severance pay is a package of benefits, which may include monetary compensation and extended healthcare insurance, that employers give to employees who are terminated for nonperformance reasons or who retire.
  • There are few regulations governing severance pay, but an employer that chooses to offer it must adhere to any stipulations agreed upon in a mutually signed severance or dismissal policy.
  • The way an employer delivers severance pay may affect an employee's eligibility for state and federal unemployment benefits.
  • This article is for business owners who are determining whether to offer their employees severance pay.

Few employers find joy in terminating employees. Employers often find that the worst part of mass layoffs, downsizing and other employee termination scenarios is what happens to the people who lose their jobs. Offering severance pay allows you to help ease your employees' transition from employment to unemployment. Before you decide whether your company should provide these types of post-employment benefits, it is important to understand what severance pay includes, how it works and who is eligible.

What is severance pay?

Severance pay is the package of payment or benefits (or both) that an employer provides to a terminated employee. Often, employers designate severance packages for retiring employees or for employees whose termination occurs through no fault of their own, such as during a mass layoff. Some employers also offer severance packages to employees who leave of their own accord or who are fired for poor job performance, though these scenarios are less common. Employers that offer severance pay generally do so to help employees keep their finances more stable in the event of layoffs or downsizing.

Key takeaway: Severance pay is a package of compensation and/or benefits offered to certain terminated employees.

How does severance pay work?

Generally, an employer that offers severance pay must put their severance package into effect immediately upon an employee's termination. Employers often deliver severance pay as a taxable lump-sum payment, and usually, the amount of compensation or benefits in the package is larger for employees who have been with the company longer.

In most cases, you can calculate the total amount of severance pay you should provide an employee using these guidelines:

  • For hourly employees: Number of years with your business multiplied by one week's worth of standard wages

  • For salaried employees: Number of years with your business multiplied by two weeks' worth of standard wages

For example, if you offer severance pay to an employee who spent five years at your company and whose most recent salary was $50,000, you would calculate the amount like this:

5 x ($50,000/year) / (52 weeks/year) x (2 weeks) = $9,615.38

In addition to this severance pay base, you may need to pay terminated employees for unused vacation time, sick time or other accrued time off. You'll need to do so only if you previously agreed upon it in the terms of your severance agreement. Unlike with standard severance pay amounts, there isn't a widely used formula for converting unused vacation time to severance pay, so be sure to establish your own terms for covering unused time off in your severance agreement.

Key takeaway: Severance pay is usually given upon termination, is delivered as a lump-sum payment and sometimes includes compensation for unused paid time off.

Who is eligible for severance pay?

There are very few regulations outlining which kinds of workers are required to receive severance pay. The only federal law governing severance pay is a stipulation of the Worker Adjustment and Retraining Notification (WARN) Act. According to the WARN Act, if an employer of more than 100 employees plans to lay off a large portion of its staff, it must offer severance pay if it fails to give terminated employees 60 or more days of advance notice. The WARN Act does not provide guidance on how much severance pay should be given in this mass-layoff scenario.

Other than WARN Act compliance, the stipulations for an employer's severance agreement are entirely up to the employer. You can choose to include hourly employees, salaried employees, part-time employees, temporary employees or some combination thereof in your agreements. In a way, the only hard rule of severance pay is that if you and your employee sign a severance agreement, you must adhere to the terms – you can't back out of severance pay once you've contractually agreed to provide it.

You should also brush up on state regulations and legal rulings about severance pay. For example, in Pennsylvania, some lawyers argue that recent court rulings have introduced the concept of an implied employment contract with an employee. If, in an employee suit, a judge or jury rules that an implied employment contract exists and the employer has violated the terms of the WARN Act, the employer may be held liable for severance pay.

Key takeaway: There are few regulations outlining eligibility standards for severance pay, so an employer may offer severance pay to any employees it chooses.

Do businesses have to offer severance pay?

As you might have guessed from the loose guidelines regarding employee eligibility for severance pay, no regulations exist that require businesses to offer severance pay. However, many employers still choose to do so as a kind gesture to employees who are laid off or retiring. Offering severance pay can also boost employee morale by showing current employees that they'll be taken care of if they lose their jobs for reasons not related to performance.

Although no employers are legally required to offer severance pay, any signed agreements must be honored. That means that if you outline a severance policy in your employment contract or employee handbook, you must honor it. If you refuse to pay severance wages or benefits as outlined in an agreement signed by both you and your employee, the employee can sue you.

There are other court-related circumstances in which giving your employees severance pay may be beneficial. For instance, if an employee sues your company for wrongful termination, you may be able to settle out of court by giving the employee a severance package. Speak with a lawyer to determine whether using severance pay to address a wrongful-termination suit makes sense for your company.

Key takeaway: Few circumstances exist in which employers are legally obligated to provide severance pay, but if you do sign a severance policy with an employee, you are legally obligated to honor it.

What should be included in a severance package?

Because employers are rarely required to offer severance pay, there are no government regulations outlining what a severance package must include. However, in general, severance packages may include the following:

  • Partial wages, as determined by the aforementioned formulas
  • Payment for accrued and unused paid time off, such as vacation days and sick days
  • Health insurance benefits
  • Retirement accounts
  • Stock options

Key takeaway: While there are no hard requirements for what must be included in a severance package, most employers that offer severance pay include wages and benefits similar to those offered during employment.

Understanding severance pay and its impact on employee unemployment

Severance pay can help terminated employees adjust to the gap between employment and unemployment. State and federal unemployment insurance can also help to ease this transition. However, you should know that severance pay can affect your terminated employees' eligibility for unemployment benefits.

The good news for your employees is that the standard methods of delivering severance pay don't disqualify them from applying for unemployment compensation. As mentioned earlier, most severance pay is delivered as a lump sum. In this case, an employee can immediately apply for unemployment benefits, because a lump-sum severance payment takes an employee off your company's payroll.

However, other forms of severance pay can disqualify your employees from unemployment compensation. For example, severance pay given in installments over a long period prevents your employees from applying for unemployment benefits until they have received all of their severance pay, because the installment-based model keeps the employees on your payroll. Additionally, in almost all cases, employees who choose to leave a company cannot apply for unemployment benefits.

Keep in mind that, as with almost all things business-related, the rules governing the relationship between severance pay and unemployment-benefit qualification, as well as the application processes, may vary by state. If you decide that offering severance pay is the right choice for your company, speak with a lawyer who is well versed in federal and state labor and employment law to keep your company compliant and your employees happy even after they're terminated.

Determining (and negotiating) severance pay with employees

According to Indeed, severance pay is one component of a severance package. Severance pay is the payment given to an employee at the time of termination. Severance pay varies depending on the employee's role in the company, how long they have been with the organization and if severance pay amounts were specified in the employee's contract.

What is the process for offering severance pay?

The Fair Labor Standards Act doesn't require employers to provide severance pay. If you choose to offer severance pay to your workers, what generally happens is that the employer (you) will present the severance package, including the severance pay to the employee in a formal setting.

An attorney should draw up the severance agreement beforehand. If the employee signs the agreement, should they later decide to seek a higher amount from you, you're not obligated to pay that. 

What if the terminated employee refuses to sign a severance agreement?

Most employers ask terminated employees to sign the severance agreement during the meeting. Employees may ask to hold off from signing. If an employee refuses to sign, an employer can't rescind the offer immediately in many cases. As an example, by law, if the employee is over the age of 40, the employer must provide 21 days for the employee to consider the offer. Further, the employee has one week to revoke the severance package after signing it.

Many times, all parties agree on a reasonable amount of severance pay. Employers can also come back to negotiations with further stipulations like the signing of a nondisclosure agreement or other clauses.

Severance payouts may also be negotiated between the employee and employer. Some employers may spread payments out over time instead of providing a single lump sum. There may also be a clause that payments end in the case of death or disability.

Key takeaway: Severance pay delivered as a lump sum does not disqualify employees from applying for unemployment benefits, but other forms of package fulfillment and contractual terms may prevent employees from applying.

Image Credit: fizkes / Getty Images
Max Freedman
Max Freedman
Business News Daily Contributing Writer
Max Freedman is a content writer who has written hundreds of articles about small business strategy and operations, with a focus on finance and HR topics. He's also published articles on payroll, small business funding, and content marketing. In addition to covering these business fundamentals, Max also writes about improving company culture, optimizing business social media pages, and choosing appropriate organizational structures for small businesses.