Severance Pay: What Employers Need to Know

  • Accracy
  • 26th Nov, 2023

Severance pay packages can come in several forms—an extension of health care benefits, or help to find a new job—but most often, severance pay is a one-time lump sum paid to an employee after their last day.

Severance Pay: What Employers Need to Know

Editor's note: this article is written by our friends at Fundera, a marketplace for small business financial solutions.

Why offer severance pay, and how much should you offer? This guide will help you understand the possibilities and options.

The laws around severance pay

The Fair Labor Standards (FLSA) Act is federal legislation that sets basic wage, record-keeping, and working standards for American workers. On the topic of severance pay, FLSA is quiet: There are no federal laws requiring businesses to offer their employees severance if they are terminated. However, states can pass their own legislation on the topic (New Jersey recently became the first to do so).

Additionally, there are a couple of related regulations to keep in mind. For example, employers must pay wages for accrued vacation time (sick days are not included) and wages through the termination date.

They are also required to offer COBRA, which allows (former) employees and their dependents who have lost their health benefits to still access the benefits provided by their health plan. Employees may choose to continue using their coverage, but employers may also require them to pay the entire health insurance premium.

Additionally, under the WARN Act (Worker Adjustment and Training Notification), businesses with more than 100 employees must give each employee 60 days' notice before laying them off. Failure to do so will make severance pay mandatory under federal law.

Besides these instances, the only other time you'll owe an employee severance is if you agreed to provide severance, either in an employment contract or as part of a policy in the employee handbook (or elsewhere in writing).

Something else to keep in mind is if your business offers stock options to employees, and what the status of unvested options means when you lay off an employee. Make sure that you understand what your company has agreed to provide to employees in the event of termination. Additional stock options may become part of the severance agreement upon negotiation as well.

Why offer severance pay?

So, unless one of the above scenarios applies, you aren't required to grant severance pay. This being said, you may want to consider it for the following reasons.

Severance pay may be a savvy business move. Severance pay is a gesture of goodwill, and it demonstrates to current and former employees that your company cares about their well-being. This can be a boon for your brand as an employer, which will help you compete for available talent in a competitive job market.

Offering severance may also help you avoid potential lawsuits from disgruntled former employees, and help maintain good relationships with past employees if you think you'd like to work with them again down the road. You may also want to explore offering additional benefits such as outplacement (a support service that helps former employees transition into new jobs) to smooth the transition.

Let's say you lay off an employee who is over 40 years old. By providing no severance, this employee may feel blindsided and harbor resentment for your company, which could lead them to look into legal action, such as an age discrimination lawsuit. On the other hand, providing severance pay creates a more positive experience and reduces the chance of a lawsuit. Plus, it's just a great thing to do for your employees—being laid off is difficult enough, without the financial stress.

When to offer severance pay

Besides helping maintain positive relationships with your past, current, and future employees, another reason to offer severance is to secure a general release from the employee stating that they will not sue the company for any reason. A general release may also prohibit employees from making disparaging comments about the company or include non-compete clauses that prevent them from bringing trade secrets to your competitors.

Most states require that employers give employees 21 days to review a general release before signing it, and another seven days to revoke their signature if they'd like. Like hiring new employees, severance is a negotiation that may take time. So if you intend to offer severance, it's important to understand the timeline you're working with and know that it likely won't be resolved in a day.

How much severance pay to offer

Severance may take a variety of forms. When severance takes the form of money, upper management typically receives a month's salary for every year on the job. For mid- to entry-level employees, it usually amounts to one or two weeks of severance pay per year on the job. Some companies may opt to provide one or two weeks of pay total, regardless of the employee's experience or time with the company.

Let's look at an example: A mid-level manager making $1,500 per week, who worked with the company for four years, is being let go:

  • 2 weeks' pay = $3,000
  • $3,000 x 4 years of service = $12,000 lump sum severance payment

Again, this is simply an example and not a formula every company will adhere to. Severance is a negotiation and many factors may affect the numbers in that formula. Title, company size, experience, and the employment contract all may influence the number you settle on.

It's also important to note that any severance payment is considered income and subject to the same taxes as ordinary paychecks, according to the IRS. Just like a regular check or payments for accumulated vacation or sick time, severance pay is subject to payroll, income, social security, and Medicare taxes. This regulation may affect how much you're willing to offer and how much an employee wants.

Alternatively, you may get creative with severance as well. Since it's not required, employers have a much better bargaining position than employees. If an employee would prefer that you continue to foot the bill on health insurance premiums in exchange for a lower severance payment, that's well within reason. Negotiating in good faith may help lower a company's severance bill while maintaining a positive image that reflects well for future employees and current employees alike.

What to include in a severance policy

Every severance agreement is the result of a negotiation and, therefore, unique. If you plan to offer severance, however, it's important to have a base policy to work from. An impressive 97% of U.S. businesses claim to have a severance policy, yet only 55% say they have a written policy. Naturally, that may cause confusion.

You'll want to work with your HR team and legal counsel to create your company's severance policy. Be sure to clearly spell out the following:

  • Which employees are eligible (for instance, employees that you terminate due to violating company policies would not qualify for severance)
  • Payment policy, services offered, continuation of benefits (if any)
  • Any releases that the employee will need to sign to receive severance
  • Disclaimer that the employer has the right to alter or terminate the policy at its discretion

Once you have a standard severance policy, you'll want to include it in your employee handbook and you should state the specifics in any initial documents new employees sign at the time of their hiring. Completing this process lets employees know what to expect in any severance negotiation and lets you simplify and standardize negotiations as much as you can, all while avoiding the appearance of discrimination.

The bottom line on severance pay

Severance pay is not required by federal law; however, there are some instances where you'll be required to provide it. Even if it's not a requirement, though, there are other reasons to consider offering severance pay—such as showing that your company cares about its employees and protecting yourself from lawsuits down the road. This guide should give you an idea of how to implement a quality severance policy in your organization, but remember to work with your HR team and legal counsel to create the right policy for your business.

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