What Employers Need To Consider About Severance Pay

Hiring and onboarding new employees is an exciting part of growing a business. As every employer knows, however, hiring is only one side of the equation. Workforce reductions and layoffs are also part of an employer's responsibility, and they are sometimes necessary when the company encounters a setback.

If you are considering layoffs to rightsize your workforce, the separation process can be challenging for employers and employees. A severance pay agreement can help alleviate some of those concerns and support employees through the transition process.

Here's what you should know as you design a strategy for employees leaving the company.

What Is Severance Pay and How Does It Work?

Severance pay includes pay and benefits typically offered to employees who leave the company through no fault of their own. Employers may provide severance packages for people who lose their jobs due to layoffs, mergers, or downsizing. In addition to compensation for lost wages, a severance package may include extended health benefits, payouts for accrued but unused vacation time, or job placement assistance. Specifics of the package are usually based on the employee's length of employment or experience.

Separation Pay vs. Severance Pay

The terms separation pay and severance pay are used interchangeably in most cases. Some companies may make a distinction between the two, but that is an internal decision unique to the company. Whichever term is used, the company’s policies should clearly state what will happen upon termination.

Other Common Terms and Phrases

A severance package may also be called an exit package, severance offer, severance benefits, or severance allowance. All these terms describe the benefits available to employees upon termination.

Are Private Employers Required To Offer Severance Pay?

At both the state and federal levels, severance pay is generally treated as an agreement between employer and employee. The Fair Labor Standards Act (FLSA) does not include any provisions that require severance pay, and no other federal mandate applicable to private employers requires it. Although some states mandate severance pay upon the closure of a plant or business, many do not.

Federal Requirements for Severance

While federal law does not require severance pay, the Worker Adjustment and Retraining Notification (WARN) Act may impact some companies. The WARN Act requires advance notice of mass layoffs or plant closings for businesses with a specified number of employees.

Some states also have WARN Acts that stipulate additional requirements. For example, the New Jersey WARN Act extends the required notification period from 60 to 90 days.

State-Specific Laws for Severance

State laws do not usually require severance pay. However, employers should examine the specifics of their state's labor laws since some states may mandate a severance package in the event of a large facility closing or mass layoff. Multi-state employers should take note of the requirements in each state where they operate to ensure compliance.

Is Severance Pay Required in Any Specific Instance?

An employer’s policies, employment contract or union agreement may provide for severance pay. State laws may also require severance pay for public employees and for certain business closures. Employers may wish to consult with an attorney knowledgeable about the applicable laws and their unique business situation to determine their potential obligations.

Layoffs and Reductions in Workforce

Many employees offer severance packages in the event of a layoff to help ease an employee's transition. Details of the package should be specified in company policies or contracts. They usually include one or two weeks' wages for every year of employment and may also provide additional benefits.

Company Mergers and Acquisitions

Mergers and acquisitions create many questions for employees, including concerns about the terms of their severance compensation. The new employer's policies may change the structure of company severance packages, and severance pay considerations may change based on the sale details.

In some cases, a sale will trigger a change of control clause in the employee's contract. Depending on the structure of the agreement, employees may be entitled to augmented severance packages or stock options. Employees and employers should carefully examine their contracts to ensure all legal requirements are met.

Contractual Obligations with Employees

The employment contract determines employee severance pay. If the contract includes a severance clause, that clause will stipulate which scenarios require severance. These may include:

• Union contracts
• Termination without cause
• Early retirement
• A change of ownership
• State-specific severance requirements

Who Is Eligible for Severance Benefits?

If your company offers severance pay, it is typically available to employees who are let go through no fault of their own. Examples of this might include employees terminated due to mergers, acquisitions, and changes in business needs. Severance is not typically paid to employees fired with cause or who leave voluntarily.

Employee Classification

Employees classified as full-time or part-time workers may determine whether they are eligible for severance pay. In most cases, severance packages are available only to full-time employees. Some employers offer severance pay to part-time employees, but it is not the norm.

Tenure and Role Considerations

Since severance packages are at the employer's discretion, employees can negotiate their terms. For example, an employee may ask for additional compensation based on their tenure at the company or their specific role. Executives often receive severance based on their total salary and may also receive vested stock options.

What Is a Severance Pay Contingency Agreement?

In many cases, severance pay offered to employees is contingent upon signing a termination agreement. These agreements often contain clauses related to non-disparagement and an agreement not to litigate against the company (sometimes called Waiver and Release Agreements). Before creating a severance pay contingency agreement, employers should consult with legal counsel to be sure it follows any state-specific laws that may apply.

Key Components of a Severance Agreement

A severance agreement protects the company from being sued for wrongful termination or violation of contract terms. It contains the details of the severance package and any conditions that apply to the employee. For example, a severance agreement may include:

• How severance pay will be distributed (a lump sum or several payments over a stated term)
• Additional benefits included in the severance package
• A general release clause that affirms the employee will not sue the company
• Prohibitions on disparaging the company
• A non-compete clause

Severance Policy Drafting Tips

Because severance agreements are legally binding, employers may wish to seek legal counsel as they draft the policy. In addition, employees should:

• Examine all applicable local, state, and federal laws
• Consider legal variations for employees working in other states
• Ensure that the document meets EEOC terms and conditions

Is Severance Pay Taxable?

Previously, severance pay was considered a gray area with regard to taxes. As a result of the U.S. Supreme Court ruling in the case of U.S. vs. Quality Stores Inc., severance pay is now taxable under FICA.

Supreme Court Ruling on Severance Pay Tax

The Supreme Court ruling determined that severance pay is classified as wages and is, therefore, subject to taxation. To avoid dissatisfied employees, the severance agreement should clearly state the type of severance pay and how it is taxed.

Employer Withholding Obligations

Because severance payments are considered taxable wages, employers must report them, pay the employer's tax portion, and withhold employee taxes as required by the IRS. Failure to comply could result in fines and penalties. A payroll tax attorney can provide guidance to ensure compliance requirements are met.

Employee Tax Implications

Employees should expect to be taxed on severance pay in the year they receive it. If it is included as part of the employee's regular wages, the employer will withhold the employee portion as they usually do. If it is paid separately, it may be taxed at a flat rate.

How Is Severance Pay Determined?

Companies should have a clear policy for determining the amount each employee receives. Consult with an employment attorney to review your organizational approach to this issue and each scenario.

Here are some factors to consider.

How Is Severance Pay Calculated?

Employers typically consider the employee's salary level and length of service to calculate severance pay. Most employers provide an average of one to two weeks' salary for each year of service. They may also adjust the amount based on an employee's tenure or role in the company.

Factors Influencing Amount

Other factors that influence the amount of severance pay offered to an employee may include the employee's experience, performance, or reason for termination. When determining severance pay, ensuring that the agreement follows all applicable laws and contractual commitments is critical.

Practical Severance Pay Examples

A typical severance package may consider a variety of factors in addition to the basic rate of pay. For example, an employer may use one of the following formulas to calculate how much severance pay an employee receives:

• Number of years employed x 1 or 2 weeks' pay = Severance pay total
• Number of years x 1 week's pay up to 10 years OR Number of years x 2 weeks' pay for more than 10 years
• Standard severance pay + an adjustment for employees over a stated age
• Standard severance pay + payouts for unused vacation time

How Do Severance Payments Work?

Lump Sum vs. Periodic Payments

It is up to the employer to deliver severance pay. Some companies offer a lump sum, while others issue payments over a stated period. As you consider which approach is best, remember that payments over time may create difficulties for the employee when applying for unemployment insurance. On the other hand, some employees may prefer periodic payouts since a lump sum could push them into a higher tax bracket.

Distribution Process

Some employers allow the departing employee to choose how they would like to receive their severance pay. This makes it possible for employees to consider their circumstances and decide which option is most beneficial. Severance policies should also explain how long it will take for an employee to receive their severance pay and how they can access other available benefits.

Timing Considerations

Severance pay is usually received on the company's regular pay schedule. However, some companies immediately offer a lump sum payment or create alternative payout schedules. Remember that final paychecks are not considered severance pay and must follow state legal requirements for distribution timing.

Why Do Companies Offer Severance Packages?

Employers offer severance packages for several distinct reasons. Here are some of the most common.

Legal Protection

Severance agreements help protect the company from legal action on the part of the employee. By signing a severance agreement and accepting the severance package, an employee agrees not to sue the company for wrongful termination.

Severance agreements should comply with state and federal laws and EEOC requirements. The agreement should also include any legal protections important to the company, such as a general release clause, non-compete clause, or non-disparagement clause.

Employee Morale and Retention

Another reason many companies offer severance packages is to boost employee morale and increase retention. Severance pay communicates that the employer cares about their people and wants to ensure a successful transition, even if they can't keep that employee on the payroll. This investment in the workforce is an important way to create a positive workplace culture built on trust and loyalty.

Company Reputation

Severance pay is an attractive benefit for many job seekers and can improve a company's reputation in the job market. For this reason, companies may choose to include severance packages in their list of benefits when appealing to new talent.

Legal Considerations for Employers

Documentation and Recordkeeping

Since severance pay is classified as a taxable wage, it is subject to applicable state and federal laws and periodic tax audits. For example, the South Carolina Department of Employment and Workforce states that severance pay is reportable for the period in which it is delivered and may be included in a complete wage audit.

Employers should keep detailed records of all severance policies and payments to ensure that all legal requirements are met.

Final Paycheck Laws

State-specific laws regulate the timing and requirements for issuing a final paycheck, which is not considered part of a severance agreement. These requirements, known as "final paycheck" laws, vary from state to state. Check with your state's Department of Employment to ensure you meet all legal obligations.

Multi-state employers should verify compliance with final paycheck laws in all states where they operate.

Tips for Employers Implementing Severance Pay

When implementing severance pay policies for your company, consider the legal ramifications and how you will communicate the policies to your workforce. Employees want to know that policies are fair and reasonable, and employers can provide peace of mind by creating clear, transparent documentation.

Legal Consultation

While severance pay is not a legal requirement, it may be subject to state and federal laws governing its implementation. As you develop your severance policy, consult a legal professional to ensure that it complies with all federal, state, and local laws, EEOC guidelines, and tax requirements. If your severance agreement includes clauses designed to protect your company from lawsuits or damaging employee actions, an attorney should also review these.

Communication Strategies

Good communication around severance agreements can make the difference between satisfied and dissatisfied employees. Communicate policies with transparency and empathy and follow change management best practices to minimize confusion and promote understanding. Here are some keys to successful communication:

• Take a people-first approach. Consider employee perceptions and design communications to alleviate concerns
• Frame severance policies as an exciting benefit, not a competitive factor
• Be sure policies are applied fairly from the top down
• Invite questions and conversations about policies or specific applications

Final Thoughts on Severance Pay

Thoughtful severance policies communicate your commitment to your workforce and protect your company from potentially damaging scenarios when employees depart.

Take time to evaluate your severance pay agreements proactively so you can support departing employees in making a successful transition.

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