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An employee leaving a company can be a complicated situation. Severance pay can help. This article explains everything you need to know about severance pay.

What Is Severance Pay?

Severance pay is pay granted to an employee upon termination, and is designed to supplement their income until they can find another position. Often it is given to employees who are terminated due to no fault of their own, such as a layoff, or to soften the blow of an involuntary termination. Employers are not required to pay employees severance pay.

The Benefits of Offering Employees Severance Pay

An employee termination is hard for all parties. Severance is one way to ease the blow. Here are some of the benefits of paying employees severance.

  • Provide additional income to the employee. This is a supportive gesture from the company when terminating an employee. It will provide a source of income while they are looking for their next job.
  • Goodwill. When an employee is terminated, the employer doesn’t know if they will bring the employee back in the future. By paying the employee severance, the employer creates goodwill with the employee and helps the employee want to return to work for the company if the opportunity arises.
  • Company culture. Another benefit of severance pay is the positive company culture it creates, where employees feel they are taken care of by the company. While seeing other employees being terminated can be hard, seeing the company take care of them financially can help put employees at peace with the situation.
  • Legal Protection. A severance package is beneficial in protecting an employer from lawsuits. This is done through the employee signing a severance agreement. This helps protect the employer if the severance agreement states the employee won’t pursue legal action if they agree to a severance package.
  • Last benefit deductions. This is another benefit to the company. Most insurance benefits run until the end of the month. If your employee is terminated midway through the month, the company will pay 100% of the employee’s premium. Severance pay essentially pays the employee for that month, which captures the last payroll deductions for their benefits.

Is Severance Pay Required?

No, severance pay is never required for an employer. However, there are some situations where it is common for employees to be given severance. Here are some of those situations.

Reduction in Force/Laid Off

Layoffs are never fun for an employer or employee. When this occurs, the employee is usually blindsided by it, and the employer is forced to terminate an employee they don’t want to let go. Often employers will give laid off employees some kind of severance as an act of goodwill.

Employee’s Last Day Change

Another common occurrence for a severance package is when an employee turns in their voluntary resignation with a 2 week notice and the employer moves up the employee’s last day. Severance pay in this situation means the employee is paid through the date they said would be their last day.

Employers sometimes do this because they don’t want an employee who is leaving to work longer but still want to act in goodwill and pay them through the original date they planned to quit. This also helps employers avoid paying the terminated employee unemployment benefits, since the termination becomes involuntary rather than voluntary.

Potential Wrongful Termination Lawsuit

A final reason an employer might pay an employee severance is due to fear of a lawsuit for wrongful termination. As part of the severance package, an employer can include in the severance contract that the employee agrees not to pursue legal action if they accept the severance agreement. This is beneficial if an employer wants to terminate a disgruntled employee without any backlash.

Resignations

Severance pay is generally only thought of in regards to involuntary terminations. However, it can also be used for resignations. If an employee voluntarily leaves the company after a significant amount of time, severance pay is a way to say thank you for their hard work over the years.

How to Calculate Severance Pay

When it comes to calculating severance pay, there isn’t a particular formula, as every employer will be different. Here are a few ways an employer might consider calculating it:

Based off Pay Period

A common way severance pay is calculated is by paying an employee their base pay over a certain pay period. Two weeks is the most common, but it can be longer if the employer prefers. This is calculated by the salary amount for the length of time specified. For an hourly employee, they would be paid for a 40-hour work week for the desired number of weeks.

Average Wages From Previous 12 Months

This calculation might be used if the employee being given a severance package has variable income, such as commissions, piece rate payment, or bonuses. In this case, an employer might consider looking over the past 12 months and average their earnings for each month, week or whatever length the employer decides is adequate.

Large Sum

Another simple way to decide how to pay an employee a severance is to pay the employee a large sum regardless of their pay. This sum could be determined by the length of service with the company or cost of living at the time. This can be a little harder to implement because there is not an exact science to how it is calculated, but can be a simple way to pay employees severance if an employer doesn’t want to spend much time calculating it.

How to Create a Severance Agreement

Deciding whether or not and how much to pay an employee is only half the battle when it comes to severance pay. It is important that the severance agreement be written clearly  so the employee understands how much they will be paid and what is expected of them if they accept the package. It is a legal contract, so it should be written as such.

Step 1: Outline What the Employee Will Receive

The first step is to make clear to the employee what they will receive as part of the severance agreement. If they are getting a certain amount based on what they earn over a length of time, it should be stated in the agreement. However the pay is being calculated, it should be outlined and stated clearly for the employee to understand. It should also state the date the employee will receive the amount.

This may be the most important step. You want to ensure that what you are paying is fair across the board. You also want to ensure that you aren’t leaving any gray areas that may be up to interpretation.  If you clearly define in your severance policy what you will pay in terms of the level of position and the length of service then you eliminate the gray area.

In addition, your recently separated employee needs to know that this will be their final check and that from now on, they won’t be getting their normal direct deposit or paycheck. Ensure that any deductions are taken care of and clearly detail what each deduction is (this will normally be done on the paystub). Essentially, you want to ensure that there is clear understanding that there won’t be another check issued.

Step 2: Explain Legal Obligations of the Terminated Employee

As part of the severance agreement, what is expected of the employee if they sign it should be clearly stated. This could include not applying for unemployment benefits, not pursuing legal action for the termination, agreeing to a non-compete, or not sharing company secrets, attempting to sell to company clients, or working for a competitor for a given length of time.

If your company has the rights to any intellectual property that the employee has created while employed, this is your chance to ensure that the employee can’t “take” that property with them. Ensure that it is clear in your agreement that you, the company, own the rights to anything they created while employed. If your industry has any specifics, it’s also a good idea to include those here as well.

Consider adding these legal obligations to a severance agreement depending on the type of company and the reason for termination.

Step 3: Seek Legal Help

Finally, after writing the severance agreement, consider having it reviewed by a legal team. This could be an internal legal team if your employer has one, or an outside team. Since a severance agreement is a legal contract, it is important that it has the right verbiage to ensure it is a legally binding contract.

What to Include in a Severance Agreement

This is probably the most important thing when we are talking about severance. The check is nice, but the agreement is where the power lies. Here are the important things to include in the agreement.

Explanation of the Severance Check

Record how you calculated the amount, the taxes, and any other deductions present on their check stub.

Necessary Clauses

This is where the HR professional gets to protect the company. Here are some clauses often included in the severance agreement.

  • Why the termination occurred. This can prevent an unlawful termination lawsuit from arising.
  • No unemployment. In some states, you can include a clause that prohibits the employee from filing an unemployment claim (be sure to research your state laws).

Signatures

Self explanatory, right? You obviously need the employee to sign the agreement before they can have the severance check. In the event the employee doesn’t want to sign the severance agreement, they simply don’t get the check.

Sample Text of a Severance Agreement

This is just a sample. You will need to adjust the section below to fit your company’s needs and what you are hoping to accomplish with the agreement.

(Employee Name),

This agreement is to let you know that your employment will be terminated effective (date). We thank you for the time and effort that you put in while employed with us. It has become necessary due to overall lack of performance, specifically regarding (list specific examples here of the reason for the termination).

In accepting the enclosed amount in terms of a severance check, you agree to the following conditions.

  1. Any intellectual property that you created while employed will remain the property of the company and cannot be used elsewhere.
  2. (Where legal) You will be unable to file for state unemployment insurance.
  3. You agree to the above statement in regards to your overall performance.
  4. Any deductions, taxes, and benefits have been deducted accordingly as to your initial agreement of employment.

(Signatures and dates)

Again, this is just an example of what a basic agreement looks like.  You will need to adjust it based on your industry and company.  It’s also a good idea to have legal counsel review your agreements to ensure compliance.

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Questions You’ve Asked Us About Severance Pay

No, severance refers to the pay an employee can receive when terminated. 

This varies, as it ultimately depends on how much a company wants to pay in severance. 

Yes, severance is classified as “supplemental wages” and is taxed at a flat rate of 22%. 

It will be based on a net amount. It is calculated after taxes and is generally included in addition to the employee’s last check.

It depends on the state and the length of the time that has passed. Some companies offer severance pay to avoid having to pay unemployment, but it’s entirely dependent on the state in which the employee lives and what is contained in the severance agreement.

Tanner has over 4 years of HR professional experience in various fields of HR. He has experience in hiring, recruiting, employment law, unemployment, onboarding, outboarding, and training to name a few. Most of his experience comes from working in the Professional Employer and Staffing Industries. He has a passion for putting people in the best position to succeed and really tries to understand the different backgrounds people come from.

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Nick is a certified HR professional holding an SPHR and SHRM-CP. Nick has built HR teams from the ground up as well as worked for big corporations. Nick enjoys consulting and training those who are just getting started in HR. When not working, he enjoys spending time with his family.

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