If you’re laid off from a job, a company will soften the blow with a severance package that typically includes pay, continued healthcare coverage and sometimes other benefits, like paying for services to help you find a new job.
Severance Pay Definition
Severance pay, also called a severance agreement, is when an ex-employee receives money and other benefits, such as continued health insurance and perhaps even stock options, in return for agreeing to not make a claim against the company for discrimination or unfair treatment.
While severance can help carry you through the financial uncertainty of unemployment, it’s not free money. Below we cover everything you need to know.
What Is Severance Pay?
Severance pay refers to the compensation and benefits an employee receives when they’re terminated due to factors outside of their control, including layoffs and organizational restructuring.
Put another way, “it’s money that can help tide you over until you find another position,” said Deane Brown, shareholder at Hughes Socol Piers Resnick & Dym Ltd.
Severance pay is also part of an agreement negotiated between the terminated individual and the ex-employer. Confidentiality, non-disclosures and even the ability to keep your company laptop can be included in a severance package.
Why Do Companies Offer Severance Pay?
Organizations offer terminated employees severance packages for multiple reasons. It’s a way to separate on a more amicable note by providing some financial support for the terminated employee. But mainly, employers provide severance packages to get terminated employees to sign a release of claims. This means that an employee cannot bring any claims or lawsuits against an employer in return for receiving certain pay and benefits.
For example, those belonging to a demographic group protected by federal or state law — like women, people of color, people 40 and older and people with disabilities — might be inclined to file a claim against their former employer for unfair treatment or discrimination. While terminated employees who have accepted severance can still report discrimination to the Equal Employment Opportunity Commission or their state’s human rights department, they waive the right to any monetary settlement from discrimination claims.
As a result, a severance package acts as a kind of insurance for a business looking to avoid future conflicts with terminated employees.
In Brown’s words: “No employer gives you money out of the goodness of their heart.”
Elements of Severance Packages
While compensation is a big part of the average severance package, terminated employees must also pay attention to any additional agreements and benefits.
Severance Pay
Severance pay varies based on an employee’s contract and position, but terminated employees commonly receive one to two weeks of severance pay for each year they’ve been with the company. However, it’s possible to negotiate this number up higher. Depending on the business, terminated employees may earn additional severance pay based on other factors like bonuses, unused sick days and stock options.
When it comes to receiving severance pay, terminated employees can expect their pay in one of two formats — either as a lump sum, or in payments that go into their bank account over a period of time with taxes and insurance deducted as if they still worked for the company.
Confidentiality Provisions
Severance agreements can also include confidentiality provisions, meaning you won’t disclose the amount of your severance pay or terms of the agreement. Terminated employees might be asked to sign a non-disparagement agreement, meaning they won’t badmouth the company or its employees after they leave. Non-disclosure agreements (NDAs) might be part of the package, preventing a fired employee from sharing confidential information and trade secrets.
However, the National Labor Relations Board has banned confidentiality and non-disparagement agreements that “require employees to broadly waive their rights under the National Labor Relations Act.” These types of agreements are still allowed, but their scope is much more limited.
Non-Compete Agreements
High-level managers might also be asked to sign non-compete and non-solicit agreements. Non-competes mean they won’t join a competitor or launch a competing startup within a certain time frame after leaving the company. Although the Federal Trade Commission has decided to ban non-competes nationwide, the ruling still allows existing non-compete agreements for senior executives to remain in place.
Non-solicits mean they won’t go after their old company’s clients or employees. Brown said that employment non-solicits are increasingly being called non-hires: “In the hiring process, it’s hard to tell who recruited whom,” she said, so the agreement means you won’t hire your old company’s workers, no matter who makes the initial contact.
Additional Severance Benefits
Severance agreements can also include health insurance. They can also have an agreement not to forfeit unvested stock options or other stock benefits tied to your old company; what you get to keep depends on the terms of the equity plan that governs stock options. On rare occasions, and usually with top-level managers and C-suite employees, employers might agree to allow former employees to retain their unvested stock options and allow the options to vest over time, as if they were still working at the company.
Who Gets Severance Pay?
Employees who quit a job generally do not receive severance. Employees fired for cause — for example, they’ve stolen from the company or exhibited criminal behavior or egregious misconduct — generally do not receive severance either.
Laid off due to a workforce reduction? You generally will get some form of severance, again in exchange for a release of claims.
For those gray areas — you’re underperforming or unhappy at work and your boss knows it, and the two of you agree it’s time for you to start looking — severance agreements might or might not enter the picture. A negotiated agreement could call for money in exchange for transitioning your duties to your successor, plus giving you time to look for another job.
“I tell my clients not to quit,” Brown said. “If you quit, you don’t get severance and you don’t get unemployment benefits.”
How Is Severance Pay Calculated?
According to Sonya Rosenberg, an employment attorney and partner at Neal, Gerber & Eisenberg, companies sometimes are contractually bound to pay a certain amount of severance, if certain conditions are made, through an employment agreement signed with an employee (usually a higher-level executive).
Absent that kind of arrangement, “employers are best advised to assess what’s fair and consistent with market practice, and to think about the precedent paying a certain amount will set,” Rosenberg said. Typically, it works out to one or two weeks of severance for each year of service.
How Is Severance Pay Taxed?
Severance pay is taxable under all circumstances. It’s merely a question of how much taxes you must pay, and that depends on how your ex-employer decides to pay you. There are two common methods for delivering severance pay:
- Regular wages: If an employer treats severance pay like regular wages, this means typical deductions like federal and state taxes, Social Security and Medicare apply before you receive your severance package.
- Supplemental wages: If an employer considers severance pay to be supplemental wages, the pay is subjected to a flat 22-percent withholding rate. This replaces the usual federal income tax withholding determined from your W-4.
Your taxes can still be affected even after you’ve collected your severance pay. For example, receiving your severance pay as a lump sum may push you into a higher tax bracket if you earn multiple paychecks’ worth of severance pay within a single pay period. Keep factors like this in mind to calculate the full extent of the taxes you’ll have to pay on your severance package.
What Should You Do When Presented With a Severance Agreement?
It may be best to get a second pair of eyes to review a severance package, especially those of an attorney. They can comb through any dense legal language, explain the terms of a severance agreement and help you determine whether to negotiate for a more favorable deal.
“Absolutely, 100 percent,” Brown said. “You want to know exactly what you’re giving up, what you’re getting, and how the agreement will impact your future employment.” Brown offers free half-hour consultations with people who think they have a claim and want to leverage it for a better severance agreement. If they don’t, “I’d say just take the severance and move on,” she said.
Frequently Asked Questions
What is severance pay?
Severance pay is the compensation and any additional benefits an employee receives after their employment is terminated — usually due to layoffs or downsizing. In some cases, employees may be offered severance pay when they retire, but this is less common.
How does severance pay work?
Severance pay is provided to employees who have been affected by layoffs or company downsizing as a way to give them extra financial support while they look for another job. Former employees are free to spend this compensation however they like, but they often use it thoughtfully since the amount only lasts for a limited time.
Is severance pay taxable?
Yes. Severance pay is considered to be part of an employee’s wages and is included on a W-2, meaning it is subject to relevant state and federal taxes.
How is severance pay calculated?
Severance pay is often calculated by following the rule of one to two weeks’ pay for each year an employee has been with the company. That said, an employee’s position, market trends and other factors may influence the kind of severance package an employee receives.
Can I file for unemployment benefits if I get severance pay?
Employees who are terminated for reasons other than serious misconduct can typically receive both severance pay and unemployment benefits. However, this can vary by state. It’s best to confirm with the appropriate local agency like a state’s workforce development office or an employment security office.
When should you decline severance pay?
A terminated employee can reject a severance agreement if it restricts any actions they plan to take. These can include working for a competing company, starting their own business in the same industry or filing a discrimination claim against their ex-employer to pursue a monetary settlement.
