When you’re laid off from a job, the 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
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 is “money that is provided to you by your former employer in exchange for a release of claims,” said Deane Brown, shareholder at Hughes Socol Piers Resnick & Dym Ltd., who represents employees in these matters. “It’s money that can help tide you over until you find another position.”
“Severance agreement” is a more accurate descriptor than “severance pay,” Brown added.
First, these are agreements, often negotiated, between the terminated individual and the ex-employer. Second, they usually involve more than just money. Health insurance, non-compete, confidentiality, non-disclosures and other provisions, and even keeping your company laptop or cell phone (wiped of confidential company info) can be part of an agreement.
Why Do Companies Offer Severance Pay?
Organizations offer laid-off employees severance pay for several reasons, according to Sonya Rosenberg, an employment attorney and partner at Neal, Gerber & Eisenberg. These reasons include achieving an amicable separation, providing some financial support for the terminated employee and ensuring that they won’t bring legal claims against the company.
What’s a Release of Claims?
A severance agreement is an exchange of money for promises that the soon-to-be ex-employee will not make a claim against the company.
In Brown’s words: “No employer gives you money out of the goodness of their heart.”
For instance, women, people of color, people 40 and older, people with a mental or physical disability or belonging to another demographic group protected by federal or state law might want to file a claim against their former employer for unfair treatment or discrimination. Accepting severance pay and signing an agreement signals that the employee will not take action against the company.
That said, terminated employees who’ve accepted severance cannot be stopped from reporting discrimination to the federal Equal Employment Opportunity Commission or their state’s department of human rights. Employees will, however, be required to waive any monetary settlement from discrimination claims as part of a severance agreement.
Are Severance Agreements Just About Money?
While compensation is a big part of any severance agreement, terminated employees must also pay attention to any additional agreements and benefits included in the package.
The 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, or NDAs, might be part of the package; those agreements state that the fired employee will not divulge 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. If an employer asks an employee to sign something that crosses this line, they may find themselves in legal trouble.
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. 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. In fact, the federal American Rescue Plan mandated that companies pay full COBRA health insurance premiums for eligible employees from April 1 through September 30, 2021 (in return, companies that did this may get a tax credit). Plus, 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.
Does Everyone Get Severance Pay?
No. 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?
It depends. According to Rosenberg, 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.
Do I Pay Taxes on Severance Pay?
Yes. Severance is considered wages and people will pay applicable state and federal income taxes on it.
How Will I Get Severance Pay?
People typically receive severance pay in one of two ways — either as a lump sum, or in payments that go into their bank account with taxes and insurance deducted as if they still worked for the company.
Can I File for Unemployment Benefits if I Get Severance Pay?
Yes, people can file, but the question is whether they’re eligible.
“If your employment has been terminated and not for serious misconduct reasons, you typically would be eligible for unemployment,” Rosenberg said. Severance pay might also offset the unemployment benefits.
Brown said that the answer to this question varies by state, and suggested people check with their state’s workforce development office or employment security office for details.
How Should I Spend Severance Pay?
“Pay your rent and other expenses that you’re going to incur, because you don’t know how long it’s going to take you to find another job,” Brown said.
When Is It OK to Say ‘No’ to a Severance Agreement?
If a terminated employee doesn’t want to be bound by the terms of the agreement — because they want to start a competing company or plan to make a discrimination claim against the company and seek damages, for example — then they simply shouldn’t sign the agreement or accept the money.
Should an Attorney Review an Agreement Before I Sign?
“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.