What is severance pay and how does it work?

Severance pay is the compensation an employer provides to an employee after their working relationship ends, typically because of a layoff or company downsizing. 

Sometimes severance pay can be offered to employees who are retiring, but it’s not usually offered to someone who’s been fired. Use this guide to learn more about severance pay, how it works and associated benefits.

Key takeaways

  • Severance pay is the compensation that a company provides to an employee when their employment ends, typically because of a layoff, downsizing or even retirement.
  • The amount of severance pay offered is usually based on the employee’s years of service and sometimes on experience.
  • Severance pay isn’t required by law, but employers may offer it as a way to attract prospective employees and help protect the company from potential lawsuits.
  • Severance packages can include compensation and extended benefits. The details are often included in an employment contract. 

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What is a severance package?

Severance packages can include forms of compensation like salary continuation, payment for unused vacation or sick time, extended health coverage and other benefits. The details are usually in an employment contract. 

Typically the amount of severance pay is based on the employee’s years of service or sometimes experience. It can either be paid in a lump sum or be offered over a period of time in installments.

Severance packages can be used as a buffer between employment, before retirement, for additional savings and more. There’s no requirement under the Fair Labor Standards Act for employers to pay employees severance, but some companies may offer it as a way to appeal to potential employees. Companies might also use severance packages as possible protection from lawsuits by having the employee sign a release before accepting the package. 

Examples of severance compensation

Below are some examples of the types of compensation that may be included in a severance package.

Salary continuation 

As part of a severance package, an employer may continue to pay an employee’s salary for a certain amount of time after their working relationship ends. The amount of severance pay is often based on the length of time that an employee has worked for the company, their experience level or their position.

Unused paid time off or vacation time

Not all states require employers to pay for an employee’s accrued time off when their employment ends. But some employers may include accrued vacation time, sick days and holiday pay in their severance packages. 

Extended health insurance coverage

When an employee leaves a company, they may be offered a continuation of their health coverage through the Consolidated Omnibus Budget Reconciliation Act (COBRA). COBRA was designed to make sure employees who leave their job, either voluntarily or involuntarily, have the opportunity to continue their health coverage without a job or under other circumstances. 

If a former employee wants to continue their health coverage using COBRA, they may have to pay up to 102% of the cost of the plan. But employers may offer to pay some or all of the employee’s COBRA premium as part of a severance package.

Uncontested unemployment benefits

When their employment ends, an employee may file for state unemployment benefits. Before the claim goes through, the employer can contest the request for benefits, depending on the circumstances. In some severance packages, employers will agree not to contest the unemployment claim.  

Other types of severance compensation

Here are a few other types of benefits that may be offered in a severance package:

  • Offering to assist the employee with their job search
  • Providing flexibility or time off while an employee looks for a new job
  • Having a formal agreement explaining what information can be shared with future employers
  • Transferring company assets, like a cellphone, to the employee 
  • Continuing additional benefits like dental insurance and life insurance options

FAQ about severance pay

Still have questions about severance pay? Below are some common questions.

Severance pay—including compensation for accrued vacation and sick time—is taxable in the year it’s received. It’s subject to tax withholding depending on how it’s paid out. If an employer pays the severance as part of normal wages, it’s typically subject to the employee’s withholding amount, which is based on their tax bracket. If the employer pays the severance separately from normal wages, it’s generally taxed at a flat rate of 22%.

Unemployment eligibility may be affected by severance pay, depending on how it’s been paid out and state-specific regulations. For example, in certain states, receiving severance pay as a lump sum may not impact benefits. On the other hand, a salary continuation over a period of time may cause a delay or reduction in benefits. 

Severance pay is usually calculated based on the employee’s regular salary and number of years at the company. Sometimes an employee’s position is also a factor. In many cases, severance pay is one to two weeks of pay for each year of service. 

Severance pay can provide a buffer while employees look for another job or plan for retirement. Some companies may also offer severance packages as a way to protect themselves from potential lawsuits by having employees sign a release. 

Severance pay in a nutshell

Severance pay can help an employee whose employment ends due to layoff, downsizing or retirement by providing some support. It can also help an employer attract talent and protect the employer from any potential legal troubles after ending a working relationship with an employee.

And once an employee lands a new job, it’s a good idea to review the benefits laid out in the company’s employment contract, like the terms of severance pay or vesting periods for retirement funds.

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