What is Severance Pay? Definition and how to calculate it

What is severance pay?

Severance pay is a financial compensation that employers may provide to employees when their employment contract ends, typically under circumstances like layoffs, job elimination, or involuntary separation.

The purpose of severance pay

The purpose of severance pay is twofold. Firstly, it serves as a financial cushion for the affected employees, assisting them during the transition period until they secure a new job. Secondly, it's a means for the employer to express gratitude for the employee's years of service and loyalty.

How does severance pay work?

Severance pay operates as a form of compensation provided to employees when they are terminated from their position under certain circumstances such as layoffs or job elimination. The company's obligation to pay severance and the amount offered can depend on a variety of factors, including the employee's position, their years of service, the reason for termination, and any applicable legal requirements.

Severance pay typically works by providing terminated employees with a lump sum or extended benefits over a specified period. The timeline for receiving severance pay can vary, but it is typically paid out soon after employment ends.

Useful Read: What is Statutory Redundancy Pay? A Guide for UK Employers

What is typically included in a severance package?

A severance package is a collection of benefits offered to employees upon their departure from a company. While severance pay is a key part of this package, it can also include several other components.

• Extended Benefits: These often cover health insurance and life insurance coverage for a specified period post-termination.

• Unused Paid Time: This can include accrued vacation time or sick days that the employee didn't use during their tenure.

• Career Counseling: Some companies offer career counseling or job placement assistance to help the laid-off employees find a new job.

• Additional Pay and Benefits: Depending on the company and the circumstances of the termination, a severance package might also include other benefits like additional pay, stock options, or non-disclosure agreement payoffs.

How much is severance pay?

There's no federally mandated amount for severance pay. It's typically negotiated between the employer and employee, or determined by company policy.

Here are some common factors influencing the amount:

• Length of service: Often, companies offer a set number of weeks' pay per year of employment (e.g., one week per year).
• Reason for termination: Severance is usually offered in involuntary terminations like layoffs, but not always in terminations for cause.
• Employee's position and salary: Higher-level positions might receive larger severance packages.
• Company financial health and negotiation leverage: Companies may offer more in situations where they need to maintain a positive reputation or avoid legal challenges.

How is severance pay calculated?

Severance pay calculation methods can vary depending on several factors, including:

• Company policy: Many companies have established policies outlining severance pay calculations based on factors like employee tenure, position, and reason for termination.
• Negotiation: In some cases, the employer and employee may negotiate the severance amount directly, considering the factors mentioned above alongside other relevant aspects.
• State continuation pay laws: While no state mandates severance pay, some have continuation pay laws requiring salary and benefit continuation for specific periods under certain circumstances (e.g., plant closures, mass layoffs).

Here are some common methods used to calculate severance pay:

• Weeks of pay per year of service: This is a widespread method, where a fixed number of weeks' pay is multiplied by the employee's years of service (e.g., one week per year, two weeks per year).
• Multiple of base salary: This method considers a multiplier of the employee's base salary (e.g., two times, three times) to determine the severance amount.
• Formula-based approaches: Some companies might use formulas that factor in multiple variables, including salary, position level, and tenure, to arrive at a severance figure.

Employee scheduling and Time-tracking software!

• Easy Employee scheduling
• Clear time-tracking
• Simple absence management

Try for free Request a demo

When do companies offer severance pay?

Companies typically offer severance pay when an employee is involuntarily separated from the company. This can happen due to circumstances such as layoffs, downsizing, or job elimination. Severance pay is designed to provide a financial cushion to employees during their job transition and can act as an expression of gratitude for the employee's years of service.

Sometimes, companies might offer severance pay even in cases of voluntary separation or retirement, but this depends on the company's policies and the specific terms of the employment contract. Certain circumstances may lead to an employer choosing not to offer severance pay, such as cases involving employee misconduct or termination for cause.

Are companies required to pay severance pay?

While severance pay is a common practice in many industries, it's important to note that federal law in the United States does not generally require employers to offer severance pay. This means that, unless there is a specific contract or policy stating otherwise, companies are not legally obligated to provide severance pay upon the termination of an employee's contract.

However, certain states might have specific laws regarding severance pay. Furthermore, the Worker Adjustment and Retraining Notification (WARN) Act mandates that employers provide at least 60 days of notice prior to mass layoffs or plant closures, and this can include providing severance pay.

If an employer has a policy of providing severance pay or if it's stated in the employee's contract, they are legally bound to honor those commitments. Failure to do so can lead to legal action by the affected employees.

Is severance pay taxable?

Yes, severance pay is considered a form of income by the Internal Revenue Service (IRS), and therefore, it is subject to income tax. It is not a gift or a windfall but compensation for your service to the company.

How much is severance pay taxed?

Severance pay is taxable as regular income. This means it's subject to:

• Federal income tax: Withholding is based on the employee's tax bracket and filing status.
• Social Security and Medicare taxes: Both employer and employee contribute 6.2% and 1.45% respectively.
• Federal unemployment tax: Employers pay 6% on the first $7,000 of an employee's annual wages, including severance.
• State income tax: Varies by state, with some not having any income tax.

How to calculate tax on severance pay

To calculate the tax on your severance pay, you should consider the following steps:

• Determine Your Income Tax Bracket: You can find the current federal income tax brackets on the IRS website. Your tax bracket will depend on your total income and filing status (single, married filing jointly, etc.).

• Calculate Federal Income Tax: Multiply your severance pay by the percentage of your tax bracket. For example, if your severance pay is $30,000 and you're in the 22% tax bracket, your federal income tax would be $6,600.

• Factor in Social Security and Medicare Taxes: These taxes combined amount to 7.65% (as of the time of this writing). So, for a severance pay of $30,000, an additional $2,295 would be deducted for Social Security and Medicare.

• Consider State Income Tax: Depending on your state, you may need to deduct additional amounts for state income tax.

Severance pay in the UK

Severance pay in the UK differs significantly from the US system. Here's a breakdown of its key aspects:

No legal mandate:

Unlike the US, the UK has no legal requirement for employers to offer severance pay in most cases. This means it's not mandatory, even in situations like layoffs or company closures.

Statutory Redundancy Pay

However, the UK offers statutory redundancy pay under specific circumstances. This applies only to redundancy, which is defined as a situation where an employee's job is eliminated due to:

• Business closure: The entire company or a specific location is shut down.
• Workforce reduction: The employer needs to reduce the workforce due to restructuring or other business needs.
• Job relocation: The employee's role is moved to a different location, and they are unwilling to relocate.

Eligibility for Redundancy Pay

To be eligible for statutory redundancy pay, employees must meet specific criteria:

• Minimum service: They must have been employed with the company for at least two years.
• Not dismissed for misconduct: Their termination shouldn't be due to disciplinary reasons.

Useful Read: Disciplinary Procedures in the Workplace: A Detailed Guide

Calculating redundancy pay

The amount of statutory redundancy pay is determined by a formula:

• A capped weekly pay: This is capped at £643 as of April 6, 2023.
• Length of service:
  • Half a week's pay for each full year under 22 years old.
  • One week's pay for each full year between 22 and 41 years old.
  • One and a half week's pay for each full year over 41 years old.
• Maximum service: The length of service is capped at 20 years for calculating the pay.

Additional severance pay:

• Contractual agreements: While not mandated by law, companies can offer additional severance pay through contractual agreements with employees. These agreements typically outline specific terms, including the amount and any additional benefits like continued health insurance.
  
  
• Negotiation: In some cases, even without a formal agreement, employees might negotiate with their employer for a severance package beyond the statutory redundancy pay, especially in situations like unfair dismissal claims.

Useful Read: Unfair Dismissal Compensation UK : An ultimate guide

In conclusion, the severance pay landscape in the UK is primarily driven by contractual agreements and redundancy pay regulations, contrasting with the US system where negotiation and company policy play a more prominent role.

Severance pay and unemployment

Navigating the intersection of severance pay and unemployment benefits can be intricate for employees who have been involuntarily separated from their roles. Severance pay, often offered in lump sum or extended benefits over a period, provides a financial safety net during this transition. However, the nature of this payout may affect the timing and eligibility for unemployment benefits.

For instance, if the severance package is structured as a monthly payout, it may postpone the commencement of unemployment benefits. Similarly, if an employee uses accrued vacation time to end formal employment or signs a non-disclosure agreement indicating voluntary departure, it could impact their ability to claim unemployment benefits.

Yet, receiving severance pay does not necessarily preclude one's right to unemployment benefits. Employees who are laid off or terminated without cause may still qualify for these benefits post their severance period. Ultimately, the terms of severance and the state-specific unemployment rules will guide this process.