What Is Severance Pay? All You Need to Know as an Employer

Severance Pay Laws, Policies, and Agreements

This illustration depicts an employee leaving after getting laid off.

Laying off or firing employees is difficult for both your company and those directly affected by your decision. If you are considering giving laid off or terminated employees severance pay, there are some things you need to do first.

Severance pay is money that an employer may give to a laid off or terminated employee, and there are three steps to take before you can give it to employees: 

  1. Check federal and state laws, to ensure you are in compliance.
  2. Write a severance pay policy, to make sure you are treating all employees equitably.
  3. Write a severance pay agreement for employees to sign, to make sure everyone understands what is being agreed to.

Laws That Apply to Severance Pay

Federal Laws 

The Fair Labor Standards Act doesn’t require employers to give employees severance pay. It’s a matter of agreement between the employer and employee, or it may be part of a union contract. 

If you are closing a plant or doing a mass layoff, you must comply with the federal Worker Adjustment and Retraining Notification (WARN) Act to give employees advance notice. The law doesn’t specifically mention severance pay, but it does discuss the concept of pay in lieu of notice. 

If you have a health plan for employees, and have 20 or more employees, you must give terminated employees notice explaining their rights to have COBRA coverage. This plan gives terminated workers the right to continue group health benefits (at their own cost) for a limited time. 

Be sure that your severance pay benefits do not discriminate against any employees. You’ll need to consider age discrimination (employees over 40), equal pay (non-discrimination on the basis of sex), and other anti-discrimination laws. 

State Laws

A few states and territories have laws requiring severance pay for employees who are not terminated for cause. For example, Puerto Rico law requires that employees discharged without cause must receive an amount of severance pay (an indemnity) based on years of service. In addition, compensation must be paid depending on years of service.

Check your state’s labor office website to see if it has severance pay requirements. 

Severance Pay and Taxable Income

Severance pay and unemployment benefits are both taxable to the employee. Be sure to withhold both federal income tax and FICA (Social Security/Medicare) tax from severance paychecks. If the employee chooses to take a lower amount of severance pay to receive outplacement services, the full amount of the severance is still taxable. 

Severance Pay Policy

If you decide to give employees severance pay, you should develop a policy for these payments and include it in your employee policies and procedures manual


Decide which employees are eligible to receive benefits. For example, you can say that only full-time employees would receive severance pay, as long as you treat all employees in that category equal. 

You may also want to list eligible termination reasons for giving severance pay. You can also exclude employees who resign voluntarily, are fired for misconduct, or fail to return from a leave of absence.

Be sure to specifically define the actions included in the term “misconduct.” 

Pay Schedule

Your policy should include a pay schedule, including: 

  • Ranges (less than one year, one to three years, etc.)
  • Page grade or salary levels
  • Amount

For example, all employees in pay level 6 with one to three years of service could receive nine months of severance pay. 

Other Benefits 

You can extend health benefits for a time period, or just let employees know about COBRA coverage (described above).

As mentioned earlier, you may also want to offer employees the option for outplacement services to help them find another job. But remember, the full amount of the severance is still taxable even if the employee takes less money because of the services.

And be sure to explain that severance isn’t affected by payments for accrued or unused vacation, or commissions

Severance Pay Agreement

As you talk to each employee at the time of the firing or layoff, you should have a severance pay agreement ready for the person to sign. Having a written agreement spells out the terms that both parties are agreeing to, so there’s no misunderstanding later. The agreement also gives notice to the employee of actions they can’t take after termination.

The severance pay agreement should include: 

  • The effective date of the termination and the agreement 
  • The amount of severance pay, how it will be paid, and when 
  • Whether accrued vacation pay or other payments due (like commissions) are being paid and the amount 
  • What health plan benefits will continue (not required), or a notice explaining COBRA coverage
  • What happens to other benefits, like life insurance or vesting in a retirement plan
  • Return of confidential information, keys, computers, and other company property

Be sure to include a release stating that the employee agrees not to bring a lawsuit for any claims against the company. 

Depending on the employee’s job description, you may want the person to sign additional agreements restricting their actions as a former employee. These agreements, called restrictive covenants, might include: 

The Bottom Line

The laws and regulations can be complex, and every business situation is unique. Consider working with an attorney when drafting a severance pay policy for your business. To be safe, precise and help reinforce your messaging, hiring an attorney to prepare both the severance policy and the severance pay agreement may save you from costly errors and lawsuits. 

Article Sources

  1. U.S. Department of Labor. "Continuation of Health Coverage (COBRA)." Accessed April 21, 2020. 

  2. Casetext. "P.R. Laws tit. 29, § 185a." Accessed April 21, 2020. 

  3. Department of the Treasury/Internal Revenue Service. "Your Federal Income Tax For Individuals: Tax Guide 2019." Page 47. Accessed April 21, 2020.

  4. Department of the Treasury/Internal Revenue Service. "Your Federal Income Tax For Individuals: Tax Guide 2019." Page 47. Accessed April 21, 2020.