Severance Pay: Are You Unknowingly Obligated to Pay?

Severance pay: it’s a concept that is often forgotten about until a terminated employee demands it. Could you be on the hook for paying out severance without knowing it? 

In this post, we’ll cover the basics of severance pay for small businesses. We’ll start by discussing when and if severance pay is required, how severance pay is calculated, and how severance pay works in general. We’ll also walk you through some of the pros and cons of the practice of paying out severance, so you can make a well-informed decision that suits your unique business. 

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What Is Severance Pay? 

Briefly, severance pay is an amount of money paid by an employer to an employee upon the employee’s involuntary termination. Severance pay may be offered alone or as part of a severance package, which could include benefits such as: 

• Payment toward COBRA premiums, 
• Employment assistance like outplacement services, 
• Retirement benefits, 
• Stock options, 
• Accrued vacation or sick time payouts, 
• and more. 

Severance pay is often provided to employees who are terminated because of no fault of their own, for example, as a result of redundancy, downsizing or reductions in force. However, many employers also provide severance pay or severance packages to employees who retire, are terminated for cause (i.e., fired), or leave for other reasons. 

Is Severance Pay Required? 

As of May 2024, no federal or state laws in the United States mandate that employers provide terminated employees with any amount of severance pay. Any requirement to pay severance is strictly a matter of agreement between an employer and their employee. 

Put another way, the only reason a company would be required to make a severance payment would be if they let their employee know they would do so. This representation may be made in many ways, but promises to make severance payments are most commonly made:

• When an Employee Is Hired

  For example, within the terms of an offer letter.

• When an Employee Is Let Go

  For example, within the terms of a separation letter or termination agreement. 

For this reason, the decision to offer severance pay is generally entirely optional for employers. However, companies should check their offer letters, employee handbooks and any material provided to a terminated employee to be sure they are aware of any obligations they have or representations they have made, even inadvertently. 

If your leadership has used template forms for any common employee-facing documents (like offer letters), you may have unintentionally made a representation regarding severance pay.

Read these materials carefully to be sure. Once you’ve made a definite representation regarding severance pay, you will generally not be permitted to retract it. 

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How Is Severance Pay Calculated? 

Typically, the amount of severance pay or the strength of a severance package will depend on the tenure of an employee. While this is the most common model of severance pay calculation, keep in mind that severance pay is not required by federal or state law—so the calculation of severance pay is chiefly up to the discretion of an employer. 

Standard severance payments typically range from one to two weeks of pay for every full year worked by the employee. It’s important to be as consistent as possible to avoid discrimination. 

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How Does Severance Pay Work? 

There are many nuances to the practice of paying employees severance. Here are some of the most common ways employers lay out the design of their severance payments. 

• Lump sum payments are typical

  Many employers prefer to make severance payments in the form of a taxable, one-time lump sum, but not all do. Employers can choose to pay severance on a periodic basis, i.e., in accordance with the ex-employee’s former regular pay periods. This model is often referred to as a “continuation of salary.” 

• Employers manage eligibility criteria

  As an employer, you don’t have to offer the same severance package to all employees. Although differing practices should always receive scrutiny and a thorough scan to ensure they aren’t causing disparate impact, it’s not uncommon for employers to offer separate severance benefits based on factors such as the reason for the employee’s departure, the “rank” of their role within the company, and, as previously mentioned, their tenure within your organization. 

• Severance payment may impact unemployment claims

  How and when severance payments are made can interact with an ex-employee’s experience with unemployment benefits. For example, a lump sum payout of severance allows employees to apply for unemployment insurance immediately, as it allows for their removal from the employer’s payroll right away. 
  
  If unemployment is paid out in increments (i.e., under the “salary continuation” method), an ex-employee may not be eligible to collect the full amount of unemployment benefits they would otherwise be entitled to. 

Should We Offer Severance Payments? 

There are pros and cons to offering severance payments to terminated employees. As you’re deciding whether you’ll establish a severance package program, here are a few of the key considerations to keep in mind: 

PROs

• A severance package can help soften the blow of a termination

After an unexpected termination, severance packages can make all the difference in an ex-employee’s financial situation. Plus, if your organization is focused on maintaining or improving its employer brand, it can help to leave employees with a bit of goodwill toward your company. 

• Employers can require ex-employees to release them from certain claims in exchange for severance payments

  In exchange for a severance package, employers may be able to require ex-employees to release them from certain claims, whether known or unknown to either party at the time of signing. These waivers must be clearly spelled out in a severance agreement signed by each ex-employee. 

Not all claims may be waived, and some states have specific laws in this arena.

Generally, employers cannot require the waiver of minimum wage and overtime claims, workers’ compensation claims, and claims under the ADEA. Most statutory claims, however (i.e., claims under Title VII, ERISA, COBRA, the ADA, and the WARN Act), can be waived via a termination agreement in exchange for consideration (in this case, severance packages or payments).

Keep in mind that employers cannot require employees to waive their right to file a claim of discrimination with the EEOC. 

Cons

• Granting severance payments may establish a precedent an employer can’t afford to keep up

  If you insert severance terms into any employee document (i.e., an offer letter, employee handbook, or termination agreement), or if you make an oral representation promising a severance payment, you’re on the hook for paying those benefits out. 
  
  Even if an affirmative representation isn’t made to a specific employee, an employer who begins the practice of offering severance payments to their employees may find themselves setting a precedent in their workforce that they can’t sustain. It’s important to discuss the pros and cons of severance packages and programs with an experienced HR consultant. 
  

• Offering a severance package may open up a negotiation with the former employee

We often see that once four weeks of severance pay is offered, the employee wants to argue or negotiate more weeks and sometimes even gets an attorney involved. 

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Axcet HR Solutions: Your Certified PEO Partner 

Axcet HR Solutions is a full-service, certified professional employer organization that can help you with a full suite of HR tasks, including helping you sort through your current severance pay obligations and working with you to design future severance packages. 

Axcet strives to provide proactive and transparent HR services that put the needs of our client organizations first. Reach out to our team today to find out how we can help.