Calculating Severance Pay: Employer Guide

Severance is a delicate process and accurately and compliantly calculating severance pay is crucial for both the employer and employee.

Use this guide to help ensure an accurate calculation and a professional and courteous severance process.

What Is Severance Pay?

Severance pay is compensation provided to an employee when they are laid off, terminated, or resign under certain conditions. It is often based on factors like the employee's length of service, position, and company policy.

As we’ll go into, severance pay can include a lump sum of money, continued benefits (such as health insurance), or other perks to help the employee transition to new employment.

What’s Included In Severance Pay?

Severance pay can be a combination of several compensation types:

1. Regular compensation

Severance pay often includes a portion of the employee's regular salary or wages. This is typically calculated based on years of service, with companies offering one to two weeks' pay for every year worked. 

This portion is meant to help employees transition to a new job and cover living expenses during unemployment.

2. Bonuses

Bonuses are sometimes included in severance packages, though it depends on the company's policies and the terms of the employment contract. 

If an employee was due a bonus (e.g., for performance or a holiday bonus) and they were terminated close to that payout date, the severance agreement may include a pro-rated or full bonus payment.

3. Benefits

Many severance packages extend certain employee benefits like health insurance, life insurance, or pension contributions for a period of time after employment ends.

In the U.S., health benefits might be extended through COBRA, which allows employees to continue their group health coverage temporarily.

4. Stock options

If an employee has stock options as part of their compensation, severance packages may address how these are handled. 

Sometimes employees may be allowed extra time to exercise their vested stock options, or they may receive payment equivalent to the value of unvested options. The terms can vary depending on the company’s stock option plan and severance agreements.

5. Outplacement services

Outplacement services are often included in severance packages to help employees transition to new employment. These services may include career counseling, resume preparation, interview coaching, and job search assistance. 

Companies provide outplacement services as a way to support employees' job search efforts and to mitigate the negative impact of layoffs on company morale and reputation.

How To Calculate Severance Pay

Calculating severance pay typically depends on a few factors, such as the company’s policies, the employee's tenure, their salary, and the country's legal requirements. 

Here’s a general approach to calculating severance pay:

1. Determine the base amount

The base amount is usually calculated as a multiple of the employee’s regular compensation. 

This is most often expressed as weeks or months of pay per year of service.

Common formulas include 1-2 weeks of pay for each year of service, though some companies may offer more, especially for long-term employees or senior executives.

Example: If a salaried employee earns $1,000 per week and worked for 10 years, and the company offers 2 weeks of severance per year of service, the calculation would be:

10 years × 2 weeks per year × 1000 = $20,00010

2. Consider minimums and maximums

Some companies or countries might impose a minimum or maximum severance amount, such as a minimum number of weeks of pay regardless of service length, or a cap on total severance.

Example: If the company policy guarantees at least 8 weeks of severance for all employees, even for someone with only 3 years of service, that employee would receive 8 weeks of pay instead of 6.

3. Factor in bonuses (if applicable)

If bonuses are included in severance pay, you may need to calculate a prorated portion based on the employee's performance during the fiscal year or past bonuses earned.

Example: An employee’s annual bonus is $5,000, but they’re being laid off halfway through the year. The employer might include half of that ($2,500) in the severance package.

4. Include benefits

Some companies include a continuation of benefits, such as health insurance, for a defined period. This is typically not a direct monetary calculation for the employee but needs to be factored into the overall severance value.

Example: If the employee's health insurance costs the employer $400 per month and the company provides 3 months of health coverage post-termination, that’s an additional $1,200 in value.

5. Account for stock options (if applicable)

If stock options are part of the severance package, the company may allow the employee to vest any unvested options or have additional time to exercise their options.

Example: An employee has vested stock options worth $10,000. If the severance package includes a payout or extended exercise window for these, this amount could be added to the total severance value.

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6. Outplacement services (if applicable)

Although not usually included in the monetary value of severance, outplacement services can add support to the employee's job search efforts and should be factored in as a non-monetary benefit.

Formula recap

A simple formula for severance might look like this:

Severance Pay = (Years of Service × Weeks of Pay per Year) + Prorated Bonuses (if applicable) + Value of Benefits Extension (if applicable) + Stock Options (if applicable)

Is Severance Pay Taxable?

In the U.S., severance pay is considered taxable income and subject to the same federal and state income and payroll taxes as regular wages:

• Federal income tax withholding: Severance pay is often subject to a flat withholding rate of 22% (as of 2024) unless the employer withholds based on your Form W-4.
• Social Security and Medicare taxes (FICA): Severance is also subject to FICA taxes, meaning both Social Security and Medicare taxes will be withheld.
• State and local taxes: Severance pay is typically subject to state and local income taxes, if applicable in the employee's jurisdiction.

If severance is paid as a lump sum, the total amount is taxed in the year the employee receives it, which may push them into a higher tax bracket for that year.

Benefits Of A Severance Package

A severance package offers several benefits to both employees and employers:

For employees

1. Financial cushion: Provides income to help cover expenses while the individual looks for a new job, easing the stress of unemployment.
2. Extended benefits: May include continued health insurance, retirement contributions, or other benefits, offering temporary support during the transition.
3. Career transition assistance: Some packages include services like job placement assistance or access to training programs to help the individual find new employment.
4. Time to plan: Offers the employee a buffer period to plan their next steps, such as finding new employment or pursuing further education.

For employers

1. Legal protection: A severance agreement often includes a waiver of the employee's right to sue for wrongful termination, reducing the risk of future legal disputes.
2. Reputation management: Demonstrates the company's commitment to treating employees fairly, helping maintain a positive employer brand.
3. Smooth transition: Encourages a more amicable separation, reducing workplace disruption and aiding in a smoother transition for both departing employees and remaining staff.
4. Retaining goodwill: Shows respect and support for the employee, preserving professional relationships that might be beneficial in the future.

What Is The Severance Process?

Severance is a delicate matter, here’s how to handle it professionally and courteously.

1. Identify the need for termination

The company determines the need for layoffs, job eliminations, or individual terminations. Common reasons include:

• Business restructuring or downsizing
• Poor financial performance
• Merger or acquisition
• Employee performance issues (though severance is less common in this case).

Obviously laying people off is far from ideal, and it’s worth exploring options such as secondments.

2. Review employment contracts and policies

Before initiating the severance process, the company will review:

• Employment contracts: If the employee has an employment agreement, it may specify severance terms, such as the amount of severance, notice period, or other benefits.
• Company policies: The company’s employee manual or severance policies should be consulted to ensure that severance is administered consistently and fairly.
• Local laws: The employer must comply with local labor laws, which may mandate severance, notice periods, or additional benefits. Leveraging the local knowledge of an employer of record or professional employer organization can help here.

3. Prepare the severance package

Using the information above, calculate any severance package based on your company’s policies and the employee’s tenure, compensation, etc.

4. Prepare legal documentation

A formal severance agreement is drafted, outlining the terms and conditions of the severance package. This document includes:

• The severance payment amount
• Any extended benefits
• A release of claims: In exchange for severance pay, the employee typically agrees not to pursue legal claims (e.g., wrongful termination) against the company.
• Confidentiality agreements or non-compete clauses, if applicable

It is important that this document complies with local labor laws, and it is often reviewed by legal counsel.

5. Hold the termination meeting

The employer schedules a meeting with the employee to inform them of their termination. Key elements of the meeting include:

• Communication: The reasons for termination are clearly explained, along with the terms of the severance package.
• Delivery of documents: The severance agreement and any other legal documents (e.g., non-disclosure or non-compete agreements) are presented to the employee.
• Timeline and expectations: The employer provides a clear timeline for the employee to review the severance agreement and decide whether to sign. This usually includes a "cooling-off" period (e.g., 21 days in the U.S.) to give the employee time to seek legal advice.

6. Review and negotiation (if necessary)

The employee has the opportunity to review the severance package and may negotiate certain aspects, such as:

• The amount of severance pay
• Continuation of benefits
• The handling of stock options or bonuses
• Outplacement services.

Both parties may engage in discussions to reach an agreement, with or without legal counsel involved.

7. Signing the severance agreement

Once both parties agree on the terms, the employee signs the severance agreement, which serves as a legally binding document. By signing, the employee typically:

• Accepts the severance package and terms
• Waives the right to pursue legal action against the company (unless local laws allow exceptions)

8. Payment and benefits processing

Once the severance agreement is signed, the employer processes the severance payments and any applicable benefits. This includes:

• Lump sum payment or periodic severance installments
• Benefit continuation: Ensuring the extension of health or other insurance benefits, if applicable
• Retirement fund contributions: Processing any contributions to pension funds or retirement accounts

9. Outplacement and transition support

If outplacement services are part of the severance package, the employer coordinates with external providers to assist the employee in their job search, resume writing, and interview preparation. These services help smooth the employee's transition into new employment.

10. Finalizing the termination

The process is finalized once all payments are made, benefits are extended, and all legal agreements are signed. As part of the offboarding process, the employer ensures:

• Return of company property: The employee returns any company property (e.g., laptops, mobile phones, ID cards, etc.).
• Revoking access: The employer revokes the employee’s access to company systems, email, and other sensitive information.

11. Post-termination obligations

The company and employee must continue to comply with any post-termination obligations set out in the severance agreement. These may include:

• Non-compete clauses: If the severance agreement includes a non-compete provision, the employee may be restricted from working with competitors for a certain period.
• Non-disclosure agreements: The employee may be bound by confidentiality agreements that prevent them from disclosing proprietary information.

What Happens If An Employee Finds A New Job While Getting Severance Pay?

When an employee finds a new job while receiving severance pay, the specific impact on their severance benefits depends on the terms of the severance agreement and company policies. 

Here are the common scenarios that may occur:

1. Lump-sum severance payment

If the employee received severance as a lump-sum payment, they typically get to keep the full amount regardless of when they find new employment. In this case:

• No repayment: The employee is not required to repay any portion of the severance, even if they secure a new job immediately after leaving the previous one.
• New job income: The income from the new job is treated separately from the severance payment, and there is usually no impact on the severance received.

2. Severance paid in installments

If severance is paid in installments (e.g., monthly payments over a set period), the situation may be different:

• New employment clause: Some severance agreements include a "stop payment" or "offset" clause, which may reduce or terminate severance payments if the employee finds a new job before the severance period ends. In this case:
  • The employee must notify the former employer when they find a new job.
  • Payments may cease entirely, or the severance could be reduced based on the new salary.
• No impact: In other cases, the company may continue paying severance installments regardless of new employment, especially if the severance agreement doesn’t include a clause about finding a new job.

3. Unemployment benefits

In some countries, receiving severance pay can impact unemployment benefits. If the employee secures new employment, the following might occur:

• Unemployment benefits end: Once the employee starts earning from their new job, they may no longer be eligible for unemployment benefits.
• Severance and unemployment coordination: Some jurisdictions treat severance pay as income, which could reduce or delay unemployment benefits. However, this does not typically apply once the employee finds new work.

4. Health insurance and benefits

If the severance package includes the continuation of health insurance or other benefits:

• COBRA or other extended benefits: The employee may continue receiving extended benefits even if they find new employment, particularly if their new job does not offer similar benefits right away.
• Benefits termination: Some severance agreements may terminate extended benefits once the employee secures new employment and is eligible for benefits through their new employer.

5. Non-compete clauses

If the employee’s severance agreement includes a non-compete clause, they need to be cautious when accepting a new job:

• Violation of non-compete: Taking a job with a competitor might breach the non-compete agreement, potentially voiding the severance or leading to legal action.
• Consulting legal advice: Employees should review the terms of their non-compete agreement carefully before accepting a new role to ensure compliance.

6. Outplacement Services

If the severance package includes outplacement services (career counseling, job search assistance, etc.), the employee may no longer need these services once they find new employment. 

However, they are usually allowed to continue using these resources to ensure a smooth transition into their new role or for additional career development.

What to check in the severance agreement:

Employees should carefully review their severance agreement to understand what happens if they find a new job. Key points to look for include:

• New employment clauses: Any provisions regarding the impact of new employment on severance payments.
• Benefits continuation: How benefits (like health insurance) are affected if they secure new employment.
• Non-compete or confidentiality clauses: Restrictions on working for competitors or within the same industry.
• Notification requirements: Whether the employee must inform the former employer if they find a new job.

Conclusion

• If severance was paid as a lump sum, the employee typically keeps the full amount regardless of when they find new employment.
• If severance is paid in installments, the agreement may allow the company to reduce or stop payments once the employee finds a new job.
• Non-compete agreements and benefits provisions may also impact the employee’s decisions about accepting new employment.

It’s important for both the employee and employer to be clear on the severance agreement terms to avoid any potential conflicts.

Is Severance Pay Legally Required?

Whether severance pay is legally required depends on the country, jurisdiction, and specific circumstances of the termination. 

In many cases, severance pay is not legally mandated, but there are exceptions based on labor laws, employment contracts, or organizational policies.

In the U.S., there is no federal law that requires employers to provide severance pay when an employee is terminated, laid off, or resigns. However, severance may be required if:

• There is an employment contract or a collective bargaining agreement that specifies severance pay.
• The employer has a policy or practice of providing severance pay to employees, which may create an obligation under employee expectations or precedents.

WARN Act: Under the Worker Adjustment and Retraining Notification (WARN) Act, certain employers must give employees 60 days' notice before mass layoffs or plant closures. Depending on the size of the company, the layoff and how remote workers are defined, the WARN Act may apply to remote workers as well.

While this doesn’t mandate severance, failure to give proper notice may result in employees being entitled to 60 days' pay as a substitute.

Can Employees Receive Severance Pay And Claim Unemployment At The Same Time?

Whether employees can receive severance pay and claim unemployment benefits at the same time depends on the country, state, and specific unemployment insurance policies. 

In the U.S., the ability to collect unemployment benefits while receiving severance pay varies by state and how the severance is paid.

Key factors:

• Lump-sum severance: In most states, if the severance is paid in a lump sum and not tied to continued employment, employees can usually file for unemployment immediately. The lump sum is typically treated as a one-time payment and does not impact unemployment benefits.
• Severance paid in installments: If severance is paid in installments, some states treat this as ongoing wages, which could delay or reduce unemployment benefits until the severance payments stop. In this case, the employee may not be eligible for unemployment while receiving severance installments.
• Severance tied to continued employment: In cases where severance is tied to a specific period of time (e.g., the employee is technically considered “employed” for several months while receiving severance), unemployment benefits may be delayed or denied during that time.

State-specific differences:

• Some states offset unemployment benefits by the amount of severance received, meaning the employee’s unemployment benefit is reduced dollar for dollar by the severance payment.
• Other states disregard severance pay entirely, allowing employees to claim unemployment even while receiving severance.

Because of the variation in state rules, employees should check their state’s unemployment laws to understand how severance pay impacts their eligibility for benefits.

Complying With Severance Pay Rules

As we’ve covered, severance is governed by certain laws and regulations to protect both employees and employers. Here’s how to continue to remain compliant with them. 

1. Understand local labor laws

The first step is to research the specific severance pay requirements in your jurisdiction.

To comply, you need to:

• Identify legal obligations: Determine if your jurisdiction mandates severance pay, and under what conditions (e.g., layoffs, terminations without cause, redundancies).
• Review minimum severance entitlements: Check if there are statutory minimums for severance pay based on factors such as length of service, salary, and reason for termination.
• Know notice periods: Many jurisdictions require employers to provide a notice period before terminating employment. if you don’t provide proper notice, you may need to compensate the employee for the notice period (sometimes called pay in lieu of notice).

2. Review employment contracts and collective bargaining agreements

To comply with severance rules:

• Check employment contracts: Some employees may have contracts that outline severance terms, including how much severance they are entitled to and under what circumstances they will receive it.
• Collective bargaining agreements: If the employee is part of a union or covered by a collective bargaining agreement, that agreement may contain specific severance provisions that you are legally obligated to follow.

3. Follow company policies

Ensure that your company’s internal policies are followed consistently. Many companies have their own severance policies that may be more generous than the legal requirements.

• Consistent application: If your company has a history of providing severance pay even when not required by law, ensure you are consistent in applying those practices to avoid legal challenges.
• Clear communication: Make sure severance policies are clearly outlined in employee handbooks or other documentation, so employees know what to expect.

4. Consult with a legal expert

Labor laws regarding severance pay can be complex, and they vary widely across jurisdictions. To ensure full compliance:

• Consult a labor or employment attorney: An expert can help you interpret local labor laws and ensure that your severance practices comply with the legal framework in your jurisdiction.
• Stay updated: Employment laws can change over time, so regularly consult with a legal expert or subscribe to legal updates to stay informed about any changes to severance requirements.

5. Calculate severance correctly

Once you know the legal requirements, calculate the severance pay based on:

• Length of service: Many jurisdictions calculate severance pay based on the number of years the employee has worked.
• Salary or wages: Severance is typically based on the employee’s regular salary or wages. Some jurisdictions also consider bonuses, commissions, or other earnings.
• Additional benefits: You may be required to provide benefits continuation (e.g., health insurance) or include payment for unused vacation or accrued time.

Make sure your calculations comply with both the legal minimum and any enhanced severance your company offers.

6. Comply with tax laws

Severance pay is typically subject to taxation. Ensure compliance by:

• Withholding the correct taxes: In most jurisdictions, severance pay is subject to income tax. Depending on where you operate, you may need to withhold federal, state, or local taxes from the severance payment.
  • In the United States, severance is subject to federal income tax and FICA (Social Security and Medicare).
• Provide tax documentation: Ensure that severance pay is accurately reported on any tax forms you provide to the employee (e.g., Form W-2 in the U.S.).

7. Consider non-monetary aspects

Severance packages may include more than just monetary compensation. Depending on local laws and company policy, you may also need to offer:

• Benefits continuation: Some jurisdictions or company policies may require that health insurance, pension contributions, or other benefits be extended for a certain period after termination.
• Outplacement services: These services, such as career counseling or job placement assistance, may be offered as part of a severance package. While not legally required, offering these services can reduce legal risks and improve company reputation.

8. Prepare severance agreements

The severance agreement is a legal document that outlines the terms of the severance package, which the employee usually must sign. This agreement should:

• Clearly state the severance amount: Include how the severance is calculated and any additional benefits provided.
• Release of claims: In many cases, severance agreements include a waiver or release of claims clause, where the employee agrees not to pursue legal action (e.g., for wrongful termination) in exchange for severance. This release must comply with local laws to be enforceable.
• Provide sufficient review time: In some jurisdictions (e.g., the U.S.), employees must be given time to review and consider the severance agreement before signing, especially for older workers under the Older Workers Benefit Protection Act (OWBPA).

9. Maintain proper documentation

To comply with severance pay rules, it’s important to:

• Keep records: Maintain detailed records of severance agreements, calculations, and communications with the employee. This will be critical in case of legal disputes.
• Ensure transparency: Be transparent with employees about their severance entitlements and ensure they understand the terms.

10. Provide notice to relevant authorities

In some jurisdictions, particularly in cases of mass layoffs, you may be required to provide advance notice to government authorities or employees. For example:

• WARN Act (U.S.): The WARN Act requires certain employers to give 60 days’ notice of mass layoffs or plant closures. Failure to do so may result in liability for back pay and benefits.
• Local labor departments: In some countries, employers must notify labor authorities when implementing mass layoffs or redundancies.

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