What is severance pay?

Severance pay definition and meaning

Severance pay refers to a temporary continuation (or extension) of compensation, which may include an extension of benefits or other perks, and which is provided by an employer to a worker who is discharged from employment.

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As part of a company severance package, the terms of severance pay should be formalized in a company policy. It should make clear what sort of terminations qualify for severance pay, on what schedule severance pay is to be received, and any conditions that must be met by the terminated employee in order to qualify.

Upon termination of employment, a contractual agreement detailing the payment schedule and amount should be presented to and signed by the terminated worker during a formal exit interview. Exit interviews can be difficult unless done right, and having a written severance agreement is the best way to ensure that there are no misunderstandings, either during the discussion or after-the-fact.

Employers can even choose to offer severance pay to employees who are terminated for reasons related to employee performance, or violations of company policy or law – it’s fully up to their discretion. Employers may also choose whether severance pay is delivered in a single lump sum, or through installments over time, or even on the same schedule as was the employee’s regular pay.

Why do employers offer severance pay?

Offering severance pay may be a gesture made by an employer to maintain a positive reputation with the exiting employee (as well as the remaining staff), especially if the termination is for reasons unrelated to job performance. This compensation shows appreciation for the employee’s contributions, and offers financial support as they update their resume and look for new work.

It’s common to think of severance packages as something that’s only paid to workers who experience layoffs due to downsizing, mergers or acquisitions, or some other restructuring of an organization, but this isn’t always the case. Some companies offer severance packages to long-serving employees or executives who resign or retire, as part of their standard off-boarding process.

It’s important to note that, in addition to protecting the relationship between the employer and the terminated employee, a severance agreement is an investment in limiting liability. Severance pay can help mitigate potential legal issues related to wrongful termination, or may include terms upon which an employee’s continued eligibility for severance pay is contingent, such as non-disclosure of company information or properties, or a non-defamation clause.

Is severance pay subject to tax?

Employees who receive severance pay should understand that the IRS considers it to be income that is subject to tax. When an employer issues severance pay, it must be taxed at the same rate as the salary of the worker when they were still employed. It’s important for both employees and employers to understand these tax obligations for severance pay, to avoid any surprises during tax time and most payroll software can process these payments while also correctly handling tax withholding. Employers should also note that payroll records of terminated employees are still subject to the payroll record retention requirements of the IRS.

Are companies legally required to compensate employees with severance pay?

There’s no law under the FLSA that requires employers to provide severance pay when ending a relationship with an employee. However, if a company spells out a policy in their employee handbook around severance pay (and how packages work), it’s important to adhere to the rules that have been set.

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