What Is Severance Pay? Definition and Why It's Offered

What Is Severance Pay?

Severance pay is the compensation and/or benefits an employer provides to an employee after employment is over. Severance packages may include extended benefits, such as health insurance and outplacement assistance to help an employee secure a new position.

Employers offer packages to employees who are laid off, whose jobs are eliminated because of downsizing, or who retire. Some employees who resign or are fired may also receive a severance package.

Severance pay can be a goodwill gesture on the part of the employer and can provide the employee with a buffer between working and unemployment.

Key Takeaways

  • Severance pay is any form of compensation paid by an employer to an employee after employment has ended.
  • Unless a contract or employee handbook requires it, employers are not legally required to pay severance.
  • Severance may include accrued vacation and extended benefits, such as health insurance and outplacement assistance to help an employee find another job.
  • As part of severance pay, employees are not allowed to sue the company for any damages.
  • Severance pay is usually offered to employees that have lost their jobs due to company actions as opposed to poor employee performance resulting in them being fired.
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Severance Package Basics

Understanding Severance Pay

Severance pay is offered to employees in certain circumstances after their employment ends. The amount an employee receives often depends on how long they were with the employer. Most employers have policies in their employee handbooks that outline how they handle severance pay.

Packages offered by employers usually come in a lump sum and are taxable. They generally include an employee's regular pay along with some or all of the following:

  • Extra pay based on months or years of employment
  • Compensation for unused, accrued vacation time, sick days, and/or holiday pay
  • Medical and dental benefits, and life insurance
  • Retirement accounts and stock options

Severance and Unemployment Benefits

Severance pay can affect unemployment compensation in two ways. If the employer pays the employee severance fee in a lump sum, the employee can apply for unemployment insurance right away as they are no longer on the company's payroll.

However, in some cases, companies issue severance pay over a period of several months. Through that process, the employee is still technically on the payroll, even if they do not go to work. This means they cannot apply for unemployment. Similarly, if an employee has unused vacation time, they are on the payroll as they use it.

The laws concerning unemployment and severance pay vary by state, so it's important to check with your local employment office about when to apply for unemployment benefits.

In other cases, severance pay affects unemployment compensation because of the contracts many people sign when they accept severance pay. In exchange for offering severance packages, some companies make their employees sign statements saying they voluntarily resigned from their posts.

These agreements prohibit the employee from claiming unemployment insurance, which is reserved for people who are dismissed from their jobs involuntarily. It is wise to read any documents carefully before signing them; legal advice may also be in order as it is sometimes possible to improve the initial severance package that was offered.

Example of Severance Pay

Company A is a large technology company based on the East Coast that is seeking to expand its footprint on the West Coast. In its efforts to expand, it decides to purchase Small Company B based in California which has a footing in the same business.

Company A wants to keep the bulk of the employees at Small Company B as they have experience in the local market; however, one division at Company B is similar in operations to an existing division at Company A, which is larger and has more experience. Company A decides that this division at Small Company B is redundant and both companies would be better served by completely replacing the division with members from Company A's existing team.

As such, the 10-person division at Small Company B is notified that they will be laid off. All 10 employees will be offered severance pay, which will be equal to one month's salary for every year that they have worked there. So if an individual has worked at the company for five years, they will receive five months' severance pay.

Why Offer Severance Pay?

Businesses are not required to pay severance, although most offer packages on a case-by-case basis and as dictated by employment contracts.

When businesses fail to offer severance packages, it can upset staff and create negative public relations. In 2018, Sears announced it planned to lay off hourly employees without giving them any severance pay. The company, which was restructuring in bankruptcy, also said it planned to pay its executives millions in annual bonuses, which drew significant criticism from employees and the general public.

Do Businesses Have to Offer Severance Pay?

According to the U.S. Department of Labor, there is no law that requires employers to provide severance pay; however, if an employee's contract stipulates that they receive severance pay upon dismissal or if the employee handbook promises severance pay, the company is legally obligated to follow through with those pledges. Additionally, if the company makes a verbal promise to provide an employee with severance pay, it must uphold that agreement.

Regardless of whether a company offers severance pay, the Fair Labor Standards Act (FLSA) mandates an employer must pay terminated employees through their last day of work, and the employer must also pay any accrued vacation time to employees.

What Is Severance Pay Taxed at?

Severance pay is taxed at the same tax bracket as when you were fully employed and earning the same salary. This is the case if the severance payment is equal to what your salary was. If it is less, then you will be taxed to the appropriate tax bracket.

The Bottom Line

Severance pay is offered to employees of a company that have been laid off. Employees are laid off for a variety of reasons; usually due to downsizing or redundancy, but other reasons may be included. Employees that are laid off are done so due to corporate decisions as opposed to the quality of their work. There are exceptions to these situations and severance may be offered for other reasons as well.

Severance is offered to employees to help soften the blow of losing their job and to give them a cushion while they look for another job. Most severance pay also comes with the stipulation that the employee cannot sue the company or speak badly of it.

Article Sources
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  1. New York State Department of Labor. "Dismissal or Severance Pay and Your Unemployment Insurance Benefit."

  2. NBC News. "While Sears Executives Get $25 Million in Bonuses, Laid-Off Workers Struggle During Christmastime."

  3. U.S. Department of Labor. "Severance Pay."

  4. U.S. Department of Labor. "Wages and the Fair Labor Standards Act."

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