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What Is Severance Pay?

At some point, you might have to terminate an employee. You might eliminate their position, make layoffs, fire for misconduct, or mutually part ways.

No matter the reason, you might consider giving the employee severance pay. Before you make a decision about severance pay, learn more about it, what you might give and when, and how to pay severance wages.

What is severance pay?

Severance pay is compensation you can give an employee when they lose their job. While the Fair Labor Standards Act (FLSA) provides rules for employee wages, it does not require you to provide severance pay. Your state’s laws might require severance pay in some situations, such as for large layoffs and business closures.

In most situations, it is your decision to give or not give severance pay.

Should you provide severance pay?

Severance pay can reduce the impact of a job loss on an employee. The extra pay can help the employee cover expenses until they find a new job.

Typically, employers only give severance pay for layoffs, job eliminations, and mutual agreements to terminate employment. Employers generally do not give severance pay when firing employees for misconduct.

You should make your severance pay policies clear. Include your terms in your employee handbook and/or the employee’s contract. If you promise severance pay in writing, you should give it.

Even if you don’t include severance pay in an employee’s contract, you can still choose to give it later. No matter what you do, be consistent in giving out severance pay. You should not discriminate.

Some employers give severance pay in exchange for the employee’s signature on an agreement that says they won’t sue your business for anything. This protects your business and gives the employee some financial stability.

How much severance pay should you give?

There is no standard amount of severance pay to give. You can decide what to give.

Severance pay is often based on how long the employee has worked for you. For example, you might give one week’s pay for every year the employee worked for you.

The severance pay is negotiable. Be prepared to negotiate with the employee and know how far you are willing to go.

Can I include other things in a severance package?

When an employee is terminated, you can give more than just wages. Below are common items that are included in severance packages.

Things you might include in a severance package graphic

Insurance and benefits: If you have at least 20 full-time equivalent employees and offer a health group plan, you must provide COBRA continuation coverage. COBRA coverage lets former employees keep their health insurance benefits for approximately 18 to 36 months.

You might also voluntarily continue the employee’s other benefits. For example, you might continue the employee’s retirement plan and life insurance.

Uncontested unemployment benefits: When a former employee files for unemployment benefits, you have the opportunity to contest the claim. If you don’t contest the claim, the former employee has a better chance of receiving benefits. As part of the severance package, you can promise not to contest the claim.

Letter of recommendation: When an employee leaves, give them a letter of recommendation that can help them find another job.

Equipment: If the employee used any company equipment to do their job, you might let the employee keep those items. For example, you might let the employee keep their cell phone and laptop.

Unused vacation and sick days: The employee might have unused accrued vacation and sick days. You can pay out this unused time, so the employee still benefits from them. Your state laws might require you to pay out the unused time.

How do I give severance pay?

There are two ways to give out severance pay: a lump sum or regular installments. You can choose how to pay the severance compensation.

A lump sum is the full amount of severance pay given upfront. The large amount might be difficult for your business to pay out at once. But with a lump sum payment, the former employee is more likely to qualify for unemployment compensation in following weeks.

With regular installments, you give the severance pay in smaller amounts and in spaced out intervals. The installments might follow your business’s normal pay schedule. Installments might help your business better bear the severance pay amount. And, regular payments can help the former employee create a budget. However, as long as the former employee receives pay from you, they might not be eligible for unemployment benefits.

Is severance pay taxable?

Severance pay is taxable. Withholding on severance pay includes all federal, state, and local taxes. Payroll taxes on severance pay include income taxes, federal income tax (FUTA tax), Social Security tax, and Medicare tax.

Include the severance pay and the taxes paid on the former employee’s Form W-2.

Is severance pay taxed at a higher rate than regular wages? For FUTA, Social Security, and Medicare taxes, severance pay is taxed at the usual rates. For federal income taxes, the amount you withhold depends on the amount of the payment. If you give a lump sum, the payment might be subject to increased income tax withholding because the payment is within a higher tax bracket than the employee’s regular paychecks.

Additional items in the severance package might also be taxable. For example, you should withhold and pay taxes on vacation and sick time payouts.

For more information on taxes for severance pay, see Publication 15 (Circular E), Employer’s Tax Guide, and Publication 525, Taxable and Nontaxable Income. Publication 4128, Tax Impact of Job Loss, might also be helpful, but it is written for employees who have lost their jobs.

Do you need to give severance pay to an employee? You can include it as a money type in Patriot’s online payroll software. We’ll accurately calculate the taxes and include the severance pay on the former employee’s Form W-2. Start using our online payroll software for all your employees. Get your free trial today.

This article is updated from its original publication date of 6/11/2012.

This is not intended as legal advice; for more information, please click here.

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