Calculating severance pay: A guide for employers

If you need to let a team member go, you may want — or may be required — to provide severance pay. 

This provides your terminated employee with a financial safety cushion as they look to find new employment. But how do severance agreements work, and how do you calculate how much to pay?

In this article, we’ll answer these questions, and explain what happens to bonuses and other benefits. We’ll also look at the possible tax repercussions. So let’s jump straight in.

What is severance pay?

Severance pay is compensation that you pay to an employee after their employment ends, usually involuntarily. The amount given often depends on how long the team member was at the company, and how senior their role was.

In some locations, severance pay is mandatory by law. In places where it is not, any severance policy is at the discretion of the employer, and must be laid out in the employment agreement.

Some companies may provide severance pay to team members who leave voluntarily (i.e., resign), but it’s usually offered to employees who are involuntarily terminated. For instance, you might offer severance if an employee is laid off, or if their services are no longer required. Note that in many employment agreements, severance pay can be voided if the employee is dismissed for gross misconduct or poor performance.

What is a severance agreement?

A severance agreement is a legally binding contract outlining the severance package’s terms. It includes all the package components and details about compensation, benefits, and outplacement services.

These agreements may also include the following elements:

• A non-disparagement clause: The employee agrees not to speak badly about the employer.

• A confidentiality clause: The employee agrees not to share confidential company information.

• A release of claims: The employee agrees not to file a lawsuit against the company for wrongful termination or related claims. In exchange, they receive severance pay, reducing the need for damages that may be won in court.

Encourage the employee to review the agreement and consult with a legal expert if necessary. Once they understand the agreement and are satisfied, they must sign it to finalize the severance package.

Who receives severance pay?

In some countries and US states, severance pay eligibility is dictated by law. In these instances, you must follow the rules set out in those locations.

To see where you’re required to provide severance pay, check out our Country Explorer tool (or, if you have employees in the US, our State Explorer tool).

If it’s not mandated by law, you can theoretically offer severance pay to anyone in your organization. However, according to Ranstad’s 2023 Guide to Severance and Workforce Transition survey, only 25% of companies in the US offer all staff members severance pay. This is likely because doing so isn’t financially viable for most companies.

Instead, many firms offer severance pay to higher-level employees in vital roles since these positions are more competitive to recruit for. For example, companies often provide C-suite executives with generous severance packages.

Union workers are also common severance recipients. Unions often require companies to offer members severance pay as part of collective bargaining agreements.

If you do opt to include a severance package in your employment agreement, you must honor it. Failure to do so can result in legal action, penalties, and fines.

How does severance pay work?

Severance pay can consist of several items, as shown below:

Regular compensation

Regular compensation often makes up the bulk of a severance package, and is usually based on how long your employee has been with the company. For instance, an employee who has been with your company for one year may be entitled to two weeks’ salary; an employee of two years may be entitled to a month’s salary, and so on.

Bonuses

If your employee was entitled to performance-based bonuses for work already performed, these should be included in their severance package. For instance, if your team member had already earned commission on deals closed, they would be due this money as part of their severance.

Benefits

In some instances, it may be possible for companies to continue benefits as part of a severance package, such as extended health coverage or supplemental insurance. Remote’s benefits experts can guide and advise you on whether this is possible, based on your circumstances and where your employee is based.

Stock options

If your terminated employee is part of a company stock option plan, your severance package may allow them to vest some of their options to take full advantage of the shares they were entitled to. 

For example, when Google laid off 12,000 employees in early 2023, many of these individuals got at least 16 weeks of accelerated vesting.

Outplacement services

Outplacement services help employees find new jobs as soon as possible, and can be offered in-house or through a third-party service. You can provide access to these services as part of the severance package.

What is the severance process?

When an employee leaves under qualifying conditions, here is the typical process for paying out a severance package:

1. After the employee is given notice of the termination, a one-to-one meeting should be called to discuss the severance package.

2. A severance package is put together and presented.

3. In some cases, the package may be negotiable. If severance pay is established by company policy, there may be less negotiation since both parties will follow company policy instead.

4. The parties agree on the package and any other elements of the severance agreement.

5. The employer pays the employee per the agreement.

The compensation portions of severance pay, which include regular compensation and bonuses or commissions, may be paid out in a lump sum or across multiple regular payments (although this can depend on local laws).

Note that, in the event of a mass layoff, the company may opt not to meet with employees individually. Instead, it may announce things companywide and be open to questions and concerns. It may even publicize the details to preserve its reputation.

What happens if an employee finds a new job while getting severance pay?

The status of an employee’s severance pay fund upon finding a new job depends on the agreement you negotiate with them.

Some employers let employees keep their severance pay regardless of if or when they find new employment. This is the most attractive option to employees. However, it may decrease their incentive to stay with you longer. They can potentially leave and quickly find new employment while keeping the severance.

For this reason, employers may instead require prorated repayment of severance, depending on when the employee finds a new job and how much they earn in it. 

How do you calculate severance pay?

When calculating severance pay, you first need to consider the following:

• Reason for termination: A layoff may have a different severance amount than a mutual agreement to leave.

• Employee position: Higher-paid or higher-ranking employees may get larger severance packages.

• Length of service: Longer-serving employees may get larger severance packages.

• Commissions, bonuses, and other expected payments: Roles that lean more heavily on performance pay may require some analysis of past periods to determine suitable compensation.

• Industry standards: Industries with more competitive labor markets may have higher standards for severance packages.

• Laws: Local laws may impact how severance amounts work. For example, countries that require severance may have certain minimums.

• Special circumstances: Mass layoffs, division closures, and other special circumstances could necessitate differences in severance pay.

• Organizational needs: Financial health, future expected performance, and similar matters can impact the viability of offering severance packages.

That said, a good starting point is this:

X weeks of regular pay x Y years of continuous service = severance pay

For instance, say you terminate an employee who has 10 years’ tenure and earns $9,000 per month (or $4,500 every two weeks). Your employment contract states that the employee is entitled to two weeks’ pay for every year of continuous service.

Using this formula, they would receive:

$4,500 (two weeks’ pay) x 10 years of continuous service = $45,000

Of course, this is a basic calculation, and doesn’t incorporate many of the additional factors listed above. Make sure you work closely with your finance and HR teams when building a severance policy, and work closely with your legal team if severance is mandatory in your employee’s location.

Is severance pay taxable?

This depends on the country, but generally, yes.

In the US, for instance, severance pay funds are taxable in the year the employee receives them. In the UK, some parts of termination payments are considered taxable. In France, employers must withhold the proper taxes on severance pay.

Our payroll tax and legal experts can advise you on what exactly your severance pay tax responsibilities are, regardless of where your team members are based.

Is severance pay legally required?

As mentioned, this depends on the law in the employee’s location.

In the US, severance pay is not mandated by federal law, but some individual states require that you provide it (often conditionally).

Other countries may legally require severance pay. For example, Brazilian employment law requires that you pay severance for employee terminations without cause. Spanish law also requires employers to pay severance under certain conditions.

In other regions, severance may not be legally required, but is culturally expected. As a result, it can be an important factor when competing for talent in those areas.

To ensure that you’re fully compliant, it’s advisable to work with an employer of record (EOR) provider, like Remote. We ensure that you’re meeting all legal obligations in every country or state that you hire in, saving you time and resources, and giving you full clarity.

Can employees receive severance pay and claim unemployment at the same time?

Again, this depends on the employee’s location. 

In Texas, for instance, unemployed people who are receiving certain kinds of severance pay can not collect unemployment insurance payments. Other states have similar restrictions, or none at all.

Your employees should check local laws to see if they are eligible, or make an application to see if they qualify. Your employees should also keep in mind that both forms of income may be taxable. 

Complying with severance pay rules

As you can see, the rules around severance pay can vary significantly, depending on where your employee is based.

As a result, it’s advisable to work with a global HR partner like Remote. Through our EOR service, we can advise you on what exactly your legal obligations are, what severance taxes you may need to withhold, and, if legally required, what the minimum severance amount will be. We can also advise and support you on how to incorporate benefits into your severance package.

To learn more about how we can help — including with the onboarding, payroll, and day-to-day management of all your global personnel — speak to one of our friendly experts today!

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