Small Business Guide to Severance Pay

  1. Severance pay is money paid to an employee after they have been terminated by their employer.
  2. A severance package can include additional benefits such as extended life and health insurance coverage and considerations for employee retirement account funds and stock options.
  3. Severance pay is not mandatory if it is not agreed upon before termination, except in circumstances like WARN Act violations. 

To ease the financial shock of an unforeseen and immediate termination, some employers offer their employees a severance package. Although severance packages are not mandatory, for employers, offering a severance is an option to help you maintain a positive reputation, avoid potential lawsuits and enforce noncompete clauses. If your company has to make drastic financial cuts due to unforeseen circumstances (e.g., the coronavirus), severance pay is a great way to assist your employees as they look for new employment.  

What is severance pay?

Severance pay is a sum of money paid to an employee after they have been terminated by their employer. It’s often included as part of a severance package, which can contain other benefits, such as continued health and life insurance coverage for a set period of time, unused vacation or sick leave that is paid out, and other considerations relating to employee retirement accounts and stock options. Payment for severance can be disbursed in one lump sum or in installments. 

Why and under what circumstances do companies offer severance pay?

Maria Veronica Saladino, a corporate and M&A attorney at Rice Reuther Sullivan & Carroll, listed four primary reasons why a company may decide to offer severance pay:  

  1. To attract top talent when hiring new employees (e.g., a prospective employee may be incentivized to sign a contract with a company if such contract provides some sort of severance package as a parachute in case the new job does not work out)
  2. To maintain a positive reputation and stay on good terms with an employee who was involuntarily terminated
  3. To avoid potential lawsuits (e.g., employees receive a severance in exchange for a “release of claims,” a signed document in which an employee agrees not to file a lawsuit against their former employer)
  4. To increase the enforceability of any noncompete and nonsolicitation provisions contained in the terminated employee’s employment contract (e.g., a court may decide under certain circumstances not to enforce a noncompete or nonsolicitation provision if adhering to such provision causes undue hardship to the terminated employee, and providing severance pay reduces such risk) 

Is severance pay compulsory? 

Severance pay is not mandatory, except in a few circumstances. For example, severance pay is mandatory if an employer is noncompliant with the Worker Adjustment and Retraining Notification (WARN) Act, which requires an employer to give employees a 60-day advance notice of termination of employment. 

“In such a case, the company will most likely be required to pay to such employee a severance package equal to the employee’s pay for a period equal to the notice, plus any other benefit required under the WARN Act,” said Saladino. “As a note, the WARN Act applies only in specific circumstances, and each company/employee should consult an attorney to analyze whether it applies to the specific situation.” 

If an employer has contractually agreed to offer a severance package, an employee can claim that the employer is legally obligated to provide said severance package if the employee met the qualifying terms of the severance. 

Who is entitled to severance pay?

Employees who fall under the criteria of the WARN Act, as well as employees who have a severance pay clause in their employment agreement and meet the severance terms, are often entitled to severance pay. Severance pay can additionally be offered to any employee that the employer so chooses and is typically agreed upon at the start of employment. 

Charley Moore, attorney, founder and CEO of Rocket Lawyer, said employees who are offered a severance package typically know the terms of severance beforehand, such as specific lengths of service required to receive severance pay. However, some sudden occurrences, like a mass layoff due to the coronavirus, can cause employers to implement new severance pay agreements.  

“Employers who are being forced to shutter their doors or temporarily lay off workers due to the current coronavirus pandemic should consider speaking with an employment attorney who is familiar with both federal and state acts,” said Moore. 

How do you calculate severance pay?

How much you include in a severance package for an employee varies widely, depending on the severance terms that are agreed upon between the employer and employee during the initial severance agreement negotiation. Although every severance policy is different, commonly, wages paid correspond with the employee’s length of service with the company. 

“In general, upper management personnel are more likely to get a more generous severance package,” said Moore. “Typically, one can expect to receive the equivalent of one- or two-weeks’ full pay for every year of service. Employees may also be entitled to a period of extended insurance benefits and access to outsourcing services to help them find a new job.” 

Moore added that employers may include other benefits in their severance packages, including an agreement by the employer to not dispute the employee’s claim for unemployment benefits. 

What are the best practices for offering severance pay?

It is always wise to assume you may need to provide severance pay if you are terminating an employee without giving him or her prior notice due to a reason other than employee misconduct. The first step, as the employer, is to review the employee’s employment agreement and see if there is a severance clause. If a severance clause exists, follow through in providing the severance package as it was agreed upon when the employee was hired. 

“If the agreement is silent, or if there is no agreement at all, then companies may consider offering a severance package in exchange for a release of claims (so that the employee cannot sue the company later on) containing a mutual nondisparagement clause (so that the employee and the company are legally prevented from bad-mouthing each other),” said Saladino. 

As a business owner, it is a good idea to have a firm severance pay policy in place, which will cover all employees. If you do not currently have one in place, Moore recommends adding one to your current employee handbook.

“Companies and employees should think about severance pay even before the employee/employer relationship is established as to avoid surprises when the relationship goes south, said Saladino. “Consulting with an attorney before any issues arise is probably the best course.”

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