What is Severance Pay, and How Does it Work?

Severance pay is compensation provided by an employer when an employee leaves the company. Not all employers offer severance packages. Those that do offer severance may choose how much.

Losing a job is devastating. It takes time to adjust, grieve the job loss, process feelings and face reality.

On top of that, finding a source of income before obtaining a new position at a different company adds more stress. Amy Miller, a senior technical recruiter, says, “Every day we hear about more layoffs. Many of my recruiting friends and colleagues in other companies are also feeling the pain of job loss.” People around the country are losing (or leaving) their jobs every day. 

One way that employers try to make this transition a little bit easier is with severance pay. This is a special type of monetary package provided to departing employees.

We will explain this package, how it works, and what to know as an employee below.

What is Severance Pay?

Severance pay is compensation that an employer offers to an employee after termination. A severance package may involve money, health insurance or assistance in securing a new position. Not all severance packages look the same. 

The idea is that the employee and employer sever ties, but this compensation makes this transition easier on the employee. 

An employee may receive a severance package in the following instances depending on the company:

• Laid off
• Terminated due to downsizing
• Retired
• Fired
• Resigned 

An employer offers severance pay to ensure no ill-will toward the employer and to avoid potential lawsuits. The severance package may also be comprehensive enough to cover the employee’s costs before they land a new job, especially with a solid employee-employer relationship.

How Does Severance Pay Work?

Employees may negotiate their severance package, especially if they can leverage their tenure at the company, their position or the company’s size. 

A severance package is always a monetary payment. Even if a few months’ worth of health insurance is part of the package, this will come in the form of money that the employee would use toward their health insurance bill.

You can ask an employer for more money as part of a severance package, but they don’t have to grant it. 

Suppose an employer offers additional severance if the employee signs an agreement. In that case, it is essential to review the stipulations in the contract and potentially have a legal professional look at it before signing. 

Are Companies Obligated to Offer Severance Pay?

An employer does not have to offer any severance package to employees upon departure from the company. It is highly discretionary, and there are no set industry-wide standards for severance in the U.S.

Only two situations when an employer must offer severance pay exist:

• They operate in a state that requires a small severance package if a facility closes or there are many employees laid off.
• They previously implied that an employee would receive severance payment (through a contract, employee handbook, personnel policy statement, position history, verbal agreement, etc.)

Employers that fail to give advance notice to employees due to closure or mass layoff under the WARN Act will also pay severance. This is a separate federal law compared to the individual states that require a similar consequence. 

How Much Severance Pay Can I Expect?

Employers typically have no legal requirement to offer severance pay, which means the severance package looks different at each company. 

Even so, there are a few basic elements within most severance packages that an employee could anticipate if their employer offers this benefit. 

Common components of a severance package include:

• Salary payments: The amount often correlates with years of tenure or position level, though one to two weeks for each year of service is standard.
• References: A disclosure agreement, referring to future roles outside the company, etc.
• Benefits: COBRA for health insurance, support with unemployment benefits, etc.
• Outplacement assistance: These are services to help find a new job.

A company may also offer loan forgiveness, release from a non-compete contract or other specialized benefits depending on an employee’s situation.

Some companies go above and beyond what others do because they have the resources to do so. When Emily Liou, a career coach and job search consultant, discusses what she believes should become standard in workplaces, one of the items she mentions is a six-month severance package for laid-off employees. Few workplaces offer this. Most do not have the funds to cover this cost.

It is important to note that employers should pay equal severance packages to employees in similar positions. For instance, employers should not pay men a higher severance than women if they are in the same role with the same tenure if they want to avoid legal action. 

Is Severance Pay Taxable?

Severance pay comes in a lump sum that is subject to taxes. The Internal Revenue Service (IRS) considers this a form of income.

Any severance payment will have the same withholding and employment taxes as a regular paycheck for salary coverage. 

Additional pay as part of a severance package is subject to other standard deductions as necessary, including:

• Social Security
• Medicare
• State income tax
• Federal income tax
• Court-ordered garnishments

How to Plan for Severance

Employees may hear about potential layoffs before they happen at their company, which can be incredibly nerve-wracking. 

To prepare in advance, employees must review their current financial situation and take the following steps:

• Create a list of financial and benefit needs
• Determine which benefits to negotiate for severance coverage
• Review the company’s severance policy
• Find out what past colleagues received in the way of severance

If an employee knows about an upcoming layoff, they should take notes during the termination session and avoid signing the severance agreement right away. This is the opportunity to negotiate, so reading this agreement or working with an employment law attorney is a smart move. 

Most agreements allow up to 21 days to accept with a seven-day window to amend, which means there is plenty of time to ensure the agreement is as fair as possible.

Final Thoughts on Severance Pay

Severance pay is a common way for employers to take the sting out of job loss, but employees should negotiate terms to ensure they receive everything possible from the deal. 

It is important to note that employees do not have to accept severance pay, but many choose to due to wanting to receive additional money before finding a new role. 

You may need to waive the right to sue the company or pursue other claims. If you experienced wrongful termination or discrimination, declining the severance pay might be in your best interest.

Always work with a legal expert to fully understand the terms and conditions and ask the right questions. 

Key Takeaways

What is severance pay, and how does it work?

• Severance pay is a compensation package employers offer after an employee-employer relationship ends.
• Companies do not have to offer severance pay in most cases, but they may choose to do so if they want to ensure the relationship ends positively. 
• The IRS taxes severance pay in the same way as regular income.

(Reporting by NPD)