Severance Pay: What You Need to Know

It is an unfortunate situation when you have to let an employee go or your are the employee being dismissed from the company. Either way, it is important to understand some of the implications of discharging an employee.

In this article, we will discuss what is severance pay, how is it used, and some important considerations for employing severance pay.

What is Several Pay?

Severance pay, or a severance package, is pay or a combination of pay and benefits given to an employee when they are involuntarily dismissed from a company.

The primary benefit associated with severance pay is a portion of the employee’s salary for a particular period of time. A common severance pay amount is two weeks of compensation. For executives, it is common to pay the executive one month of salary for each year that individual has worked for the company.

In some cases, such as with high-level executives who secure very handsome compensation packages, the severance pay can exceed what the employee would have received in salary had they remained at the company. This occurs when the executive has a contract that assures them this minimal amount of compensation. Obviously, the idea of an executive being fired from a company and taking away a massive amount of shareholder money is not a pleasant thought for shareholders. For this reason, this very situation is commonly the subject of derivative shareholder actions against the departing executive and the board of directors in charge of overseeing that director.

Other benefits commonly associated with employee severance packages includes:

• Accrued Pay Benefits - The departing employee will generally be paid for her accrued benefits prior to the date of firing. This might include paid time off (PTO), vacation, holiday pay, sick leave, etc. Salespeople who have vested in a commission or sales-related bonus are often awarded these funds or some percentage of those funds.

• WARN Act Compensation - The Worker’s Adjustment Retraining and Notification Act (WARN Act) requires that certain employees being laid off as part of a “mass layoff” at a qualifying location or facility must be given 60 days worth of notice prior to being dismissed. If the employer fails to give this warning, it can be subject to fine and will be liable to the employees for pay during that 60-day period. A severance package may offer funds to employees in exchange for forgoing the right to 60 days of notice prior to being terminated.

• Health and Life Insurance - Employers often incentivize employees by offering employer-sponsored health plans or life insurance policies. The employer can generally secure far more affordable rates on group plans than can the employee when searching for an individual plan. These employers often pay a portion of the insurance employee, as the employee is not taxed on these incentives and the employer receives a tax deduction for said payments. In any event, offering an employee continued health coverage (medical, dental, vision) or life insurance plans (generally term policies offered to employees). Employers who offer an employee health plan may be required by federal law (the Consolidated Omnibus Budget Reconciliation Act or “COBRA”) to offer employees the ability to extend their health benefit coverage until they are able to join another health plan. Allowing the employee to continue their coverage is very important if the employee has a pre-existing condition that could be contested or excluded under a subsequent plan. If the employee keeps coverage under COBRA, HIPAA prohibits an insurance provider at a subsequent employer from excluding those conditions from coverage.

In all instances of employment separation, the employer is required by law to offer COBRA. Regulations were established by COBRA that gives employees and their families, who lose their health benefits because of unemployment, the right to continue group health benefits provided by their group health plan. Employees may choose to continue coverage, however, employers may require the employee to pay the entire health insurance premium for health care coverage.

• Retirement Accounts - Employers generally offer some sort of retirement plans for their employees. Defined benefit plans (such as pensions) have become extremely rare outside of government positions. Defined contribution plans (such as IRAs, 401Ks, 403Bs, etc.) have become extremely popular employer-sponsored plans. As part of the severance package, the employee may be able to maintain or acquire any unvested interest in a retirement account. Further, the employee may receive additional contributions to the retirement account as compensation for the separation.

• Stock Options - Many employees are part of an employee stock option plan (ESOP). The ESOP allows employees to purchase an interest in company shares at fair market value. Generally, the employee does not become owner of the stock option at the time that the employer grants it to them. Instead, the stock options are subject to a vesting period. The vesting period is a specific period of time that the employer will designate for the employee to become full owner of the shares. This is used to incentivize the employee to stay with the company and to maintain loyalty. If the employee leaves the company, there is generally a provision in place that causes her to forfeit her interest in any unvested stock options. As such, a severance package may accelerate the vesting of any unvested options at the time of the employee’s separation. As such, the employee can exercise all of the unvested shares or sell them back to the company at the difference between the option exercise price and the current fair market value. If the company has risen in value since the issuance of the options, this can result in a lot of profits for the employee.

• Employment Assistance - Surprisingly, it is quite common for employers who dismiss an employee to assist the employee with the process of finding further employment. This can be helpful to the employee and the employer. If the employee immediately finds future employment, she will not have to file for unemployment benefits. Also, the employee will not be as drawn to the prospect of suing the employer for a claim of wrongful termination. The assistance provided by the employer might include, referrals, assisting with connections, helping with resume development, etc.

How are severance packages used? 

The first thing to remember is that a severance package is generally voluntary on the part of the employer. There is no federal law in place that requires an employer to pay a severance package to the fired employee. Of course, the Fair Labor Standards Act (FLSA) prohibits an employer from withholding any of an employee’s earned pay at the time of discharge. A severance package is in additional to any benefits that the employee has already accrued.

In some cases, the employee will have a contractual right to a severance package if fired “without cause” — meaning that discharge was not the employee’s fault. It is not always required that the employee have a written employment contract with the employer. Some states recognize a a contractual relationship between the employer and employee in all employment situations. The terms of the employment are established by employer assurances, such as an employee handbook. If any of these assurances indicate that the employee is entitled to a severance package, then it could be legally enforced.

Severance packages are most commonly offered to employees who are involuntarily dismissed without the employee’s conduct or performance giving just cause for the firing. This is most often used when the employee is laid off as part of a reduction of force or the employee receives an early retirement package.

Another common use of the severance package is when an employee is fired as a result of their deficient performance or inappropriate actions. The objective of the severance package in this scenario is completely different. Generally, it is used as consideration (value) in a contract whereby the employee promises not to sue the company (for any matter related to being fired) in exchange for the benefits in the severance package. While an employee’s legal action against the employer may be fruitless, it can be very expensive for the employee to defend a legal action for wrongful discharge. As such, the employer often finds it easier to pay a severance to the employee in exchange for a release or waiver from potential liability, a promise not to sue, and a promise not to seek unemployment compensation.

Severance pay is generally paid in one lump sum. This allows the employee to make a quick claim for unemployment benefits. Of course, any other benefits that are a part of the severance package are fulfilled over the stated or negotiated time period.

Should you Accept a Severance Package?

Obviously, the severance package offers pay and benefits to which an employee is not otherwise entitled. When losing one’s employment, these benefits can be extremely important for keeping up with one’s obligations. If, however, you feel that you were wrongly discharged from employment, you likely should not take the severance package.
As previously discussed, the severance package generally requires the employee to sign a contract agreeing not to sue the employer for wrongful discharge. It may also contain a generally waiver and release of any cause of action the employee may have against the employer.

Considerations When Employing a Severance Package

Here are some things to consider when offering or negotiating a severance package:
1. If the employer offers a severance package to the employee, this is an offer to contract. If the employee refuses the offer or tries to negotiate the offer further, it affectively rejects the offer. The employee cannot later come back an accept the severance package once it is rejected.
2. Employers should indicate whether the severance offer is negotiable or no. This will avoid any dispute as to whether attempting to negotiate the severance package constitutes a new offer or rejection of an offer.
3. The severance package should include a release and waiver of all potential causes of action by the employee against the employer. This is far broader than just forgoing any claims for wrongful discharge. It can receive the employer for liability for any causes of action arising much earlier.
4. When an employee is over 40 years of age, there is a definite threat of legal action under the Age Discrimination and Employment Act (ADEA). As such, you should make certain that the employee initials this provision within the contract or signs a completely separate contract forgoing any legal claim under this law.
5. If the employee is a member of a union, you will have to work with the union concerning the discharge. If this is the case, make contact with the union early in the process. Generally, the union will act as mediator in the situation. They will also have pre-negotiated procedures in place that must generally be followed before trying to discharge and offer severance to an employee.
6. Don’t forget about state law. State law applies in additional to the applicable federal laws. Your state (or locality) could have laws in place that allow for specific employee rights in the event of layoff.