Discover How Severance Pay Works and How it Should Be Used In Your Organization
Severance pay, also referred to as post-employment compensation, gap pay, or a separation package, is rarely a fun topic to discuss—no matter what your company calls it. Typically, severance pay is money given to an employee at the time of a layoff or termination. How severance pay works typically is the pay is often provided as part of a larger severance package, which can also include benefits such as outplacement services or the continuation of healthcare coverage for a period of time.
Because there are no universal rules around how severance pay works, it is best to know your options so you can execute a severance package that best suits your company’s needs in the case of a reduction in force.
Not sure how severance pay works? Here’s what to consider when drawing up, executing, or updating a severance package.
Why Provide a Severance Package?
Unlike a last paycheck, which usually covers all of an employee’s time worked—and in some cases, compensation for unused vacation days—severance pay is not required by law. The Fair Labor Standards Act (FLSA) states that there is no requirement for severance pay, and that employees in a layoff situation are not entitled to any post-employment compensation.
There is one exception to this rule: If your company has more than 100 employees, your company is required by law to give 60 days’ notice of a company or a large departmental closing, under the WARN (Worker Adjustment and Retraining Notification) Act. Failure to give notice legally obligates your company to provide severance pay to employees who were impacted.
That being said, providing a separation package shouldn’t be viewed solely as a final parting gift or kind gesture. Severance pay protects the employer from potential litigation or bad press—as most packages are only issued if an employee separation agreement is signed. The agreement generally requires that the individual not sue or disclose information about the company to outside sources.
In most cases, post-employment compensation is extended when job loss is not directly connected to job performance—but there are exceptions. A company may extend a severance package to an employee who has underperformed to avoid a lawsuit. Even if the accusation lacks merit and the employee didn’t perform their tasks to their best ability, a company may prefer to avoid entering into a legal fight.
Examples of items that you might want to include in a standard severance agreement can include: payment terms, healthcare benefits, an agreement to return company property, a non-compete clause, a confidentiality agreement, a general release of claims (agreement not to sue), and unemployment information.
How to Develop a Severance Pay Policy
Times surrounding a layoff or termination can be stressful and confusing for all parties involved. Instating a formal policy that outlines your company’s specific terms can help the employer and employee navigate the situation with more clarity.
Begin by laying out a clear purpose for the severance package—such as wanting to provide assistance while the employee looks for another job. The agreement can also include conditions for receiving a severance package. For example, an employee might be eligible if they were laid off for reasons outside of their job performance, but not eligible if terminated with cause.
Clearly define what your company’s specific payment terms will be and how they will be calculated. Additionally, a formal policy should include an employer’s rights to modify the agreement at any point in time. Including this disclaimer will protect your company’s interests in the event that the policy needs to be updated, as in the case of an acquisition or merger.
How to Calculate Severance Pay
While there is no one golden rule or formula when it comes to calculating severance pay, a few standard methods can help you reach a fair number.
First, most severance packages typically factor in the amount of time someone has been employed, providing either a week or two of exempt or non-exempt pay for each year worked. Standard agreements usually max out at a total of 26 weeks. Severance packages for upper management can sometimes average for longer lengths of time—in some cases you could be working with a range of six months to one year.
An employee’s position or rank and size of the company can also impact how severance pay is calculated. When looking to establish a severance check amount, beyond reasons for dismissal, a company should also consider if an employee is paid on an hourly or salary basis.
When it comes to the actual physical severance check, many companies opt to pay out in one lump sum. However, a company could also pay out in installments. This option can be described as a salary continuation. Employees would remain on payroll for a specified length of time and receive pay at the end of each pay period as if they had been working as usual. In both instances, the employee’s pay would still be subject taxes, as the severance amount is considered income. As your company’s representative, you may want to highlight this fact to mitigate any surprises for the employee later on.
In addition to severance pay, non-monetary benefits can also be included in a severance package to benefit both exiting employees and the company, encouraging an amicable split. Some common benefits include compensation for unused vacation or sick time, extensions of medical, dental, or vision insurance coverage, bonuses, retirement account benefits, and stock options.
One popular benefit many companies offer today is outplacement: career transition support provided by the employer to exiting employees to help them find new jobs. Providing outplacement services can help mitigate lawsuits, lessen unemployment costs, and help employees focus on the future with a more positive outlook.
Now that you know how severance pay works, it’s time to consider how you treat exiting employees. CareerArc’s outplacement program offers on-demand, one-on-one coaching from premier career counselors, detailed resume reviews, video interview coaching, and many other career tools and benefits—all available on a conveniently accessible virtual platform. Schedule a demo today to learn more about how to execute a smooth workforce transition with CareerArc’s outplacement services.