Severance Pay: How It Works and How to Calculate It

Severance pay is any type of compensation or benefits that employers provide to their workers after their employment has been terminated. It can help workers bridge the gap between two jobs, smoothing their transition and helping them out in difficult times.

This article explores the intricacies of severance pay. We’ll explore what it is, what it encompasses, how it works, how it’s calculated, and whether it shows on pay stubs and Form 1099. We’ll also explain the pay laws and regulations surrounding it to help employers and employees better understand their rights and obligations.

Key Takeaways

• Severance pay is a form of compensation that companies offer to their employees upon termination.
• The type of compensation and amount are usually at the sole discretion of the employer.
• It can take the form of financial compensation, extended benefits, stock options, and more.
• Severance pay isn’t mandatory or required by federal law, but there are some exceptions with state laws.
• The IRS sees it as taxable income, so it will appear on your pay stub and Form W-2.

What Is Severance Pay?

Severance pay is compensation employers provide to their staff upon employment termination. It can come in the form of monetary payment, extended benefits, retirement accounts, stock options, and more.

This is different from a standard paycheck, as it’s not given for regular work. Instead, it’s meant to support the employee as they leave the company and look for another job. As a result, severance pay is most commonly given in situations like layoffs, company restructuring, or job elimination.

When offering this type of monetary compensation, employers can give the workers who are leaving their company a lump sum or they can pay them in installments.

It’s important to note that there are no federal laws that mandate employers give severance pay. The Fair Labor Standards Act does not require it, so it’s typically an act of employers’ goodwill. However, there may be exceptions with some state laws requiring it; plus, if a business offers severance in its handbook or employee contract, it’s mandatory.

What Does Severance Pay Include?

Severance pay may include one or more components, depending on what the company offers. As a result, severance packages can vary significantly between businesses.

The key components that can be included in this type of pay are:

• Monetary payment. Monetary compensation is the most common element of a severance package. It’s typically calculated based on the worker’s salary and length of employment. For instance, a company can offer a month of pay for every year of service a worker has.

• Continuation of health insurance and other benefits. Employers can offer to continue covering health, dental, life insurance, and similar benefits for a specified time period. This is typically done through COBRA, where employees can continue their coverage for 18 to 36 months.

• Payout for unused vacation and/or sick days. Depending on the company policy, employees may be reimbursed for the accrued sick or vacation days that they haven’t used.

• Stock options and retirement accounts. A company handbook or employment contract can outline the details regarding vested stock options and retirement accounts, such as a 401(k).

• Outplacement. Some companies offer outplacement services to help former employees find new jobs. These can include career counseling, help with resume writing, support when searching for a new position, and more.

How Does Severance Pay Work?

Severance pay works as a single lump sum or as an amount paid in installments, similar to regular paychecks. The method is usually determined by the employer and outlined in a policy or contract as a severance agreement.

If paid as a lump sum, severance pay will typically be issued within a few weeks of the employment termination. The date will generally be determined based on the employee’s last day of employment. Some companies can include severance in the final paycheck, while others can issue it separately and at a later date.

There are several factors that typically affect the severance amount, and they are:

• Length of employment. This is the most common and most important determinant employers use to calculate severance pay. Generally, the practice is to offer anywhere between a week's or a month's salary for every year the employee has worked for the company.

• Position and salary. Higher-level employees with more responsibilities and greater salaries typically receive more generous severance packages.

• Company policy. Since employers set their own policies regarding severance pay, they can come up with specific rules and rates used to perform calculations. That’s why you should always refer to the company handbook or the terms in your contract to know when the severance pay is due and in what amount.

• State laws. Even though there are no federal laws that govern it, some state laws (e.g., in New Jersey and Massachusetts) can make severance pay mandatory, dictating the amount and terms.

How Is Severance Pay Calculated?

There is no one unique way for calculating severance pay, as every employer may do it differently. However, common methods involve using employment duration and salary to come up with the severance sum.

Here’s an example of a severance pay calculation proportional to the worker’s time of service:

• An employee has worked for the company for 7 years, 3 months, and 15 days.
• Their monthly salary was $6,500.
• The severance pay is calculated as a 1-month wage for each full year of service.

Here is the calculation for years, excess months, and excess days:

• Full years: 7 * $6,500 = $45,500
• Excess months: 3 / 12 * $6,500 = $1,625
• Excess days: 12 / 365 * $6,500 = $213
• Total severance payment: $45,500 + $1,625 + $213 = $47,338

To simplify calculations, some companies will round the severance pay, offering one or more weeks of pay per year.

Additionally, some businesses use a tiered system. For instance, they can offer one week of pay for the first five years and two weeks for each following year. Let’s see that in an example:

• An employee has worked for the company for 8 years.
• Their weekly salary was $2,000.
• The severance pay is calculated as a 1-week wage for the first 5 years and a 2-week wage for the next three years.
• Total severance payment: 5 * $2,000 + 2 * 3 * $2,000 = $22,000

Severance Pay Laws and Regulations in the US

In the U.S., there are no federal laws and regulations that mandate severance pay for employees who have been terminated. The FLSA, which governs aspects like minimum wage and overtime pay, doesn’t include severance pay; in most cases, it is calculated and provided at the discretion of the employer.

However, there are a few legislative exceptions in the form of state laws for severance pay, and they encompass the following instances:

• New Jersey. Severance pay is subject to the Millville Dallas Airmotive Plant Job Loss Notification Act. This act mandates that every employee who’s been affected by a mass layoff be given severance pay. The amount is one week’s wage for each full year of employment.

• Massachusetts. There is no all-encompassing state law regarding severance pay, but there are regulations in specific cases and for certain industries. For example, employers may be required to provide severance pay to workers who transfer to another country.

Another regulation worth mentioning is the Worker Adjustment and Retraining Notification (WARN) Act. This is a federal act that, while not mandating severance pay, requires employers to provide notice to their workers in cases of mass layoffs or plant closures. They need to notify employees about layoffs 60 days in advance in case they have 100 workers or more.

Is Severance Pay Taxable?

In general, severance pay is taxable. The IRS recognizes several types of income made during a job loss as taxable in the year in which it is received. The employer will have to withhold relevant federal and state taxes for you and report everything on your Form W-2.

The same rules apply for unused annual leave, vacation, and sick days. They are considered wages and should be taxed and included in your W-2.

The tax bracket depends on the amount of severance pay that you receive. If it’s the same as your salary, you will be taxed in the same tax bracket as if you were still earning the salary. However, if your severance pay is reduced compared to your salary, you will be taxed at the corresponding bracket.

Severance Pay vs. Final Check

It’s critical to make a distinction when comparing severance pay vs. final paycheck, as they are governed by different rules and serve entirely different purposes.

For starters, a final check is mandated by federal and state laws, and it’s a form of regular payment for the work the employee has done prior to being laid off. On the other hand, severance pay is optional and serves to financially assist the employee until they find a new job.

Severance pay also varies, depending on what the employer offers, and, as previously mentioned, can be paid as a lump sum or in installments. The final check is the wage the employer has earned during their final pay period in the company, and it’s typically due on their last day or shortly after.

Here’s a concise table that outlines the key differences:

Do Contractors and Freelancers Receive Severance Pay?

There’s generally no severance pay for contractors and freelancers. A severance package is usually a benefit employers offer to W-2 employees who are laid off involuntarily. Since freelancers and independent contractors aren’t considered traditional employees, in most cases, they don’t receive these benefits.

However, contractors and freelancers may include some form of severance pay in their contracts with clients. For instance, they can negotiate with clients to set aside a provision for a payment upon the agreement's termination.

The sum and the payment terms are entirely subject to an individual agreement between the two parties. However, once the contract is signed, it becomes legally binding and both parties must adhere to it.

Pros and Cons of Severance Pay

Severance pay comes with pros and cons for both employees and employers. Let’s find out what these are.

Pros of Severance Pay

Let’s start with the key benefits of severance pay for employees:

• Financial assistance. Severance pay offers much-needed income to workers who aren’t employed anymore and need time to find another job.

• Continuation of benefits. Employees can continue to receive health insurance and other benefits for a specified time.

Now, here are the benefits for employers:

• Legal protection. Most companies ask employees to waive their rights to file claims if they want to receive severance pay. This protects the company from potential lawsuits.

• Find talent and improve their morale. By offering good severance packages, companies can stand out and attract employees in a competitive job market. This will also positively affect their morale while they work, resulting in improved efficiency.

Cons of Severance Pay

Here are the drawbacks of severance pay for employees:

• Waived rights. Accepting severance typically means employees waive their rights to sue the employer for various reasons.

• Taxed income. Severance is taxed—much like a salary—so the net amount received will always be lower than outlined in the contract.

• Potential clash with unemployment benefits. In some states, receiving severance pay can reduce the amount of unemployment benefits or make the employees ineligible for them entirely.

Finally, here are the drawbacks for employers:

• Financial cost. Severance pay is typically optional, and offering it can be a significant expense for the company. This is especially prominent during large-scale layoffs.

• More administrative work. Planning and processing severance pay takes time and resources. There’s also the risk of intentionally or unintentionally violating an agreement or applicable law, which can result in disputes and penalties.

How to Track Severance Pay on Pay Stubs and Tax Forms

Since severance pay is taxable, you can track it on pay stubs and relevant tax forms.

Its appearance on pay stubs depends on how the document is designed; still, it should be distinct and clearly identifiable. In general, severance pay can be included in a specific section titled, for example, “Other Payments.” It can also be a standalone item in the “Earnings” section.

On top of that, severance pay will also appear on your Form W-2 provided by your former employer. If you’re a contractor and received a termination payment that was included in your contract, it will show in your Form 1099-MISC.

Due to these complexities and various documents where your severance pay may appear, it’s good practice to consult a tax professional if you’re unsure how to report this income and pay taxes.

Manage Severance Pay With Paystub.org

If you’re looking to streamline your payroll processes and manage severance pay, you can use our pay stub generator. We developed a user-friendly solution with a built-in calculator for severance pay, overtime, gross and net wage, hours, rates, and more. Pick a template, fill in the form, and download a finished product in minutes!

Final Thoughts

Now that you understand the meaning of severance pay and its nuances, you can negotiate more favorable terms as an employee or attract and retain talent as an employer. When used correctly, this form of compensation benefits everyone involved.

The companies mainly use severance pay to protect themselves legally and maintain a good reputation. On the other hand, employees receive financial assistance during a difficult transition period, especially if they live paycheck to paycheck.

Lastly, note that this income is taxable and may clash with unemployment benefits.

Severance Pay FAQ

#1. Can I negotiate severance pay?

Yes, you can negotiate severance pay in many cases. This is typically done during the hiring process, once you receive the initial offer. You should review the offer carefully and even consult an employment lawyer to ensure the best outcome.

#2. Can I receive severance and unemployment?

Yes, you can receive severance and unemployment at the same time, depending on the state laws and your agreement with the employer. In some instances, signing a contract that involves severance may reduce your unemployment benefits or remove them altogether.

#3. How is severance listed on a pay stub?

Severance pay on a pay stub will typically be listed as a separate item in the earnings statement. For instance, it can be included in a dedicated section titled “Other Payments” and marked as “Severance” or “Termination Pay.”

#4. How much severance pay can I get after 5 years of work?

How much severance pay you can get after 5 years of work depends on the company's policy. In many cases, companies offer one or two weeks of your regular pay per year worked as severance, resulting in 5–10 weeks of pay.