Severance Pay: What You Should Know

By: Bob Skladany | Source: AARP.org | July 27, 2009

Approximately 467,000 people lost their jobs in June 2009. If they were fortunate, their employers offered them severance packages.

Severance pay is best described as “a voluntary offer of payment from an employer to a worker who has been let go or whose job has been eliminated.”

I hope you never have to deal with severance pay. But if that should happen, here are a few things that you might want to know. I’ll also discuss things you should consider before accepting a severance agreement.

Why Offer Severance Pay?
Slightly less than 50 percent of employers provide some amount of severance pay to workers whose employment is terminated. Except in those cases where an employment contract, union agreement, or a preexisting employer policy requires or provides for severance pay, there is no law or regulation requiring any company to offer severance.

Employers voluntarily choose to provide severance to protect their goodwill with current, past, and future employees. These employers generally consider the severance pay to be a sort of voluntary, supplemental unemployment compensation. Employers recognize the reality that unemployment compensation, even in the most generous states, is usually far less than half a worker’s salary. Severance pay can alleviate some financial hardship in the short term.

Employers also use severance pay to enforce a “release from liability,” or waiver from lawsuits, for improper or discriminatory termination. In most cases, an employer will require a departing employee to sign a release before paying out severance. These releases help employers reduce the possibility of legal action by terminated employees. In fact, it may be to your benefit that an employer requires a liability release, because it may affect your eligibility and amount of unemployment compensation.

What’s Included in Severance?
Large employers often have established and formal severance-pay policies, which are based on a formula factoring in length of service, pay level, and job category. Once established, and once severance is paid to employees, such severance policies become almost de facto commitments, though even these can be modified.

For instance, an employer may offer one week’s pay for every year of an employee’s service. Nevertheless, the severance an executive receives is often covered by an employment agreement and is more generous. One month’s pay for each year of service, up to a stated maximum amount, is not unusual. 

A severance package may also include continuation of health and life-insurance benefits. Employers may elect to allow laid-off employees to continue paying “active employee” premiums, or employers may only offer COBRA (Consolidated Omnibus Budget Reconciliation Act) health-benefits continuation.  Occasionally, employers may also offer job-search or “outplacement” services.

Small to mid-size employers tend to rely on informal severance pay, but they may also elect to not pay any severance. 

Don’t confuse severance pay with the payment of accrued vacation days at termination of employment. Federal and state laws require that all unused, accrued vacation time be paid out in cash upon termination. States vary in how they adjust unemployment benefits for accrued vacation pay. In general, your vacation payout will not affect the amount of unemployment compensation you receive.

Lump Sum or Payments?
An employer may elect to pay severance in a lump sum upon termination and the signing of a liability-release agreement. More likely, they will provide periodic payments, essentially making severance payments on a payroll cycle. Getting paid in this manner may help you maintain a sense of normalcy income-wise, but it can result in a loss of eligibility for unemployment compensation or in reduced unemployment payments. The good news is that ongoing periodic payments are often accompanied by continued health benefits provided on favorable terms.

Employers often base their decision whether to provide lump-sum versus periodic payments on the unemployment compensation laws of the employee’s state of residence. In some states, workers are not eligible for unemployment payments if they receive ongoing, periodic income from a severance. So a person may need to wait to file for unemployment until the employer is finished paying out the severance. Paying out severance in this fashion helps employers avoid or reduce unemployment claims charged to their records, and as a result, prevents their unemployment-compensation premiums from increasing. 

If you accept the severance agreement, I would recommend filing for unemployment compensation immediately. Let the state officials sort out your eligibility. You can always appeal an unfavorable decision.

Unemployment and Severance Pay
Again, whether severance pay affects your unemployment benefits is based on the laws of the state where you live.

In California, severance pay, whether lump-sum or periodic, never affects unemployment benefits. In Michigan, ongoing, periodic payments or a lump sum that an employer “allocates” over a specific period—either reduces unemployment benefits for every week in which there is an allocation assigned.  Massachusetts also cuts unemployment benefits in the weeks in which you receive severance payments, but it does not lower the benefits if you were required to sign a release of liability.

Your best course of action is to contact the state agency that manages unemployment compensation. Review your state’s rules. You can do this online or by doing a search for “severance pay” and “unemployment compensation.”

Do I Need a Lawyer?
If offered severance pay with a required release of liability, your employer is obligated to suggest you seek independent legal counsel. Unless you’re a highly-paid executive with a complex employment agreement and your severance package is worth a large sum, a lawyer’s service is not cost-justified.

You should always read the agreement carefully, talk with colleagues, and ask the human resources department for its interpretation of the documents. Employers are also required to grant you a “cooling off” period after you sign, in case you change your mind and decide not to accept the terms of the severance agreement.