A severance package doesn’t make it feel any better to terminate employees. But it does give them a softer landing and gives you a clean, documented end to the employment relationship.
Severance is voluntary in almost every case, which means the terms are yours to set. Here's how to decide who qualifies for severance, what to include in a severance package, what to ask for in return, and how to pay it out correctly.
How to structure a severance package, step by step
1. Set written criteria before you make any severance offers
With severance, you decide who's eligible. Common criteria for eligibility include minimum tenure (such as two years of service) or everyone in a department or role being eliminated. Decide who qualifies, then apply the same rule to everyone who does.
Write your criteria down before you make any offers, and watch out for these mistakes:
Inconsistency. If some employees in a layoff get severance and those who don’t are similar in age, race, sex, or disability, those offers can become evidence in a discrimination claim.
Risky criteria. Don’t exclude employees close to retirement age and don’t cite job performance you can't document.
Creating an unstated pattern. Paying severance consistently can create a right to it, even with no written policy. If you don't want that, state in each agreement that severance is discretionary and decided on a case-by-case basis. Be careful about making severance promises in your employee handbook.
2. Choose what to include in the severance package
Some companies offer a wide variety of severance benefits, such as outplacement services and career coaching, stock options, or an agreed-upon statement about the departure, but most severance packages come down to pay and health care coverage.
Pay. Most employers base severance on years of service, such as one to two weeks of pay per year. Senior roles often get more, sometimes measured in months.
Health care benefits. You generally can't keep a terminated employee on your active group health plan. But what you can do is help pay for their continued coverage after they leave:
If you have 20 or more employees, you're required to offer COBRA continuation coverage when someone's employment ends, whether or not you give severance. The employee decides whether to elect it, and by default they pay the full health insurance premium. You’re not required to cover any of the premium, but you can choose to include paying premiums for employees in your severance package.
If you have fewer than 20 employees, federal COBRA doesn't apply, but your state may have a continuation law.
Keep these tips in mind about continued coverage:
State how many months of the premium you'll cover. Tying it to the same tenure formula you used for pay keeps it consistent.
How you pay affects taxes on both sides. If you pay the carrier or COBRA administrator directly, or reimburse the employee with proof of payment, it's generally not taxable income to them. But if you give them cash for premiums, it becomes taxable wages, which means they owe income tax on it and you owe the employer’s share of payroll taxes.
3. Draft your separation agreement
Most employers who pay severance ask for a signed separation agreement in return. This is where the employee gives up the right to sue over their employment or termination of employment. For that to hold up, the severance has to be something they weren't already owed.
If you do make severance contingent on a signed agreement, keep these three things in mind:
Know what a release can't cover. It can't stop someone from filing a charge with the Equal Employment Opportunity Commission (EEOC) or the National Labor Relations Board (NLRB), though it can waive their right to collect money from one. It generally can't waive workers' compensation claims, unemployment benefits, or vested retirement benefits either.
Build in review time for employees 40 and over. A general release in a separation agreement covers age discrimination claims along with everything else. But the Age Discrimination in Employment Act (ADEA) only recognizes an age claim waiver if the employee got enough time to think about it: 21 days to consider the agreement, plus 7 days after signing to change their mind. If you're offering severance to two or more people at once, the consideration time increases to 45 days, and each person's packet has to include a written breakdown of how you chose who was laid off. If you violate these, the ADEA waiver is void, so the employee can keep the severance and sue over age discrimination. Talk to an employment attorney before a mass layoff.
Some clauses have their own rules. If you want to include nondisparagement, confidentiality, or noncompete terms, these all come with restrictions (see more in the FAQs).
How to pay out severance
To make severance payments, choose what type of payment you’ll offer—a lump sum payment or in installments—and then run it through payroll.
1. Choose a lump sum payment or installments.
You can pay severance pay as a lump sum or in installments. There are are the differences between the two:
Lump sum | Installments | |
Admin | One payroll run | A separate payroll run for each installment |
Cash flow | Full amount leaves your bank account once | Spreads payments out over time |
Ongoing obligation | Closed once paid | Continues even if your finances change |
Unemployment benefits | Usually no delay if stated as a dollar amount rather than a number of weeks | More likely to delay when former employees’ benefits start |
Tax complications | None beyond normal withholding | Payouts crossing calendar years can raise issues |
If you're structuring a payout that runs longer than a year, review it with a tax advisor.
2. Run it through payroll.
Severance pay counts as taxable wages subject to federal income tax withholding, Social Security, Medicare, and Federal Unemployment Tax Act (FUTA), and it belongs on the employee's W-2. The IRS treats it as a supplemental wage, which affects how you calculate withholding.
Follow these best practices for paying out severance through payroll:
Keep severance separate from the final paycheck. Your state's deadline for final wages can be as short as the employee's last day, while severance waits on a signed agreement. Keeping them separate lets you pay the wages on time without waiting on the signature.
Run it off-cycle. Terminated employees are no longer on a pay schedule, so severance runs outside your normal payroll.
Withhold for the right state. State income tax follows where the employee worked, not where they live now. Make sure you have their current address before the payout.
Expect no 401(k) deferral on it. Most plans exclude severance from eligible compensation, since it's paid after employment ends and isn't pay for hours worked. Typically, no employee deferral comes out and no match goes in. Check your plan document to confirm how your 401(k) provider handles it.
Don’t release severance payment right away. Wait until the agreements are signed and the revocation window for employees aged 40 and over has closed to maintain your leverage.
What’s not included in a severance package?
Severance is a voluntary offer, given on top of what you already owe. Everything below is either an obligation you have regardless or something outside your control, not severance. This matters because if you're asking the employee to sign a waiver, the severance has to be something they weren't already entitled to.
Here’s what’s not part of severance:
Their final paycheck. Wages the employee already earned are owed no matter what. In some states, they're due on the employee's last day.
Unused paid time off. Whether you have to pay out accrued PTO depends on your state and your own written policy. Either way, it's separate from severance.
Unemployment benefits. Unemployment isn't yours to give or withhold. Your state administers it, funded by the unemployment taxes you already pay, and a waiver generally can't sign it away.
Pay in lieu of notice. The federal Worker Adjustment and Retraining Notification (WARN) Act requires large employers to give advance notice of a major layoff or closing. If you don’t give notice, you owe back pay for the days they were shorted. But this is a penalty, not severance.
The right to continue health coverage. If federal COBRA or a state continuation law applies, the employee can elect coverage even if you don't offer help with premiums. Agreeing to cover part of the premium is what makes it severance.
How Gusto helps you manage severance pay
Gusto has a dedicated severance field built into its dismissal payroll, so it codes the payment as severance, applies the right tax treatment, keeps it off the 401(k) deferral calculation, and puts it on the right W-2. You don’t need a separate tracking tool. Gusto also alerts you to your state's final-pay deadline, so that you can keep severance and final pay organized.
FAQs
What is the average severance package?
Most employers pay one to two weeks of salary per year of service. In LHH's severance benchmark study, exempt and non-exempt employees averaged 8 to 9 weeks, managers and supervisors 12 to 13 weeks, and directors and senior leadership 15 to 16 weeks. There's no legal minimum. Severance is voluntary almost everywhere, so the amount is yours to set.
Can I require a noncompete in exchange for severance?
In most states, yes. You can make severance contingent on signing a noncompete agreement. Whether the noncompete clause holds up depends on state law. California, Minnesota, North Dakota, and Oklahoma void employee noncompetes by statute, and other states limit them by income threshold or industry. There's currently no federal ban on noncompetes.
Can I require a nondisparagement clause in a severance agreement?
Yes, but keep it narrow. The NLRB has held that broad nondisparagement and confidentiality clauses in severance agreements violate federal labor law, because they discourage employees from discussing wages or working conditions. If you want to include something, it’s better to include a clause limited to knowingly false statements than a blanket ban on criticism. Have an employment attorney review the wording.
What should I do if an employee negotiates their severance package?
Before you make offers, decide what you’ll negotiate on and what you won’t. Most counter offers focus on a bigger payment, more months of health premium coverage, or narrowing a clause in the release. If you improve the offer for one person and not others in the same layoff, be able to explain the difference for reasons that have nothing to do with age, race, sex, or disability. Also, for employees 40 and over, a material change to the offer restarts the review period.
