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Severance Pay In A Nutshell – What Is It? How Does It Work?

Severance Pay In A Nutshell – What Is It? How Does It Work?

Severance Pay In A Nutshell – What Is It? How Does It Work?

In some unavoidable situations, many companies lay off some of their employees. After laying off some employees, these companies offer payment to meet the expenses of the employees while they are searching for a new job. A company offers this payment in the form of a severance package. The company decides on its unique terms about who can receive this benefit.

In this article, you will learn about severance pay how it works for companies, and the way it helps employees during layoffs. Furthermore, we will also give you an idea of the taxing of the severance pay. Then, we shall discuss the way in which severance pay affects unemployment compensation. Hence, to learn answers to some more common questions regarding severance pay, read on through to the end of the article.

What Is Severance Pay?

In simple words, businesses grant severance pay to employees once they terminate their employment with the company or during layoffs. This payment helps an employee to sustain a livelihood while the employee searches for new employment elsewhere.

According to the definition given in Investopedia,

Severance pay is the compensation and/or benefits an employer provides to an employee after employment is over. Severance packages may include extended benefits, such as health insurance and outplacement assistance, to help an employee secure a new position.

Furthermore, the basis of severance pay depends on the employee’s length of employment, for which an employee can be eligible to receive benefits after getting terminated.

Here, you must understand that severance packages are for employees who faced layoffs from their employers, provided the employer the contract talks about severance pay. This is also applicable to employees who retire. Even some employees who are fired can receive severance payments; however, it is rare.

How Does Severance Pay Work?

How Does Severance Pay Work

Every company has its own terms and rules about who receives the benefit of severance pay and how the company must provide it. However, there are some common rules that every company must follow. The employee handbook, in most cases, is where businesses inform how they have created their severance pay policies.

The severance pay basically acts as a buffer while an employee, who involuntarily lost a job, can look for another job.

The amount an employee receives with severance pay depends upon how much the employee spent time with the company. Furthermore, the employee’s regular salary also plays a big part. Sometimes the employee’s position in the company is a major factor as well.

Since severance packages come in a big sum, hence they are liable for taxation. The following are some of the essential constituents of a severance package:

  1. Employee’s regular pay
  2. Extra pay based on the time of employment
  3. Compensation for unused leaves provided by the employer
  4. Life insurance and medical benefits
  5. Retirement accounts and other stock options.

Taxing Of Severance Pay

The tax percentage for severance pay is the same for a situation where you are fully employed and earning the same salary. If your severance pay is the same as that of your salary, then the taxation bracket is the same. However, if the severance pay is less than that of your salary, then the tax bracket will be lowered accordingly.

If the employer pays severance as a part of the employee’s normal wages, the tax bracket is the same as that of the salary. However, if the employer pays severance separately, the tax rate is generally 22%.

Does Severance Pay Affect Unemployment Compensation?

According to CapitalOne.com,

Unemployment eligibility may be affected by severance pay, depending on how it’s been paid out and state-specific regulations. For example, in certain states, receiving severance pay as a lump sum may not impact benefits. On the other hand, a salary continuation over a period of time may cause a delay or reduction in benefits.

If the employer pays the severance to the employee as a lump sum, the employee can then apply for unemployment insurance since the payment is not a part of the payroll. However, if the company offers severance to the employee over a period of time (months/ weeks), it means the employee is on the company’s payroll. In such a case, the employee cannot apply for unemployment benefits.

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Is It Compulsory For Businesses To Offer Severance Pay?

The answer is ‘No.’ However, it is essential for businesses to pay severance pay to their employees. This shall help the employees when the company is in ‘layoff’ mode. Hence, businesses must sponsor a severance plan for their employees.

The US Department of Labor’s official website says,

There is no requirement in the Fair Labor Standards Act (FLSA) for severance pay. Severance pay is a matter of agreement between an employer and an employee (or the employee’s representative). The Employee Benefits Security Administration (EBSA)may be able to assist an employee who did not receive severance benefits under their employer-sponsored plan.”

Hence, as an employee if you cannot expect to get severance pay at the time of layoff if the company does not have a policy of providing severance packages. However, if your company has a severance package, and you did not receive the severance pay, you can contact EBSA to get help during unemployment.

When a business fails to offer a severance package to an employee, it can upset the employees and can create a negative public image for the company. Most companies offer severance packages on a case-by-case basis. This package is dictated as per the employment contract.

Wrapping Up

Hence, you can understand from this article that employers compensate a terminated employee with severance pay. However, this does not mean that every company is bound to offer severance packages to employees. It is not legally binding for a company unless the contract with the employee requires a severance package.

However, severance pay is for employees that lost their jobs due to layoffs from the company and not for termination due to an employee’s poor performance or any other issues. Do you have any more information to add regarding severance packages? Share your info in the comments section below.

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