What employers need to know about severance packages 

What is a severance package?

A severance or exit package is a bundle of benefits offered to employees who are laid off, terminated, or, under specific circumstances, voluntarily leave their jobs. They most often include financial compensation, continuation of certain benefits, and placement services to find a new job. These are sometimes referred to as severance benefits for departing employees, and can include the following:

• Severance payment. An amount of money either in recognition for years of service, to ease the financial pain of job loss, or both. Lump sum payments are the most common, but they can be periodic as well. Employers are not required to offer severance pay to most laid-off employees in most circumstances. If an employer chooses to, however, a common way to determine the amount of severance pay is two weeks of severance pay for each year of service. Some employers choose to put this in their employee handbook. On one hand, this sets clear expectations; on the other, it commits an employer to something that might later prove regrettable.
• Outplacement services. Help for off-boarding employees in finding new work. They often include resume writing assistance, career coaching, and job search support. These services are often appreciated by employees who have been with an employer for many years and are no longer familiar with job searching.
• Stock options. The right to exercise vested stock options or receive retirements benefits.
• Vacation time payout. An employer does not need to pay out unused paid time off (PTO) when an employee is terminated except in three circumstances:
  • The employee is located in one of the 20 states where paying out unused vacation days is required: California, Colorado, Illinois, Indiana, Louisiana, Maine, Maryland, Massachusetts, Minnesota, Montana, Nebraska, New Mexico, New York, North Carolina, North Dakota, Ohio, Rhode Island, West Virginia, and Wyoming. 
  • An employment contract stipulates that unused vacation time will be paid out upon termination.
  • A collective bargaining agreement calls for the payout of accrued vacation time.
• Continuation of insurance benefits. Continuation of their health insurance, life insurance, or other insurance coverage for a specified period. However, this is often at employee’s own expense. Healthcare is a very serious concern for most people, so it is worth special consideration. 

Continuation of health insurance after termination

Terminated employees can continue to receive health insurance benefits in certain circumstances. 

The Consolidated Omnibus Budget Reconciliation Act (COBRA), is a federal law that allows for terminated employees to continue their health insurance coverage for a certain amount of time (typically 18 months) provided that they pay the full premium.

Unemployment benefits vary state to state, but numerous states recognize the need for health insurance and have programs designed for those unable to obtain it through their employer, including nine states (California, Colorado, Connecticut, Maryland, Massachusetts, New Jersey, New Mexico, Washington, and Vermont) that offer state subsidies to make health insurance more affordable and two states (Minnesota and New York) that offer very basic health insurance coverage to low-income individuals.

Is a severance package mandatory? 

A severance package is not legally required by federal or state law in the United States, and employers are not required to provide severance packages in most circumstances. As the U.S. Department of Labor states it, “Severance pay is a matter of agreement between an employer and an employee (or the employee's representative).” If there is an employment agreement in place, that agreement – not state or federal law –may call for an exit package. But in the case of most at-will employees who can be terminated for any legally permissible reason at any time, severance packages are not mandatory. 

Reasons to offer severance benefits

Most employers choose to offer severance packages out of a sense compassion, to guard against legal risk, and to protect their brand:

• Compassion. There is never a good time to lose a job. Severance packages are often a gesture of goodwill and loyalty, particularly to employees with many years of service. They are also meant to help ease the burden of lost income, particularly when it is unexpected or if the employee is terminated due to an event out of the employee’s control (such as a reduction in force).
• Mitigation of legal risks. Terminating employment and providing no means of support is a surefire way to generate ill will and animosity, and those things can easily translate to a wrongful termination lawsuit. Even if the grounds for that lawsuit would be shaky, a former employee who feels hurt or wronged may proceed anyhow out of the need to feel like a score has been settled. Severance packages can reduce feelings of injustice or resentment and therefore might be a good investment if they prevent such lawsuits.
• Brand and reputation management. To let go of employees without providing any kind of severance package at all might outwardly appear impulsive and heartless. That is not good for morale among remaining employees and might cause investors to question the judgment of a company’s decision-makers. In addition, employers need to be mindful of maintaining positive image for future employee recruitment purposes.

Severance packages can vary greatly in size and scope. If a great many newer, entry-level employees are being let go, each may receive a smaller package, whereas a departing executive with many years of service under their belt might receive a more generous one (see this Practical Law severance package example for terminating a senior executive). You might have noticed the words “may” and “might” in the last sentence. That’s because in the case of most at-will employees, exit packages are not mandatory.

What legal considerations are there with severance packages?

Severance packages should be developed with the Fair Labor Standards Act (FLSA), Worker Adjustment and Retraining Notification (WARN) Act, the Employee Retirement Income Security Act (ERISA) Act, and noncompete agreements in mind when employees are let go, fired, or leave voluntarily:

• The Fair Labor Standards Act. The FSLA establishes minimum wage and overtime standards for employees in the United States, among other things. It does not require severance packages, but it comes into play when a severance occurs with things like compliance with wage-and-hour laws.
• Worker Adjustment and Retraining Notification Act. When there is a mass layoff or facility closure, the WARN Act mandates that employers provide advance notice to affected employees and state agencies. There are circumstances in which it mandates severance pay and continuation of benefits. For example, if an employer has not provided adequate notice, it can provide severance in lieu of such notice.
• Employee Retirement Income Security Act. A federal law that establishes minimum standards for private sector retirement and health plans. Generally, a severance package that is given as a one-time gesture is not subject to ERISA. However, if an employer maintains an ongoing severance program, especially one with specific eligibility criteria, and regularly provides severance pay in keeping with a broader policy, that severance plan might be classified as an ERISA-covered welfare benefit plan. ERISA coverage can lead to more administrative requirements, but it offers advantages to both employers (because it preempts state laws, thus streamlining compliance) and employees (eligibility criteria and legal recourse if benefits are unjustly denied). Depending on how large an employer is and how they approach severance packages, ERISA compliance may be an obligation that is worth it.
• Noncompete agreements. Severance agreements often include a noncompete clause, which bars the soon-to-be-former employee from working for a competitor or stating a business that might compete with the former employer for a certain period of time. However, courts have been increasingly skeptical of non-compete clauses, because they are warming up to the idea that they restrict marketplace-wide competition too much, and on April 23, 2024, the FTC announced the ban on noncompete agreements. This decision was bombarded with legal challenges, so this particular pocket of legal consideration is likely to change quickly. Another thing to remember is that departing employees may have had access to sensitive information. Regardless of whether the FTC’s ban on noncompetes survives its inevitable legal challenges, it is a good idea for employers to have a policy in place regarding clear communication to off-boarding employees reminding them that sensitive information is company property.

How you can protect your company

As you have read, employers are not required to give departing at-will employees severance benefits in most cases. Even so, there are compelling reasons to do so, including compassion, protecting against lawsuits, and preserving morale among remaining employees. Even after a severance package is paid out, employers should keep in mind that they may have continuing obligations to former employees in the form of COBRA, WARN Act, or—it’s a covered plan—ERISA recordkeeping and administration.

Staying on top of labor and employment laws when designing a severance package can be tricky – the stakes are high due to severe penalties for noncompliance. With its always up-to-date information, toolkits, and checklists, Practical Law helps you to make informed decisions and stay compliant. Relevant resources include the Severance Benefits, Plans, and Agreements Toolkit with insights on how to assist employers providing severance benefits to terminated employees, an executive severance plan template that provides senior executives with guidance on severance payments and benefits for certain terminations of employment, and Employee Termination: Best Practices with termination protocols and practical tips.

Those are three of the more than 90,000 helpful resources available on the Practical Law platform, to ensure your company’s compliance with this complicated legal matter. If you are not a Practical Law subscriber, try it for free today!