This article explores the definitions of severance and redundancy pay, their key differences, eligibility criteria, and how severance packages are structured under UK law. It also provides guidance on calculating severance payments and highlights tax considerations businesses must address when implementing severance policies.
What is Severance Pay?
Severance pay is financial compensation provided to employees when their contracts are terminated through no fault of thewithout their faultin cases of restructuring, downsizing, or role eliminations. This payment acts as a financial buffer, allowing affected employees to manage expenses while seeking new job opportunities.
Unlike redundancy pay, severance compensation is not legally required in the UK. However, many businesses offer severance packages as part of their benefits to attract and retain skilled employees. Providing severance pay can also reduce the risk of legal claims related to dismissals, especially when agreements include clauses preventing litigation. Employers should also consider how severance tax applies to different package elements, such as bonuses or accrued holiday pay.
Severance Pay vs. Redundancy Pay: What’s the Difference?
Although severance and redundancy pay both offer financial support to departing employees, they are not the same. In the UK, redundancy pay is a legal requirement, while severance pay is optional.
Redundancy pay must be provided when an employee is dismissed due to factors such as restructuring, outsourcing, or business closure. The Employment Rights Act 1996 governs redundancy pay, ensuring that eligible employees receive compensation based on their age, length of service, and weekly earnings.
Severance pay, on the other hand, is negotiated between the employer and employee. It can include additional incentives such as bonuses, extended notice pay, or other benefits. Employers often offer enhanced severance packages to departing employees, but it’s important to distinguish between redundancy compensation (which is mandatory) and severance pay (which is discretionary). Understanding these distinctions is crucial, especially in relation to UK tax laws that may apply to parts of the severance package.
How is Redundancy Pay Calculated in the UK?
UK redundancy pay follows a legally defined formula based on age, service duration, and weekly pay, subject to a statutory limit. Employees with at least two years of continuous service are entitled to redundancy pay if their job is eliminated.
The redundancy pay calculation is as follows. Employees under 22 receive half a week’s pay per year of service. Employees aged 22–40 receive one week’s pay per year. Employees 41 and older receive 1.5 weeks’ pay per year.
As of 2022, the maximum weekly wage used for redundancy calculations is £571, with a total statutory redundancy cap of £17,130. While redundancy pay is compulsory, employers may enhance severance packages by offering additional payments such as bonuses or holiday pay.
Employee Eligibility for Redundancy Pay
To qualify for redundancy pay, an employee must be made redundant for legitimate business reasons, such as downsizing or restructuring. The redundancy should not be performance-related or due to misconduct, as dismissals for these reasons do not qualify for redundancy payments.
Employees with at least two years of continuous service are entitled to statutory redundancy pay. Employers must also compensate for any outstanding wages, unused holiday leave, and payments in lieu of notice. In cases where 20 or more employees are being made redundant within 90 days at the same location, employers must adhere to collective consultation regulations. Failing to follow these procedures could result in unfair dismissal claims.
Severance tax rules vary depending on the type of payment included in a redundancy package. While statutory redundancy pay is generally tax-free up to £30,000, elements such as salary, bonuses, and notice payments are subject to income tax and National Insurance contributions.
Implementing a Severance Pay Policy
Although severance pay is not a legal requirement in the UK, having a structured severance policy can help employers manage dismissals fairly and efficiently. A well-defined policy ensures transparency, protects the company from legal disputes, and promotes consistency in how severance benefits are offered.
Key considerations when designing a severance policy include:
- Defining eligibility criteria, such as minimum tenure requirements.
- Specifying components of the severance package, including lump sum payments, pension contributions, and bonuses.
- Requiring employees to sign a severance agreement waiving legal claims against the employer.
Employers should also be aware of tax obligations when structuring severance packages. While redundancy payments up to £30,000 are tax-free, other elements—such as bonuses and accrued holiday pay—are taxable. To avoid tax-related disputes, employers should ensure compliance with HMRC regulations.
How is Severance Taxed in the UK?
Since severance pay is not legally mandated, its structure and tax treatment vary. Many employers offer severance packages to support employees and maintain positive working relationships.
Unlike redundancy pay, which follows a statutory formula, severance payments are typically negotiated based on factors such as the employee’s tenure and salary. However, tax considerations play a crucial role in structuring severance packages.
- Redundancy pay up to £30,000 is tax-free.
- Payments for unused holiday leave, bonuses, and notice pay are subject to standard income tax and National Insurance contributions.
How to Calculate Severance Pay
Employers should clearly communicate tax liabilities to employees so they understand how much of their severance package will be taxed.
A structured approach can help employers determine fair severance payments. Many businesses use a basic formula:
Employee’s Weekly Salary × Weeks of Severance per Year of Service × Years of Employment = Total Severance Package
For example, if an employee earning £600 per week has worked for eight years and the employer offers two weeks of severance per year of service, the total severance would be:
£600 × 2 × 8 = £9,600
However, severance packages may also include other elements such as pension contributions, bonuses, or holiday pay. Employers must consider the tax implications when calculating final severance amounts.
How EOR Services UK Can Help
Managing severance pay and redundancy compensation can be complex, especially when navigating tax regulations. Partnering with an Employer of Record (EOR) service can simplify the process by ensuring compliance with UK employment laws, handling payroll, and managing severance payments.
EOR Services UK provides end-to-end HR solutions, including severance management, contract handling, and tax compliance. By outsourcing these administrative tasks, businesses can focus on their core operations while ensuring fair and lawful treatment of employees.