Severance Pay: A Complete Guide for Small Business Owners

Here's a statistic that might surprise you: 72% of employees who are let go don't receive any severance package at all. Yet for the businesses that do offer severance, these packages have become 72% more generous over the past five years. What's driving this dramatic shift, and what does it mean for your small business?

Severance pay sits at the intersection of legal compliance, employee relations, and financial planning. Whether you're navigating your first layoff or establishing policies for future workforce changes, understanding how severance works can protect your business and support departing employees through difficult transitions.

This guide covers everything small business owners need to know about severance pay—from legal requirements to calculating packages to negotiating with employees who push back.

What Is Severance Pay?

Severance pay is compensation provided to employees when their employment ends, typically through layoffs, position eliminations, or company restructuring. Unlike regular wages earned for work performed, severance is a payment made after the employment relationship concludes.

Severance can take several forms:

• Lump sum payment - A one-time payment made on or shortly after the employee's last day
• Salary continuation - Regular paycheck amounts paid over a defined period
• Extended benefits - Continued health insurance, retirement contributions, or other benefits
• Outplacement services - Career coaching and job placement assistance

Most companies use a combination of these elements. The most common arrangement includes cash payment plus continued health benefits for a specified period.

Is Severance Pay Required by Law?

Here's the critical point many business owners miss: federal law does not require employers to provide severance pay. The U.S. Department of Labor explicitly states that severance is "a matter of agreement between an employer and an employee."

However, there are important exceptions:

The WARN Act

The Worker Adjustment and Retraining Notification (WARN) Act requires employers with 100 or more employees to provide 60 days' written notice before mass layoffs or plant closings that affect 50 or more workers. Employers who fail to give proper notice must compensate affected employees for up to 60 days of back pay plus benefits—essentially creating a mandatory severance obligation through the back door.

State-Specific Requirements

New Jersey stands alone as the only state that mandates universal severance pay for qualifying layoffs. Under the expanded NJ WARN Act, private-sector employers with 100 or more full-time employees must provide:

• One week of severance for each year of service (up to 26 weeks maximum)
• An additional four weeks if the employer fails to provide 90-day advance notice
• No exemption for economic hardship—employers must pay regardless of financial difficulties

Maine requires severance when employers relocate or terminate operations at facilities with 100 or more employees, providing one week of pay for each year worked.

Massachusetts requires severance payments specifically when employers violate WARN Act notice requirements.

Illinois mandates severance for certain public employees through collective bargaining agreements, though private-sector workers aren't covered.

Contractual Obligations

Even without legal mandates, you may be required to pay severance if:

• An employment contract specifies severance terms
• Your employee handbook contains a severance policy
• Collective bargaining agreements include severance provisions
• You've established a consistent practice of paying severance (which can create an implied contract)

This last point is crucial. If your company has historically provided severance to departing employees, suddenly stopping that practice could expose you to legal claims.

How Much Severance Should You Offer?

Severance amounts vary widely based on industry, company size, position level, and tenure. Here are the most common calculation methods:

By Position Level

According to recent industry benchmarks:

• C-suite executives: Average of 16 weeks
• Directors: 15 weeks
• Managers: 13 weeks
• Supervisors: 12 weeks
• Exempt employees: 9 weeks
• Non-exempt employees: 8 weeks

By Tenure

The most widely used formula ties severance to years of service:

• Upper management: One month's salary per year of service
• Mid-level employees: Two weeks' pay per year of service
• Entry-level employees: One week per year of service
• Minimum threshold: Some companies offer one to two weeks regardless of tenure

Example calculation: A mid-level employee earning $75,000 annually ($1,442 weekly) with 5 years of service would receive:

• At 2 weeks per year: $1,442 × 2 × 5 = $14,420
• At 1 week per year: $1,442 × 1 × 5 = $7,210

Market Benchmarks

For context, the most common average severance package at U.S. listed companies is approximately $40,000 per employee. Tech workers average higher at $75,000. However, these figures include large corporations—small business packages typically run smaller.

About 25% of employers offer one week of severance for each year of service. Only 25% of U.S. firms make all employees eligible for severance in the event of a layoff.

Creating a Severance Policy

Having a documented severance policy protects both your business and your employees. Yet only 43% of organizations have written guidelines for their severance plans—up from just 31% in 2020, but still surprisingly low.

What Your Policy Should Include

Eligibility criteria:

• Which employee categories qualify (full-time, part-time, contractors)
• Minimum tenure requirements
• Circumstances that trigger severance (layoffs, position elimination, company closure)
• Circumstances that disqualify employees (termination for cause, voluntary resignation)

Calculation method:

• Formula for determining payment amount
• Any caps or minimums
• How position level affects calculations
• Treatment of partial years

Additional benefits:

• Health insurance continuation (beyond COBRA obligations)
• Outplacement services
• Reference letters or recommendations
• Equipment the employee may keep

Procedural requirements:

• Release agreement requirements
• Timeline for payment
• Review and revocation periods
• Confidentiality expectations

Employer rights:

• Ability to modify the policy
• Discretion in unusual circumstances
• Process for handling disputes

Release Agreements

Most employers require departing employees to sign a release of claims in exchange for severance. This release typically waives the employee's right to sue the company for wrongful termination, discrimination, or other employment-related claims.

Important timing requirements:

• Employees over 40 must receive at least 21 days to review agreements that release age discrimination claims
• All employees must have 7 days to revoke their signature after signing
• Agreements must be written in plain language the employee can understand

A well-structured release agreement significantly reduces your litigation risk. Employees who receive fair severance packages are less likely to pursue legal action or speak negatively about your company.

The Business Case for Severance

Severance pay represents a significant expense, so why offer it at all when not legally required?

Reduced Litigation Risk

Disgruntled former employees can file expensive lawsuits even when claims have little merit. Defense costs alone can exceed what a reasonable severance package would have cost. The release agreement that accompanies severance eliminates most legal exposure.

Reputation Protection

In the age of Glassdoor reviews and social media, how you treat departing employees affects your ability to recruit new ones. Companies known for generous severance attract better candidates and maintain stronger employer brands.

Remaining Employee Morale

Current employees watch how you handle layoffs. Treating departing colleagues fairly signals that the company values its people—reducing anxiety and preserving productivity among those who remain.

Competitive Positioning

With 68% of large companies offering severance compared to only 29% of small businesses, providing this benefit can differentiate you in talent acquisition. Prospective employees increasingly ask about severance policies during interviews.

Tax Implications

Severance pay is treated as ordinary income for tax purposes. This means:

For employers:

• Severance payments are tax-deductible business expenses
• You must withhold federal income tax, Social Security, and Medicare taxes
• Report payments on the employee's W-2 form

For employees:

• Payments are subject to income tax at the employee's marginal rate
• Social Security and Medicare taxes apply
• Large lump sums may push employees into higher tax brackets

One negotiation point employees sometimes raise: spreading payments across two tax years or structuring them as installments can reduce the tax burden for the recipient while costing the employer nothing additional.

Handling Negotiations

Even with a clear policy, employees may push for better terms. Here's how to handle these conversations:

When to Be Flexible

Consider negotiating beyond your standard offer when:

• The employee has potential discrimination or wrongful termination claims
• The termination was sudden or particularly difficult
• The employee has unique knowledge or relationships that require careful transition
• You need the employee's cooperation during the transition period

What's Typically Negotiable

Beyond the base payment, employees often seek:

• Extended health insurance coverage
• Outplacement services
• Positive reference letters with specific language
• Extended stock option exercise periods
• Modification of non-compete clauses
• Earlier payment dates

Setting Boundaries

It's reasonable to:

• Require a signed release agreement for any severance payment
• Decline requests that would create inequity among similarly situated employees
• Refuse to negotiate terms that expose you to legal risk
• Maintain confidentiality requirements

The average negotiation takes three to six weeks. Build this timeline into your planning when possible.

Common Mistakes to Avoid

Inconsistent application: Offering different severance amounts to employees in similar situations—especially if differences correlate with protected characteristics like age, race, or gender—creates discrimination liability.

Verbal promises without documentation: Anything you commit to should be in writing. Verbal assurances can create enforceable obligations and lead to disputes about what was actually promised.

Pressuring employees to sign quickly: Rushing employees, especially those over 40, violates legal requirements and can void the release agreement entirely.

Forgetting about benefits continuation: Beyond severance pay, you must comply with COBRA requirements and pay out accrued vacation time in states that require it.

Ignoring your own policy: If you have a written severance policy, follow it. Deviating from documented procedures weakens your legal position.

Tracking Severance Expenses

Severance payments can significantly impact your financial statements, especially during restructuring or downsizing. Proper accounting treatment depends on whether the expense is:

• Routine: Part of normal business operations, expensed as incurred
• Restructuring-related: May need to be accrued and disclosed separately
• Contractual: Recognized as a liability when the obligation becomes probable

Tracking severance expenses by department, reason for termination, and employee category helps you analyze patterns and plan for future workforce changes. This data also demonstrates consistent policy application if your practices are ever questioned.

Keep Your Financial Records Clear

Managing severance expenses, final paychecks, benefits payouts, and tax withholdings requires careful record-keeping. Beancount.io provides plain-text accounting that gives you complete visibility into these expenses—track severance by employee, department, or reason for separation, and maintain records that are audit-ready and easy to understand. Start for free and bring clarity to your business finances.