Guide to Severance Pay Taxation: Rates & How to Calculate It

What Is Severance Pay?

‍Severance pay is a type of compensation package given to employees when their job ends, usually due to layoffs, redundancies, or mutual agreements – it can be a lump-sum payment or paid periodically.

While not always required by law, many employers offer severance packages to support employees as they leave the organization and to avoid potential legal fallout. 

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Why do Employers Offer Severance Packages?

 There are a few main reasons companies provide severance:

• In some places, severance is legally required, especially during mass layoffs. For example, many countries in Europe and Latin America require severance pay as part of the termination process.
  
  
• Providing severance and ongoing support helps keep things positive between the company and departing employees. Employees who leave a company on bad terms are likely to share their negative experiences, harming the company reputation and its ability to attract top candidates in the future.
  
  
• A well-planned severance package can prevent legal trouble down the line and ensure relevant local tax rules are followed.

If severance is handled incorrectly, companies may face fines, audits, or even disputes with employees. For global companies that operate in multiple countries, it’s especially important to research local tax laws and stay compliant when issuing severance packages.
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Get Playroll's guides to country-specific termination laws

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What is Typically Included in a Severance Package?

‍ A severance package might include:

• Lump-Sum Severance Pay: This is a one-time payout provided to an employee upon termination, often calculated based on the employee’s length of service and salary. For instance, a company might offer two weeks of pay for each year of service. So, an employee with five years at the company could receive ten weeks of pay.
  
  
• Salary Continuation: Salary continuation involves the employer maintaining the employee's regular paychecks for a specified duration post-termination. This approach can provide a sense of ongoing income stability.

For example, an employee with a weekly salary of $1,000 and five years of service might continue to receive their regular pay for ten weeks, aligning with a severance policy of two weeks' pay per year of service.

• Payouts for Unused Time Off: Paying employees for any vacation or sick leave they didn’t use. For example, if an employee has ten unused vacation days, they would receive payment equivalent to ten days' wages.
  
  
• Continued Benefits: Some severance packages extend health insurance or other benefits for a limited time post-termination. For example, an employer might cover health insurance premiums for two months after the employee's departure.
  
  
• Career Support: Outplacement services are often included to assist former employees in finding new employment. These services may include resume writing assistance, interview coaching, and job search support.
  
  
• Legal Agreements: Severance agreements may contain clauses like non-compete or confidentiality agreements to protect the company's interests. For instance, an employee might agree not to work for a direct competitor for six months following their departure.

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Is Severance Pay Taxable?

Yes, in most jurisdictions severance pay counts as taxable income. It’s often taxed like regular pay, with income tax and possibly social security contributions taken out.

How Severance Pay is Taxed

 Severance package tax rules depend on the country and how the payment is set up. Here are some general tax implications to keep in mind:

• Income Type: Severance pay is typically considered a form of supplemental income, though this can vary by jurisdiction. It is subject to taxation, though the rates and methods of taxation also differ based on region.
  
  
• Withholding Requirements: 

Employers are generally required to withhold applicable taxes from severance payments. This can include:

Income Tax: Withheld based on the employee's tax status and local tax laws.

Social Security Contributions: Depending on the country, both employer and employee may contribute.

Other Deductions: This can include unemployment insurance or pension fund contributions, as mandated by local regulations.

• Lump-Sum vs. Installments: Receiving a large severance payment in a single lump sum payment may push an employee into a higher tax bracket for that year, potentially resulting in a higher overall tax liability.

Distributing severance pay over several periods may help mitigate this effect, keeping the employee's income within a lower tax bracket.

• Flat Rate vs. Progressive:

To simplify the withholding process, tax authorities often set a flat withholding rate for such payments. For instance, in the United States, the IRS mandates a flat federal withholding rate of 22% on severance pay, regardless of the employee's usual tax bracket . This approach contrasts with the graduated tax system applied to regular income, where the rate increases progressively with higher income levels.

The flat rate provides a straightforward method for employers to calculate and withhold taxes on severance payments.
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How Severance Pay Is Taxed in Key Countries (+ Examples)

Let's deep-dive into the severance tax rate for the U.S., and other countries including the United Kingdom, Canada and Germany for comparison:

• United States:

Severance pay is considered "supplemental wages" by the IRS. Employers typically withhold federal income tax at a flat rate of 22% for such payments. However, if the severance exceeds $1 million in a calendar year, the withholding rate increases to 37%.

Social Security and Medicare: These are withheld at 6.2% for Social Security and 1.45% for Medicare, up to the annual wage base limit for Social Security. There is no wage base limit for Medicare .

State Taxes: Vary by state. Some states tax severance pay as regular income, while others may have different rules or exemptions.

For example, if an employee receives a $50,000 severance they would have $11,000 withheld for federal income tax (22%), $3,100 for Social Security, and $725 for Medicare, totaling $14,825 in federal withholdings.

• United Kingdom:

The first £30,000 of a severance payment may be exempt from income tax. This exemption applies to statutory redundancy pay, additional severance, and non-cash benefits .

National Insurance Contributions (NICs): No employee NICs are due on the first £30,000. However, employer Class 1A NICs at 13.8% apply to amounts exceeding £30,000 .

For example, let’s say an employee receives a £35,000 severance package. The first £30,000 is tax-free, and the remaining £5,000 is subject to tax and NICs.

• Canada:

Severance pay is fully taxable at both federal and provincial levels.

RRSP Transfer: Employees may transfer a portion of their severance (up to a certain limit) directly into a Registered Retirement Savings Plan (RRSP) to defer taxes. This transfer must be done within 60 days of the end of the year in which the severance was received .

For example, if an employee receives a $20,000 severance they can transfer up to $20,000 into their RRSP, deferring paying tax on that amount until withdrawal.

• Germany:

Severance pay is subject to income tax in Germany. However, there is a special tax treatment known as the "one-fifth rule" (Fünftelregelung), which can reduce the tax burden by spreading the income over five years for tax calculation purposes .

For example, an employee receives a €50,000 severance. Under the one-fifth rule, the tax is calculated as if the severance were spread over five years, potentially lowering the marginal tax rate applied.

• India:

Severance pay is taxed under “Income from Salary." 

Exemptions include the following:

Section 10(10C): Compensation received under a Voluntary Retirement Scheme (VRS) is exempt up to a maximum of ₹5 lakh, subject to certain conditions .

Section 89: Provides relief on salary received in arrears or in advance, which may apply to severance pay received in installments .

For example, an employee receiving ₹6 lakh as severance under VRS would be exempt from tax on ₹5 lakh, with the remaining ₹1 lakh subject to tax.
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How Is Severance Pay Calculated?

Severance pay is usually calculated as one week’s pay for every year an employee has worked continuously with the same employer. Use this easy severance pay calculator:

Basic Formula: 

Severance Pay = Weekly Salary × Years of Service, representing one week’s pay per year of service.

For example, if someone has worked for 5 years and earns $1,000 per week, their severance pay would be $5,000.

Some employers may offer more generous severance packages, depending on things like the employee’s role, length of service, or company policies. For example, certain companies might offer two weeks’ pay for each year worked, especially for senior employees or those who’ve been with the company for a long time. 

If you offer more than one week’s pay per year of service, follow this formula:

Severance Pay = Weekly Salary × Number of Weeks × Years of Service

In this example, an employee with a $1,000 weekly salary and 5 years of service would receive:

$1,000 × 2 × 5 = $10,000

Severance packages can also include extra benefits such as payment for unused vacation days, bonuses, or continued health insurance, which can make the overall package even more valuable.

Be mindful of local tax laws and consider how taxes affect employees when putting together severance packages. Offering a well-rounded severance package not only helps employees during their transition but also shows your commitment to treating workers fairly and ethically.

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Severance Tax and Payroll Compliance

Not following relevant local laws around severance pay can lead to costly penalties and harm the company’s reputation. To stay compliant with severance pay and tax rules, follow these few key practices:

Report Severance Pay Accurately: Make sure severance pay is properly reported on the right tax forms, like the W-2 in the U.S., so everything is in order for tax authorities.

Withhold Taxes: Ensure the correct amount of taxes are withheld from severance payments, such as  income, social, federal, state, and local tax. For example, this would include social security and Medicare contributions in the U.S.

Keep Records: Keep detailed records of severance agreements and payments. These documents are essential if an audit comes up or to settle any future disputes.

Use the Right Tools: Leverage automated payroll software to accurately calculate taxes and manage payments. This helps prevent human error and ensures everything stays compliant.

It’s a good idea to work with experts in global employment and compliance such as Playroll, who can provide hands-on guidance for tricky severance situations.
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Simplifying Severance Pay with Playroll

Calculating severance pay taxes is tricky for employers managing a distributed team. Partnering with global employment experts like Playroll can help in the following ways:

• Automate payroll deductions: Make calculating payroll taxes for severance pay easier with automation, reducing the chance of tax filing mistakes or errors by ensuring the correct amount of taxes are withheld.
• Stay compliant across regions: With tax laws varying by state, region, or even city, our system adapts automatically to local tax requirements, ensuring compliance wherever your employees are.
• Expert support: Our team stays on top of changing regulations, and our legal experts are always ready to make sure terminations are handled properly and smoothly for both employees and employers.
• Spot discrepancies: Our payroll management tool, with built-in controls, helps you proactively identify and resolve issues in payroll reconciliation.

Book a chat with our team to learn how we can help streamline your global payroll processes and make issuing severance pay easy.