The 2 Ways to Address Severance Pay

As a nationally recognized provider of payroll and benefits administration services, we deal with just about everything having to do with payroll. Even obscure things, like grossing up severance pay, are things we have to be familiar with. It is our responsibility to make sure that our service is always top notch and up-to-speed.

In light of that, we have decided to discuss severance pay in this blog post. An employer offering severance pay to terminated workers has one of two options for delivering that pay. Employees can be paid straight up or with grossed up severance.

 

Paying Severance Straight Up

A straight up severance package is generally a lump sum payment intended to provide income for a certain amount of time while the terminated employee looks for a new job. For purposes of illustration, let's say that amount is $30,000. The employer would cut a check and give it to the employee upon departure.

The IRS considers severance pay supplemental wages. As such, it is taxed based on supplemental wage rules. The flat rate for supplemental wages in 2018 is 22%, dictating a $6,600 withholding to pay federal income tax. The severance amount will also be subject to standard FICA and state tax withholding.

FICA would amount to 6.2% for both employer and employee. Any state withholding would be subject to the laws in that particular state. And of course, there may be local taxes assessed as well. The point is this: the only difference between straight up severance and regular pay is the rate assessed for federal income tax. Everything else remains the same.

 

Grossing Up Severance Pay 

The other option for making a severance pay is to gross it up. What does this mean? It means taking the base amount and adding an additional amount to cover the employee's taxes. So using that same $30,000 example, the employer might add an additional amount so that, after all taxes are paid, the employee still walks away with $30,000 in his or her pocket.

Grossing up severance pay is something a company might want to do to reward a severed employee who has put in many years of exemplary service. By the same token, an employer might make a policy of grossing up severance pay just because management believes it is the right thing to do. At any rate, grossing up severance pay requires applying a multi-step formula.

In order to gross up pay, the employer must account for:

  • Federal income tax (supplemental rate)
  • Social security tax
  • Medicare tax
  • Any applicable state taxes.

All the individual tax rates are added together to come up with a single rate. For sake of argument, let us say that works out to a total of 35%. The employer would subtract 35% from 100% to arrive at a rate of 65%. Divide $30,000 by 65% and you end up with $46,153. That is the total amount paid to the employee to cover both severance and taxes.

 

Employer Tax Liabilities 

It must be noted that grossing up severance pay does not eliminate employer tax liabilities. So in addition to covering federal income tax, FICA, and any state and local taxes on behalf of the employee, the employer must also contribute its share of Social Security and Medicare taxes.

Grossing up obviously costs a company more than paying straight severance. But some companies believe this is the right thing to do when circumstances beyond anyone's control lead to layoffs, downsizing, etc. Grossing up severance is a way that employers can offer a little more assistance to those being let go.