What is Severance Payment? How is Severance Payment Calculated?

Key takeaways

• Severance pay eligibility requires at least 24 months of continuous service and specific termination conditions, mainly redundancy situations.
• When you calculate severance pay, follow a strict formula of two-thirds of wages multiplied by years of service, with a maximum cap of $390,000 per employee.
• The May 1, 2025 end of MPF offsetting changes employer liability, removing the ability to offset mandatory retirement contributions against severance obligations.
• Missing payment deadlines and calculation requirements carries severe financial penalties, making proper process management essential for legal protection.

Severance payment is a legal financial obligation that employers must provide to employees whose employment is terminated under specific circumstances. This payment helps bridge the gap between employment and the employee’s move to new opportunities, but it is not a universal right. Understanding when and how these obligations arise is key to effective workforce planning and financial risk management.

The concept centers mainly around redundancy situations – circumstances where business needs change rather than employee performance issues. Redundancy occurs when an employer closes or plans to close the business, stops operations in a particular location, or has less need for certain types of work. These situations trigger severance obligations because the termination comes from business decisions rather than individual employee actions.

Who is eligible for severance pay?

Not every terminated employee qualifies for severance payment, and understanding these eligibility rules is crucial for accurate financial planning and legal compliance.

Basic eligibility requirements:

• At least 24 months of continuous service under employment contract
• Termination due to redundancy, lay-off, or non-renewal of fixed-term contract due to redundancy
• Not dismissed for serious misconduct

Employees dismissed for serious misconduct lose their right to severance payment, regardless of their length of service. This provision protects employers from having to provide financial support to employees whose actions warranted immediate termination. Similarly, employees who voluntarily resign under normal circumstances are not entitled to severance payments, though specific exceptions exist for resignations due to ill health or employees aged 65 and above.

The distinction between employee turnover types, like voluntary and involuntary separation or layoffs vs firing  becomes particularly important in borderline cases. Employees who refuse reasonable alternative employment offers may also lose their right to severance payments, provided the employer follows proper notification procedures and the alternative offer meets specific reasonableness criteria.

How is severance pay calculated?

How do companies calculate severance pay follows a precise legal formula that varies significantly depending on when the employment relationship began and ended, particularly in relation to the critical transition date of May 1, 2025.

1. The core calculation formula

For employees whose service does not cross the May 1, 2025 transition date, calculate a severance package remains straightforward:

1. Monthly-paid employees: (Last full month’s wages × 2/3) × Years of service
2. Daily/piece-rated employees: (Any 18 days’ wages from last 30 working days) × Years of service

However, employees whose service crosses the transition date face a more complex calculation split into two portions:

1. Pre-transition portion: Uses wages immediately before May 1, 2025
2. Post-transition portion: Uses wages immediately before actual termination date

This split approach reflects significant changes in the rules that directly impact employer obligations. Service calculations include provisions for incomplete years on a pro-rata basis, ensuring fair treatment regardless of termination timing. Employees also have the option to use their average wages over the 12 months before either the transition date or termination date, potentially maximizing their entitlement where wage changes have occurred.

2. Payment caps and limits

Financial exposure is controlled through a comprehensive cap system designed to balance employee protection with employer predictability. 

The maximum severance payment is limited to $390,000 per employee, regardless of salary level or years of service. This cap applies to the total payment, meaning that for employees with both pre-transition and post-transition service, the combined amount cannot exceed this threshold.

When the calculated amount exceeds $390,000, the excess is deducted from the post-transition portion, effectively prioritizing the pre-transition calculation. Additionally, individual payment components are capped at two-thirds of $22,500, or $15,000, ensuring that extremely high earners do not receive disproportionate individual payment calculations.

3. The MPF offsetting arrangement

The May 1, 2025 transition represents a fundamental shift in how employers can manage severance payment obligations through retirement scheme contributions. Prior to this date, employers could offset severance payments against their mandatory contributions to employee retirement schemes, significantly reducing actual cash payments.

Key changes from May 1, 2025:

• Mandatory MPF contributions can no longer be used to offset severance payments
• Voluntary MPF contributions and service-based gratuities remain available for offsetting
• Employers must budget for full severance payment obligations for post-transition service periods

This change has major implications for financial planning. Employers must now budget for full severance payment obligations for post-transition service periods, representing a substantial increase in potential liability. The government has introduced a subsidy scheme to help eligible employers manage this transition, but the fundamental shift toward increased employer responsibility remains.

4. The payment process and timelines

Strict procedural requirements govern both the claiming and payment of severance entitlements, with significant penalties for non-compliance. When you calculate severance pay tax, remember that these payments are subject to appropriate deductions for income and Social Security taxes.

Critical deadlines:

1. Employee claim deadline: Written notice to employer within 3 months of dismissal/lay-off
2. Employer payment deadline: Maximum 2 months after receiving employee notice
3. Penalty for non-compliance: Prosecution liability and fines up to $50,000

The payment process requires careful documentation and adherence to proper procedures to ensure legal compliance and avoid disputes. Understanding proper labor contract provisions helps ensure your employment agreements clearly outline severance obligations from the start. For employees claiming severance on grounds of ill health, additional medical certification requirements apply, including provisions for second medical opinions at the employer’s expense. These procedures ensure that claims are legitimate while providing appropriate safeguards for both parties.

Frequently asked questions

Can an employee receive both a severance payment and a long service payment?

No. An employee is not entitled to receive both payments for the same period of employment. The law stipulates that an employee will qualify for one or the other based on their years of service and the specific reason for their contract’s termination, but not both. Understanding how companies calculate severance pay versus long service payments helps ensure proper compliance and accurate financial planning.

What legally constitutes “redundancy”?

Redundancy is specifically defined as a dismissal resulting from the fact that: (1) the employer closes or intends to close the business; (2) the employer has ceased, or intends to cease, operating where the employee was employed; or (3) the business’s requirement for employees to carry out work of a particular kind has ceased, diminished, or is expected to do so. This definition directly impacts how to calculate a severance package, as redundancy is the primary qualifying condition for severance payments.

What happens if an employer offers to renew an employee’s contract and they refuse?

An employee may forfeit their eligibility for severance or long service pay. If the employer makes a written offer to renew the contract or re-engage the employee at least 7 days before the dismissal or contract expiry, and the employee unreasonably refuses the offer, the employee is not eligible for the payment. Proper seasonal work contracts documentation can help clarify renewal obligations and protect both parties’ interests.

If an employee who is eligible for long service payment dies, who can claim it?

There is a clear order of priority for beneficiaries to claim the long service payment. The claim must be made within 30 days of the employee’s death. The priority is: (1) The spouse of the deceased employee; (2) The children of the deceased employee (divided equally); (3) The parents of the deceased employee (divided equally); (4) The personal representative of the deceased employee’s estate. When you calculate severance pay tax obligations, remember that these payments to beneficiaries may have different tax implications than payments to the original employee.

Proper HR compliance guidance ensures your organization maintains accurate records and follows correct procedures throughout the severance process.

For organizations managing significant workforce transitions, outplacement services can help support departing employees while demonstrating your commitment to ethical workforce management. Additionally, ensuring comprehensive payroll compliance processes will help prevent costly errors and maintain legal compliance throughout severance payment administration.