Is Severance Pay Required for Small Businesses? What Employers Should Know

Federal and most state laws generally do not require businesses to provide severance pay for individual terminations or layoffs. However, an agreement, policy, other commitment, or applicable state law may require it in a particular situation.

Even the smallest employers experience layoffs and discharges: from May through July 2026, private-sector establishments with fewer than 10 employees recorded roughly 200,000 to 300,000 layoffs and discharges a month, according to the Bureau of Labor Statistics.

If you pay cash severance, the IRS generally treats this as ordinary taxable wages you  process as wages through payroll, including when you use payroll software such as SurePayroll® By Paychex.

What federal employment law says about severance pay

The federal Fair Labor Standards Act (FLSA) doesn't require you to pay severance. The U.S. Department of Labor describes severance pay as "a matter of agreement between an employer and an employee (or the employee's representative)." Severance is pay beyond the wages an employee already earned for work performed, and it may be based on length of service. Your agreements, policies, and other commitments may create a severance obligation even though the FLSA doesn't. Applicable state law may also require severance in some circumstances.

How business size can affect layoff requirements

If you have fewer than 100 employees, federal WARN generally doesn't apply to your business. State layoff and closing requirements can have different thresholds, so check your state's rules with your state labor department before a layoff or closing.

The Worker Adjustment and Retraining Notification (WARN) Act generally applies beginning at 100 employees under its statutory counting rules, and it requires covered employers to give advance written notice before a plant closing or mass layoff. If you are covered and don't give the required notice, you can owe affected employees back pay and benefits. Those payments are remedies for missing the required notice, not federally required severance.

Very small businesses make up a substantial part of the employer landscape: about 5.7 million U.S. employer firms had fewer than 20 employees in 2022, according to the SBA Office of Advocacy.

When a small business may be required to pay severance

You may owe severance because of terms in an offer letter, employment agreement, handbook, or other commitment, even when the federal WARN Act doesn't apply. State law may also create an obligation in limited circumstances. Use the table to identify which sources could apply to your business and what to review next.

Start with the exact language in your documents and review how you've handled similar separations. An offer letter, handbook, or prior severance practice may affect employee expectations and, depending on the facts and applicable law, may also be relevant to whether you have a severance obligation. If your documents or past practice leave the answer unclear, have an employment lawyer review them.

How severance differs from final pay and accrued PTO

Severance, the final paycheck, and accrued paid time off (PTO) are separate payments, and different rules determine when you owe each.

• Final paycheck. The final paycheck covers wages the employee already earned. Federal law doesn't require you to pay it immediately, but deadlines vary by state. See how to issue a final paycheck for what goes into it and when it's due.
• Accrued PTO. Your obligation to pay out accrued, unused PTO or vacation depends on state law and, in some states, your company policy or agreement. In California, for example, if your policy or contract provides paid vacation, earned, unused vacation is treated as wages and must be paid at the employee's final rate of pay when employment ends (California Labor Code §227.3). Your PTO policy sets the terms where state law allows.
• Severance. Severance is pay beyond what the employee earned for work performed. You may have to pay it under an agreement, policy, other commitment, or applicable state law. Otherwise, you can decide whether to offer a severance package.

Offering severance doesn't change what you owe in final wages or PTO payout, and a PTO payout isn't severance.

What to consider when deciding whether to offer severance

When severance pay isn't legally required, you may choose to offer it to provide transition pay after an employee's job ends. You might also offer severance pay in exchange for a written agreement that sets the terms of the separation, including a release of claims when appropriate. If an agreement includes a release, have an employment attorney draft or review it.

Whether offering severance pay makes sense for your business depends on the circumstances of the separation, the employee's service, your cash flow, your existing documents and past practices, and whether you're requesting a signed agreement. Consider five practical questions:

• Why is the employment ending? You may treat an employee who's laid off or whose role is eliminated differently from one who's fired for cause.
• How long has the employee worked for you? You may decide to recognize longer service when setting eligibility or the payment amount.
• What can your cash flow support? Consider both the severance payment and your other near-term payroll obligations before setting an amount.
• What do your documents and past separations show? Review your offer letters, handbook, and prior severance decisions so you can identify existing commitments and consider consistency with similar situations.
• Do you want a signed agreement in return? If you plan to offer severance in exchange for a written agreement that includes a release of claims, have an employment attorney draft or review it.

Approaches to setting a severance amount

You can base a severance amount on length of service, a flat amount, or another method that fits your policy and circumstances. No federal rule sets a standard severance amount.

• Tenure-based. A set amount of pay for each year of service, such as one week of pay per year.
• Flat amount. The same number of weeks of pay for everyone, regardless of tenure.
• Other factors. You may also consider the employee's role or the circumstances of the separation when setting the amount.

Research among larger employers also shows that organizations consider multiple factors. In Randstad RiseSmart's 2025 severance research, U.S. respondents from larger employers cited base salary (40%), tenure with the organization (36%), and agreements made at the time of employment (26%), among others.

As an example of a tenure-based approach, if an employee worked for you for four years at $1,000 a week and you offer one week of pay per year of service, the severance would be $4,000 before taxes.

What to watch for before offering severance

Before you provide a severance package, confirm what your documents require, compare the decision with similar situations, set the amount and payment terms, and put those terms in writing.

• Confirm your documents. Reread offer letters, employment contracts, and your handbook before setting severance terms.
• Check consistency. Compare the decision with how you've handled similar separations, including other employees leaving at the same time.
• Set the amount and payment terms. Decide the amount, how it will be paid, and when.
• Put the terms in writing. Document the amount, timing, and payment method. Have an employment attorney review the severance agreement when legal terms or a release are involved.
• Release of claims. If you ask an employee to sign a release in exchange for severance, have an employment attorney draft or review the severance agreement.

How to pay severance through payroll

You pay cash severance through payroll as wages, following the payment terms in the applicable severance agreement or policy.

You can process cash severance in the same payroll as final wages or in a separate off-cycle payroll, a run outside your regular pay schedule. Either way, identify severance and final wages separately because the payments serve different purposes and may be subject to different requirements.

In SurePayroll, you can run an off-cycle payroll on any plan, review and approve it before it processes, and pay by direct deposit with the same two-business-day lead time as a scheduled run.

Severance payments are wages subject to Social Security and Medicare taxes, federal income tax withholding, and federal unemployment (FUTA) tax, according to IRS Publication 15. As wages, they're reported on the employee's Form W-2, Wage and Tax Statement, as covered in the IRS Form W-2 instructions. State income tax, local tax, and state unemployment tax treatment of severance can vary by state.

To estimate withholding and take-home pay on a severance payment, use the severance pay calculator.

Paying severance with SurePayroll

If you pay severance separately from final wages, you can process it in a separate SurePayroll payroll run. SurePayroll supports unlimited payroll runs with no additional fees, so you can process severance separately without an additional payroll-run fee.

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