Severance pay

The most important things at a glance:

• In only a few cases is severance pay mandated by law.
• In practice, a severance payment is regularly agreed upon in a termination agreement. However, there is no statutory entitlement to this.
• The severance payment must be taxed. However, the lump-sum taxation rule ("Fünftelregelung") according to § 34 EStG can lead to tax relief.
• Particular attention should be paid to the crediting towards unemployment benefits as well as the blocking periods for receiving unemployment benefits.

Note: The term „employee“ below includes all genders (m/f/d) and is used for improved readability..

What is severance pay?

Severance pay is compensation for the loss of employment. Severance pay is a one-time monetary payment and is made by the employer to the employee. It is legally regulated in various places and plays a significant role in labor law practice.

Is there a legal right to severance pay?

No. Severance pay upon termination of employment is only explicitly required in a few statutory cases. However, as a rule, the employee has no claim severance pay. The most common exception in practice is severance pay in case of operational termination according to § 1a KSchG (Protection Against Dismissal Act).

The employer can offer redundancy pay in the termination letter.

This may seem surprising at first glance: Isn't it true that severance payments are often agreed upon in practice?

That is correct, but it is related to the fact that in many cases, the employer voluntarily agrees to pay severance pay to avoid a legal dispute. More on individual cases shortly.

A severance package can be contractually agreed upon in several ways:

A severance payment can be agreed upon in a company social plan or in a judicial or out-of-court settlement. This is the only way to create a Entitlement to severance pay.

In addition, a severance payment can also be stipulated in a termination agreement when an employment relationship is terminated. However, the employer is not obligated to agree to a severance payment in the termination agreement. Since the employer may have an interest in terminating the employment relationship, they agree to voluntarily pay a severance payment in these cases.

Redundancy severance package

In cases of operational dismissal, the employer can offer severance pay in the termination letter if the employee waives the right to file a lawsuit challenging the dismissal in return. The prerequisite for this is that the employer must expressly state in the termination declaration that the dismissal is based on urgent operational requirements and that the dismissed employee is entitled to severance pay upon expiration of the notice period. The employer can make this payment conditional on the employee not filing a lawsuit challenging the dismissal. By waiving the lawsuit, the employee accepts the dismissal and receives compensation for the loss of their job in return. However, if the employee files a lawsuit challenging the dismissal, they are contesting the validity of the dismissal, and the employer's offer becomes invalid.  

Severance pay amount for operational redundancy

The amount of severance pay upon termination according to § 1a KSchG is a maximum of 0.5 gross monthly salaries per year of employment. This is stated in § 1a II KSchG.

A small calculation example for clarification:

An employee has been working for a company for 20 years. Their gross monthly salary is €3,500.

This results in: 0.5 * 3,500 (=gross monthly salary) * 20 (=number of years employed at the company) = €35,000

NoteBy the way, you can find a detailed article on dismissal for operational reasons here: Redundancy dismissal.

Severance payment according to social plan

Severance pay can be determined in the so-called social plan in the event of company changes according to sections 111 and 112 of the Works Constitution Act (BetrVG). This becomes relevant in practice when the entire company or essential parts of a company are shut down, and a certain number of jobs are eliminated.

Severance pay in judicial or out-of-court settlement

The action for protection against dismissal itself does not establish a claim to severance pay. However, in the majority of legal disputes, the parties agree on a court settlement within the framework of a dismissal protection procedure, which stipulates that the employment relationship will be terminated upon payment of severance pay. This has the advantage for the parties that the costs of a protracted legal dispute are avoided. 

NoteYou can find a detailed article about unfair dismissal lawsuits here: Unfair dismissal lawsuit.

Severance in Dismissal Protection Proceedings: Termination Judgment

In the context of a protection against dismissal procedure, there is a possibility that the court may order a severance payment through a dissolution judgment. The prerequisite for this is that the dismissal issued by the employer is invalid, but it is no longer reasonable for the employee to continue the employment relationship because the necessary basis of trust no longer exists. However, the requirements for this are very high. The severance payment through a dissolution judgment arises from § 9 (1) of the Protection Against Dismissal Act (KSchG). The amount of the severance payment will generally not exceed 12 months' salary, see § 10 (1) of the Protection Against Dismissal Act (KSchG).

Severance pay in a termination agreement

There is no legal entitlement to severance pay in a mutual termination agreement. However, severance pay is often agreed upon in practice. This is particularly the case when the mutual termination agreement originates from the employer.

Severance pay amount in termination agreement

In the case of termination agreements initiated by the employer, the severance pay is generally based on the rule of thumb of 0.5 of gross monthly salary per year of employment.

However, this value serves only as a guideline in individual cases and may deviate from it. The actual severance pay depends primarily on the following factors:

• The employer's interest in the (prompt) termination of the employment relationship
• The employee's prospects of success in the event of termination protection proceedings instead of a severance agreement
• The employer's financial means
• How quickly the employee finds a new job
• The parties' skill in negotiations

This leads to practical values fluctuating between 0.25 and sometimes up to 2.0, depending on the aforementioned points and their weighting in the specific individual case.

Calculation example for severance pay: An employee was employed by a company for over 30 years. His gross monthly salary from his work at the company was €3,000. With a factor of 0.5, this results in: 0.5 * €3,000 (gross monthly salary) * 30 = €45,000.

Using a factor of 0.25, the severance pay would be €22,500. With a factor of 1.0, it would be €90,000. As you can see, the actual amount of severance pay can therefore fluctuate significantly.

Note: A detailed article on termination agreements from an employer's perspective can be found here: Termination agreement employer. For a detailed article on the termination agreement from an employee's perspective, click here: Termination agreement employee.

Does the employee have to pay social security contributions on the severance pay?

No. According to § 14 SGB IV, severance pay is compensation for the job and not wages. Therefore, no social security contributions are due. Contributions to health insurance, pension insurance, unemployment insurance, or long-term care insurance are not payable.

Tax implications

The severance payment has implications for income tax. This is because receiving severance pay also increases the employee's gross annual income for the year in question. This may result in reaching the next tax bracket. An exception, of course, applies if the employee is already paying the top tax rate.

Due to this tax burden, the legislature has established the so-called „one-fifth rule“ in the Income Tax Act. This can be found in § 34 of the Income Tax Act.

Within the framework of the "Fünftelregelung" (a special tax rule in Germany), severance pay is treated as if it were not paid all at once in one year, but rather distributed over five years. This reduces the tax burden, and the recipient of the severance pay typically no longer falls into the next higher tax bracket.

This, of course, only makes sense if the employee - as noted above - does not already pay the top tax rate, as in this case splitting it over 5 years brings no benefit. This threshold is currently around €53,000 gross annual income for single individuals and €106,000 for jointly assessed spouses.

Important: To claim the fifths calculation, an application must be submitted to the tax office.

Caution: Severance pay offset against unemployment benefits

In principle, severance pay is not offset against unemployment benefits.

However, there is an important exception here: If the employee leaves before the ordinary notice period expires (because they agreed with the employer in the context of a termination agreement not to wait for the notice period to expire), the severance pay will be offset against unemployment benefit I.  

Example for clarification: The standard notice period for an employee who has been employed for 12 years is 5 months/at the end of the month. If he is terminated on February 1, 2020, the employment relationship will end on July 31, 2020. Instead of termination, the employee in question and his employer agree in a mutual termination agreement that the employment relationship will end as early as April 1, 2020. This date is before the expiry of the actual notice period. Accordingly, severance pay will be offset against unemployment benefits in this case.

The exact formula for the credit is complicated. It uses the gross monthly salary, the severance payment amount, and the period of early termination. A specialist lawyer for labor law can explain the exact calculation for your specific case.

Caution: Deadlines for unemployment benefits

In the context of a termination agreement with severance pay, there is a risk of a „block period“ imposed by the Employment Agency. This means that unemployment benefit entitlement will be suspended for a period of at least 12 weeks.

The reason for this waiting period is that the employment agency assumes that an employee has culpably terminated the employment relationship in the case of a voluntary termination of employment (termination agreement = mutual consent). Employees who culpably terminate the employment relationship should not receive money from the state as well. Therefore, in these cases, it is necessary to show the employment agency that the employment relationship would have been terminated anyway without signing the termination agreement, for example, because a dismissal for operational reasons was pending (for which the employee is not to blame).

Another prerequisite for avoiding the waiting period (during which no unemployment benefit is paid either) is that the termination agreement does not end the employment relationship before the date of an otherwise issued employer termination.

However: For the employee, the waiting periods are naturally only relevant if they depend on receiving unemployment benefits. If they have already found a new job that they can start immediately, the waiting periods naturally pose no problem for the employee if they do not wish to claim unemployment benefits.

Conclusion

In labor law, severance pay plays a significant practical role. Employees regularly have an interest in achieving the highest possible severance pay upon the (unwanted) termination of their employment relationship. However, there are a multitude of regulations to consider that can have implications for social security and tax law.

Employers are well-advised to consult with a specialist lawyer for labor law before issuing a termination or presenting a severance agreement to avoid making legal and strategic mistakes.

If the termination has already occurred, specialist lawyers for labor law have the necessary practical experience in strategic negotiations and litigation. Only in this way can costly mistakes be avoided during potential dismissal protection proceedings and severance negotiations, mistakes that would entail a high financial burden.

For employees, the pressure is usually even higher when a termination is issued: If the termination is to be contested, there is only a 3-week period from the date of receipt of the termination, which must be strictly adhered to. Expensive mistakes often happen here, for example, because employees prematurely sign a termination agreement, react emotionally, and do not fully exploit their negotiating position. As Specialist lawyers for labor law we are also here with our many years of experience to minimize risks for employees and achieve a high severance payment.