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Guide for employers: the pitfalls to avoid when using settlement agreements

View profile for James Hodgson
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If you're an employer and need to use a settlement agreement to end a long standing dispute, here is my guide to avoiding the most common pitfalls.

Understand the fundamental purpose of settlement agreements

Under the terms of a settlement agreement, an employer offers a payment to an employee. In exchange, the employee agrees to waive their rights to employment related claims that he or she may be able to pursue in an Employment Tribunal or through the courts, such as a claim for unfair dismissal or discrimination.

Plan ahead

Disciplinary hearing proceedings against an employee can begin in advance of a settlement agreement being offered. This can help to protect an employer’s position in the event the settlement agreement is not signed and can also manage an employee’s expectations. 

However, it’s important to note that in straight forward cases - for example a genuine redundancy - initiating disciplinary proceedings just before a redundancy consultation exercise without a good reason could leave the employer open to claims of unfair dismissal.

Offer the correct severance payment

Payments made under the terms of a settlement agreement (severance payments) typically comprise the following elements:

  • contractual entitlements
  • redundancy pay (if applicable); and
  • compensation for loss of employment / directorship

The compensation element can generally be used as a bargaining tool between employer and employee. This is usually negotiated through the employee’s legal adviser in an attempt by the adviser who will attempt to secure the best severance package for the employee.  To avoid lengthy negotiations, employers should give careful consideration to the payment sum.

In most cases where a compensation payment is paid in addition to the employee’s contractual entitlements, the first £30,000 of the compensation element can be paid to the employee on a tax-free basis.  For higher rate taxpayers this saves the employee £13,500 plus their national insurance contributions. Contractual elements might include notice pay or payment in lieu of notice, any holiday pay accrued and bonuses.

Consider the level of compensatory awards made by an employment tribunal

When considering the level of compensation to pay an employee, bear in mind the level of compensatory awards which can be awarded to successful applicants in an employment tribunal or court. 

Average pay outs in employment tribunals are usually quite modest.  In 2019-2020 the average award for unfair dismissal was £10,812 and for race discrimination the average was £9,801.  In cases of discrimination on the grounds of sex, sexual orientation, disability and age, average pay outs ranged from £17,420 to £38,794. 

Make use of staged payments

To help deter employees from pursuing claims, employers can offer severance payments in the form of staged payments, for example a lump sum payment either 4 or 7 months after the employee’s termination of service date. This coincides with Employment Tribunal timescales for instigating claims.

If the severance payment is paid by instalments (or when there is a time delay between the parties entering into the Settlement Agreement and the employee’s termination date), the settlement agreement should contain a re-statement certificate. This requires the employee to re-state the terms of the settlement agreement either just before the final instalment is paid or the employee’s termination date. This approach is generally reserved for senior employees who could pose a threat to the employer if they were to go on to work for a competitor.                 

Ensure your settlement agreement includes all necessary terms

An effective settlement agreement should contain the following:

  • Termination Date. This is the last day of the employee’s employment. 
  • Termination Payment. Include details of the amount, what it is for and when it is to be paid, including instalment dates, if applicable
  • Holidays. You should detail any payment in lieu of any accrued but untaken holiday
  • Tax indemnity clause. This ensures the employee is liable for all tax on payments made under the settlement agreement. Should HMRC seek to recover sums from the employer, the employer will need to be able to recover the relevant amount from the employee
  • Pension. Details are generally provided by the pension administrator who will also contact the employee to outline alternative options
  • Share Awards. If an employee holds shares, include details about how the shares will vest upon their departure
  • Bonus. Include details of the employee’s eligibility/non- eligibility for bonus awards whether they are discretionary or performance related
  • Company Property. Provide details of any specific company property the employee has in their possession which should be returned to the employer by the termination date. This might include laptops, mobile phones, company vehicles, uniform, office equipment and documents
  • Confidentiality clause. Include details of any information about the employer which should not be disclosed by employees (and to whom the information should/should not be disclosed). It is commonplace for employees to be permitted to disclose information to their legal adviser and their spouse/civil partner, providing they too observe the same confidentiality obligations
  • Reference. An employer may provide a simple reference in an agreed form as an annex to the settlement agreement. Alternatively, within the main agreement, include a statement that a reference will be provided upon request
  • Full and final settlement. The agreement should spell out that the severance package is “in full and final settlement of all and any past, present or future claims”
  • Post-termination restrictions. Any post-termination restrictions which were set out in the employee’s contract of employment should be re-stated.  As well as proving clarification, this enables the employer to refresh any restrictions. Often a nominal payment is paid to the employee in addition to their severance payment, in acknowledgement of the employee entering into post-termination restrictions a second time.  At the time of writing, HMRC do not question the commerciality behind such payments;
  • Without prejudice and subject to contract. The settlement agreement is not enforceable until both parties have signed.
  • Legal fees. Whilst there is no legal requirement to pay an employee’s legal fees, in practice many employers offer a contribution of £300-£600 +VAT.  For more highly paid staff where the restrictions an employer wishes to impose are more complex, higher contributions can be made.Refer to new guidance on non-disclosure agreements (NDAs)

Refer to new guidance on non-disclosure agreements (NDAs)

In November 2020 the Solicitors Regulation Authority (SRA) revised its Warning Notice to provide further guidance on the proper use of NDAs.

The notice includes the following examples of what the SRA considers to be improper use of NDAs:

  • seeking to use an NDA to prevent the proper disclosure about the agreement or circumstances surrounding it to legal professional advisers or medical professionals bound by a duty of confidentiality;
  • using warranties, clawback clauses and/or indemnities to improperly prevent or inhibit permitted reporting or disclosure(s) from being made; or
  • including or suggesting clauses which are known to be unenforceable.

The guidance also states that:

  • the NDA must be clear on what disclosures can and cannot be made and to whom;
  • plain English should be used so that the terms are clear and relevant to the issues and the claims likely to arise;
  • where the agreement is or forms part of a Settlement Agreement, ensuring that the employee is aware of the requirements governing such an agreement i.e. that the employee receives independent advice on its terms; and
  • that the terms of the NDA are provided to clients clearly and ideally in writing so as to avoid any confusion or uncertainty about what is or is not permitted.

The revised Warning Notice also states that neither party should take unfair advantage of the other party and that failure to adhere could result in a breach of professional obligations.   


For a settlement agreement to be correctly administered:

  • the employee must take independent legal advice
  • the agreement must be signed by both the employer and the employee
  • the legal adviser must provide their legal adviser’s certificate

As long as a settlement agreement is entered into correctly is will serve as an effective legal contract which:

  • will become legally binding when signed by both the parties
  • should remain confidential to both parties

For expert advice on all aspects of employment law including severance packages and settlement agreements, disciplinary and grievance issues, employment contracts, handling claims of discrimination, unfair dismissal and redundancy, please contact James Hodgson or Maureen Cawthorn at our Halifax office on 01422 339600.