Severance Pay vs. PTO Payout: A Guide to Final Pay Compliance

The final paycheck can be tricky for founders. It’s a moment fraught with legal complexity, where founders often confuse what they might choose to offer with what they must legally pay.

This confusion between severance pay and final wage payments can lead to costly wage theft lawsuits and significant penalties. Understanding the legal definition of an employment termination payment helps you avert risks.

In this article, you’ll learn the differences between the two concepts and your legal duties while issuing a termination payout.

Final Wages and Mandatory PTO Payout

Let's start with what is legally required. Every final paycheck must contain the employee's final earned wages for all hours worked.

The complex part of this calculation, however, is the handling of accrued but unused vacation or PTO. This is not governed by a single federal rule but by state laws.

Earned wage states

In many states, accrued vacation time is legally treated as earned wages, just like an hourly rate. This means it cannot be forgone and must be paid out to the employee in their final paycheck. In these states, a ‘use it or lose it’ policy is illegal.

For example, the California Department of Industrial Relations clarifies that an employer must pay out all vested or accrued vacation time upon termination. Similar laws exist in other states like Illinois and Massachusetts, making this a critical compliance point.

Did You Know? 47% of Americans left their PTO unused in 2024. This is despite 61% of them saying they’d like to have more PTO and 75% of them reporting dissatisfaction with their current amount of leave.

Company policy-governed payouts

In many other states, the law is silent on PTO payout. In these locations, your company’s established, written policy dictates the rule.

If your employee handbook states that unused vacation time is not paid out upon termination, you are not required to pay it. However, if your policy is silent or unclear, you may have to pay.

Severance Pay: A Strategic Benefit, Not a Legal Right

In most cases, severance pay is not a legal requirement. With the exception of some mass layoffs covered by the federal Worker Adjustment and Retraining Notification (WARN) Act, severance is a voluntary payment offered by an employer.

While it’s not legally required, offering severance is a common business practice. The primary reasons to offer severance pay are:

To obtain a release of legal claims

In exchange for a severance package, the departing employee signs a separation agreement, which includes a clause releasing the company from any future legal claims.

To enhance brand reputation

Especially during a difficult layoff, offering severance demonstrates good faith and supports employees during their transition. This helps maintain morale among surviving staff and protects your employer brand.

As per LHH's Severance & Separation Benefits 2024 Benchmarks Study, more than 9 in every 10 employers surveyed (91%) have reviewed their separation and severance policies in the last two years. And 70% of organizations have made their severance packages more generous.

To bridge a transition

For a long-tenured employee, severance can provide a financial cushion while they search for a new role. It acts as a safety net in support of their years of service.

The type of termination also affects this decision. Severance is rarely offered for a termination with cause (e.g., for misconduct). It is most common in layoffs, restructurings, or for senior-level departures. A voluntary termination, such as a resignation, also typically does not warrant a severance package.

Compliant Strategies With a Reliable Partner

Navigating an employee termination requires more than just a final paycheck. It requires a compliant, step-by-step process. At DianaHR, expert HRs turn complexity into clarity.

They manage the entire final payment, ensuring every paycheck is compliant with the specific laws of the state.
They help design and execute strategic severance packages and separation agreements.
They manage the full employee offboarding checklist, ensuring all notices are delivered on time, creating a complete and compliant exit experience.

Let seasoned HR professionals at DianaHR manage HR compliance and paperwork so that you can offer a worry-free farewell to departing employees. Chat with DianaHR.

FAQs

1. What is the legal difference between severance pay and PTO payout?

The key difference is that one is often an obligation, and the other is a choice. PTO payout is a mandatory component of the final employment termination payment in many states, like California and Illinois, where it's considered an earned wage.

Severance pay, however, is not legally required in most individual terminations. It is a discretionary payment offered by a company.

2. My company has an unlimited PTO policy. Do I have to pay anything upon termination?

This is an evolving area of employment law. In states that mandate vacation payout, like California, courts have ruled that unlimited leave policies can't be used to get around the law.

Employers may be required to pay out a reasonable amount, often calculated as the amount of vacation the employee would have accrued under a traditional policy. Because courts are still defining the rules, it's wise to consult with an HR expert to understand your specific obligations under the state law.

3. When is severance pay legally required?

While severance is voluntary for most situations, there is a federal exception. This is the Worker Adjustment and Retraining Notification (WARN) Act. The WARN Act applies to employers with 100 or more employees and requires a 60-day advance notice of mass layoffs or plant closures.

If the company fails to provide this notice, they are generally required to provide 60 days of pay and benefits.