Payroll tax on severance pay is owed in full in the United States: the IRS treats severance (what some jurisdictions call a redundancy payment) as wages, so Social Security, Medicare, and federal unemployment tax all apply, and federal income tax must be withheld. There is no tax-free threshold and no carve-out for payments tied to a layoff or position elimination.1IRS Publication 525
Why Severance Is Treated as Wages
Federal tax law defines “wages” broadly. Any payment an employer makes to an employee in connection with employment counts, and severance sits squarely inside that definition. IRS Publication 525 states that severance payments are subject to Social Security and Medicare taxes, income tax withholding, and FUTA tax. Ending the employment relationship does not change the character of the payment.
The Supreme Court settled the question for FICA in United States v. Quality Stores, Inc. in 2014. Considering severance paid to workers laid off during bankruptcy, the Court held unanimously that “the severance payments at issue are taxable wages for FICA purposes,” rejecting the argument that payments tied to a job elimination should be treated differently from ordinary compensation.
One boundary worth naming: “redundancy” is a term from Australian and British employment law, and those systems attach specific tax exemptions to redundancy payouts. Those exemptions do not exist in the U.S. Whether the position ended through restructuring, downsizing, or a plant closure, the payment is taxable wages.
FICA: Social Security and Medicare
Both sides pay FICA on severance.
Social Security tax runs 6.2% from the employer and 6.2% from the employee on wages up to the annual wage base, which is $184,500 for 2026. Once a worker’s total compensation for the year passes that cap, further wages, including severance dollars above the cap, are not subject to Social Security tax.
Medicare tax is 1.45% from each side on all wages, with no cap. An additional 0.9% Medicare tax applies to the employee’s share once total Medicare wages exceed $200,000 for single filers or $250,000 for married couples filing jointly. The employer does not match that extra 0.9%.
The wage base mostly matters for higher earners with large payouts. A departing employee whose regular wages already sit near the Social Security cap will see only part of the severance hit by Social Security tax, while every dollar still faces Medicare.
Federal Unemployment Tax
FUTA also applies. The rate is 6.0% on the first $7,000 of wages paid to each employee during the calendar year, and most employers get a credit of up to 5.4% for state unemployment taxes paid, dropping the effective rate to 0.6%. Employers in states with outstanding federal loan balances may see a reduced credit and a higher effective rate.
Because the $7,000 base is low, most employees will already have cleared it through regular paychecks by the time severance is issued. When that is the case, no additional FUTA is owed on the severance. The tax only bites when someone is terminated early in the year before their regular wages have reached the cap.
Federal Income Tax Withholding
The IRS classifies severance as a supplemental wage, which gives employers two withholding options.
The percentage method withholds a flat 22% on severance up to $1 million in total supplemental wages for the year. Anything above $1 million is withheld at 37%.
The aggregate method combines the severance with the employee’s regular pay for the pay period and withholds based on the employee’s W-4 and the IRS wage bracket tables, as if the combined amount were a single paycheck.
Most employers default to the flat 22% because it is simpler. The aggregate method can produce noticeably higher withholding if the combined total pushes the paycheck into a higher bracket. Neither figure is the employee’s final tax liability. The actual tax owed is calculated on the annual return, and any overwithholding comes back as a refund.
Other Termination Payments That Owe Payroll Tax
Severance is rarely the only line on a final check. Several other components carry the same treatment:
- Payment in lieu of notice. If the employer ends the relationship immediately instead of running a notice period, the lump sum paid in place of that notice is ordinary wages subject to all payroll taxes.
- Accrued vacation and PTO. Unused time cashed out at termination is compensation earned during employment. FICA, FUTA, and income tax withholding all apply.
- Bonuses and commissions. Earned but unpaid amounts paid at departure follow the same supplemental wage withholding rules as severance.
Each component should be calculated separately for withholding, even when everything appears on one final paycheck. That keeps W-2 reporting clean.
The Narrow SUB Plan Exception
One structure can shield termination-related payments from FICA and FUTA: a supplemental unemployment benefit (SUB) plan. Under a SUB arrangement, the employer ties payments to the worker’s receipt of state unemployment benefits and pays them in periodic installments rather than as a lump sum. When properly structured, SUB payments are treated as unemployment compensation rather than wages, so neither side owes Social Security, Medicare, or FUTA on them. Income tax withholding still applies.
SUB plans are uncommon. They are complex to administer, the payments cannot be lump sums, the employee must actually be receiving state unemployment benefits, and the plan documents need careful drafting. For a one-off layoff, most employers decide the administrative burden is not worth the FICA savings. For companies eliminating hundreds of positions, the savings can justify the effort.
How Severance Gets Reported
Severance is reported on the employee’s Form W-2 for the year the payment is made, not the year the employee was terminated if those differ. It goes into the same boxes as regular wages: Box 1 for wages, tips, and other compensation, Box 3 for Social Security wages up to the wage base, and Box 5 for Medicare wages. No separate form or special box is required.
For the employer, severance flows into Form 941, the quarterly federal tax return that reports income tax withheld and both shares of Social Security and Medicare taxes. Form 941 is due by the last day of the month following the end of each quarter. FUTA tax is reported separately on Form 940, filed annually by January 31 of the following year.