Payroll tax on severance pay works the same way as payroll tax on regular wages: employers owe Social Security, Medicare, and federal unemployment tax on the payment, and they must withhold federal income tax before the employee sees the money. The U.S. Supreme Court confirmed in 2014 that severance paid to involuntarily terminated employees counts as wages under the Federal Insurance Contributions Act.1Oyez. United States v. Quality Stores A lump-sum redundancy check cannot be handed over free of the usual payroll tax line items. Every component of the final payout has to be classified, taxed at the correct rate, and reported on the right forms.
Social Security and Medicare on Severance
Both the employer and the employee owe FICA on severance. Social Security tax runs 6.2% on each side up to the annual wage base, which is $184,500 for 2026.2Social Security Administration. Contribution and Benefit Base Medicare is 1.45% each side with no cap. Once an employee’s total wages for the year pass $200,000, the employee also owes an additional 0.9% Medicare surtax on the excess.
Year-to-date wages drive how much FICA actually applies. If an employee already earned $175,000 in regular wages before the layoff and then receives a $40,000 severance package, only the first $9,500 of that severance is subject to Social Security tax, because the $184,500 cap is hit partway through the payment. The full $40,000 remains subject to Medicare. Payroll systems that ignore prior earnings will overwithhold Social Security on the severance.
Before 2014, some employers argued that severance tied to job elimination sat outside the FICA definition of wages. The Supreme Court disagreed, and the IRS now treats all severance as FICA-taxable regardless of whether the separation was voluntary or involuntary.1Oyez. United States v. Quality Stores
Federal Income Tax Withholding
Severance is classified as supplemental wages. The Internal Revenue Code specifically treats payments made because of an involuntary separation from employment as subject to withholding, calling them supplemental unemployment compensation benefits.3Office of the Law Revision Counsel. 26 USC 3402 – Income Tax Collected at Source
Employers have two withholding options. The flat-rate method applies 22% federal income tax to the severance, provided the employee receives less than $1 million in total supplemental wages during the calendar year. Any portion above $1 million must be withheld at 37%.4Internal Revenue Service. Publication 15, (Circular E), Employers Tax Guide Most employers use the flat rate for one-time severance payments because it’s cleaner for payroll.
The aggregate method combines the severance with a regular paycheck and withholds based on the employee’s W-4 elections. This sometimes produces higher withholding than 22%, which catches employees off guard. Either approach is only an estimate; actual tax owed gets reconciled on the annual return.
Federal Unemployment Tax
FUTA also applies. The rate is 6.0% on the first $7,000 of wages paid to each employee per calendar year.5Internal Revenue Service. Topic No. 759, Form 940, Employers Annual Federal Unemployment Tax Act (FUTA) Tax Return The FUTA definition of wages captures all remuneration for employment, with limited statutory exceptions that don’t cover severance.6Office of the Law Revision Counsel. 26 USC 3306 – Definitions
In practice, FUTA on a severance payment is often zero. Most employees laid off partway through the year have already earned past the $7,000 wage base in regular pay, so the cap is already met when the severance check is cut. The obligation still needs to be checked though. An employee terminated in January after earning only a few thousand dollars will have FUTA liability on the severance. Most employers receive a credit of up to 5.4% for state unemployment taxes paid, reducing the effective FUTA rate to 0.6%.
Accrued Vacation and PTO Payouts
The severance itself is only one piece of a redundancy package. Accrued vacation, paid time off, and similar leave balances paid out at termination are fully subject to FICA, federal income tax withholding, and FUTA. These payouts are treated as deferred wages rather than compensation for job loss, so they get no special tax break.
Track leave payouts as separate line items from the severance. Lumping everything into one termination payment creates problems at reporting time and makes pay stubs harder for employees to follow. The distinction can also matter for state unemployment insurance calculations, which sometimes treat accrued leave and severance differently.
Section 409A and Structuring Deferred Payments
Section 409A of the Internal Revenue Code can turn a routine severance package into a tax problem if the arrangement is structured incorrectly. Any severance plan that gives an employee a legally binding right to payments in a future tax year potentially falls under Section 409A’s timing and distribution rules.7Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
The penalties fall on the employee. All deferred amounts become immediately taxable, plus the employee owes a 20% additional tax and interest at the underpayment rate plus one percentage point, calculated back to the year the compensation was first deferred.7Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans Employers face their own exposure for failing to withhold correctly.
Most standard severance packages avoid Section 409A through the separation pay plan exemption. To qualify, the arrangement must meet three conditions under the Treasury regulations:8eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
- The severance must be triggered by an involuntary termination or a window program (a voluntary early-exit offer with a limited enrollment period).
- The total severance cannot exceed two times the lesser of the employee’s prior-year annual compensation or the qualified plan compensation limit under Section 401(a)(17). For 2025, that limit was $350,000, capping severance at $700,000 or two times annual pay, whichever was lower.
- All payments must be completed by December 31 of the second calendar year after the year of separation.
A lump-sum check paid shortly after the layoff date almost always clears these requirements. The risk appears with installment arrangements paid monthly over 18 or 24 months, or packages that include deferred stock or retention bonuses tied to a future date. Those need careful structuring to stay within the exemption.
WARN Act Back Pay
Federal law requires employers with 100 or more employees to give 60 calendar days’ written notice before a plant closing or mass layoff.9Office of the Law Revision Counsel. 29 USC 2102 – Notice Required Before Plant Closings and Mass Layoffs The Worker Adjustment and Retraining Notification Act does not offer pay in lieu of notice as an alternative; the notice itself is the requirement.10U.S. Department of Labor. WARN Advisor
When an employer violates WARN, each affected employee can recover back pay for up to 60 days of the violation period, calculated at the higher of the employee’s average rate over the last three years or the final regular rate. The employer also owes the cost of lost benefits, including medical expenses that would have been covered, plus a separate civil penalty of up to $500 per day to the affected local government unless all employees are paid within three weeks of the layoff order.11Office of the Law Revision Counsel. 29 USC 2104 – Administration and Enforcement of Requirements
WARN Act damages are back pay, which means they carry the same payroll tax obligations as regular wages. FICA, federal income tax withholding, and FUTA all apply. Voluntary payments the employer makes to employees during the notice-violation period can offset back pay liability, but those payments themselves are also taxable wages.
W-2 Reporting and Record Retention
Severance appears on the employee’s Form W-2 for the year the payment is made. The IRS instructs employers to include severance in Box 1 (wages, tips, other compensation), Box 3 (Social Security wages, up to the annual wage base), and Box 5 (Medicare wages and tips).12Internal Revenue Service. General Instructions for Forms W-2 and W-3 (2026) The corresponding withholding goes in Boxes 2, 4, and 6. If severance is paid in a different calendar year than the employee’s last day of work, it goes on the W-2 for the year of payment, not the year of separation.
Employers must retain employment tax records, including the calculations behind severance amounts, years-of-service documentation, and withholding worksheets, for at least four years after the tax becomes due or is paid, whichever is later.13Internal Revenue Service. Topic No. 305, Recordkeeping The four-year clock starts fresh with each quarterly filing. Holding records for five years builds in a buffer, and companies with qualified sick or family leave credits on file need six years.14Internal Revenue Service. Employment Tax Recordkeeping
State Payroll Tax on Severance
State treatment varies. Most states with an income tax treat severance as taxable wages and require withholding, but rates and methods differ. Flat supplemental withholding rates range from under 4% to nearly 12%. States without income taxes, like Texas and Florida, require no state withholding at all. A handful of states use the same progressive withholding tables for severance as for regular pay, which can push the rate higher than expected on a large lump sum.
State unemployment insurance is a separate variable. Whether severance counts as wages for state unemployment tax depends on each state’s definition, and some states also consider severance when determining an employee’s eligibility for unemployment benefits, sometimes delaying the start of payments. Employers running a mass layoff across multiple states have to apply each state’s rules separately, based on where each affected employee performed the work.