Settlement and exit agreements in the United States
Reviewed by Mellow Editorial Team, HR & payroll content team
When an employment relationship ends on disputed or sensitive terms, a settlement and exit agreement lets both sides draw a clean line — the employee receives agreed compensation and the employer gets a release of legal claims.
What these agreements actually are
A settlement agreement (sometimes called a severance agreement or separation agreement) is a contract between employer and employee that governs the terms of departure. The core trade is straightforward: the employer pays something of value, and in return the employee waives the right to sue over employment-related claims.
"Exit agreement" is informal shorthand covering the same ground. In practice, the document typically addresses: severance pay, benefits continuation, treatment of equity or bonuses, non-disparagement obligations, a release of claims, and sometimes confidentiality provisions.
These are civil contracts governed by state law, so the precise rules vary. Always have employment counsel review the final document before it is signed.
The release of claims — the legal core
The release is why the agreement exists from the employer's perspective. A well-drafted release extinguishes claims the employee has or might have arising from the employment relationship — wrongful termination, discrimination, wage and hour violations, breach of contract, and similar causes of action.
A few constraints apply that employers need to know:
ADEA requirements. If the employee is 40 or older, the Older Workers Benefit Protection Act (OWBPA) imposes specific rules. The employee must be given at least 21 days to consider the agreement (45 days if the release is part of a group layoff). After signing, they have 7 days to revoke. The agreement must explicitly refer to ADEA rights. Skipping any of these steps invalidates the release of age-discrimination claims even if the employee signs.
Knowing and voluntary standard. Courts assess whether the waiver was made knowingly and voluntarily. Plain language, adequate consideration, and time to review all support that standard. A take-it-or-leave-it deadline of a few hours is a warning sign.
What cannot be released. Employees generally cannot waive claims that arise after the agreement is signed, the right to file a charge with the EEOC (though they can waive the right to personal monetary recovery), workers' compensation claims in many states, or vested retirement benefits under ERISA.
Severance: what you are required to give versus what is typical
There is no federal law requiring severance pay. The Fair Labor Standards Act (FLSA) does not mandate it. An employer's legal obligation is to pay all earned wages and any accrued PTO if state law requires it — nothing more.
That said, a release of claims is only enforceable if the employee receives something of genuine value they were not already entitled to. Offering to pay out wages already owed does not constitute consideration for a release.
Common practice for office and professional roles runs from one to four weeks of base pay per year of service, often with a floor (say, four weeks regardless of tenure) and a ceiling. Executive agreements are negotiated individually. Whatever formula you use, apply it consistently within comparable employee groups to reduce disparate-impact exposure.
Benefits continuation through COBRA is another common component. COBRA is already available by law, but an employer can offer to subsidize the premiums for a defined period as part of the package.
Confidentiality, non-disparagement, and non-competes
Confidentiality. It is common to include mutual confidentiality covering the agreement's terms. Overly broad clauses that prohibit an employee from discussing the underlying conduct — particularly harassment or discrimination — are increasingly scrutinized by state legislatures. Several states now limit or prohibit non-disclosure provisions tied to workplace misconduct. Check current state law before drafting.
Non-disparagement. Most agreements include mutual non-disparagement. The National Labor Relations Board has taken the position that one-sided, overly broad non-disparagement clauses can interfere with employees' rights under the NLRA, so the clause should be narrowly tailored and mutual where possible.
Non-competes. Enforceability varies sharply by state. California prohibits most non-compete agreements outright and will not enforce them even if signed. Other states enforce them but require reasonableness in scope, geography, and duration. A non-compete buried in a exit agreement is still subject to the same state-law scrutiny as one signed at hire.
Tax treatment and payroll obligations
Severance payments are treated as ordinary wages for federal income tax purposes. That means they are subject to federal income tax withholding, Social Security (6.2% employee, up to the annual wage base), and Medicare (1.45%, with no cap). The employer pays the matching share of Social Security and Medicare on top.
For payroll reporting, severance paid to a departing employee in the same tax year goes on their Form W-2. If payments extend into a new calendar year, a W-2 for that year is required as well. All of this flows through how Mellow runs payroll across six countries in the same structured way as regular payroll — there is no special treatment that bypasses standard reporting obligations.
Payments specifically allocated to claims for physical injury or physical sickness may be excludable from income under Section 104 of the Internal Revenue Code, but this is a narrow exception and requires careful documentation.
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