Settlement Agreement
Quick Summary
A settlement agreement is a legally binding contract where you agree to waive your employment claims in exchange for a financial payment from your employer. Your employer must pay for you to receive independent legal advice before signing. The first £30,000 of a termination payment is usually tax-free. Never sign without understanding your full entitlements.
What Is a Settlement Agreement?
A settlement agreement (formerly called a compromise agreement) is a legally binding contract between you and your employer. You agree to waive your right to bring specified claims against your employer (such as unfair dismissal, discrimination, or breach of contract), and in return, your employer agrees to pay you a sum of money and often provides other benefits such as an agreed reference.
Settlement agreements are used in a wide range of situations. Your employer might offer one as part of a redundancy process, to resolve an ongoing dispute or grievance, as an alternative to a disciplinary process, when restructuring or reorganising, or simply when they want to part ways amicably. Receiving a settlement agreement does not mean you have done anything wrong — it is a standard business tool used to bring the employment relationship to a clean end.
For a settlement agreement to be legally valid, it must be in writing, it must relate to a particular complaint or proceedings, you must have received independent legal advice from a qualified adviser (usually a solicitor) about the terms and effect of the agreement, the adviser must be identified in the agreement, and the adviser must have a current professional indemnity insurance policy. If any of these requirements is not met, the agreement is not binding and you retain the right to bring claims.
Your employer is legally required to contribute to the cost of your independent legal advice. The standard contribution is £250 to £500 plus VAT. This covers the solicitor's fee for reviewing the agreement and advising you on whether to sign. If the agreement is complex or you have strong potential claims, the cost of advice may exceed the employer's contribution, but many solicitors will handle straightforward agreements for the contributed amount.
Is the Offer Fair?
Assessing whether a settlement offer is fair depends on several factors. The most important is the strength and value of any claims you might have against your employer. If you have been unfairly dismissed, the median tribunal award is approximately £13,000, but your specific award would depend on your salary, length of service, and how long it takes you to find new employment. If you have a discrimination claim, compensation is uncapped and can be substantially higher.
Your solicitor will assess the strength of your potential claims and the likely range of compensation at tribunal. They will compare this against the settlement offer, taking into account the time, cost, and stress of a tribunal claim, the risk that your claim might not succeed, and the certainty of a settlement payment versus the uncertainty of litigation.
As a rough guide, settlement agreements in redundancy situations typically offer statutory redundancy pay plus a number of weeks' or months' salary as an enhanced payment. In dispute situations (unfair dismissal or discrimination), a fair settlement often reflects 3 to 12 months' salary, depending on the strength of the claim. However, there is no fixed formula, and each case turns on its own facts.
Consider the non-financial terms as well. An agreed reference can be extremely valuable for your future career. Check whether the agreement includes a non-derogatory clause (preventing both parties from making negative comments about each other), continuation of any benefits (such as private healthcare or company car) during a notice period, and accelerated vesting of share options or bonuses.
Tax Treatment of Settlement Payments
The tax treatment of settlement payments is an important consideration that directly affects how much money you actually receive. The rules depend on what the payment is for.
Payments in lieu of notice (PILON) are always subject to income tax and National Insurance, whether or not your contract includes a PILON clause. If you have a three-month notice period and your employer pays you in lieu of notice rather than requiring you to work it, this payment is taxed as normal earnings. This is the case since April 2018, when the rules changed to ensure all PILON payments are taxed.
Termination payments above the notice pay are tax-free up to the first £30,000. This means if your settlement agreement provides a total payment of £50,000, of which £15,000 is contractual notice pay, the remaining £35,000 is split as follows: £30,000 is tax-free, and £5,000 is subject to income tax (but not employee National Insurance contributions, although employer NICs apply above £30,000).
Outstanding holiday pay, bonus payments, and commission owed to you are treated as normal earnings and subject to full tax and National Insurance. It is important that the settlement agreement clearly breaks down the payment into its component parts, so you and your employer both know how each element should be taxed. Your solicitor should check this carefully, as errors in the tax treatment can create problems for you down the line.
Negotiating a Better Deal
The first offer is rarely the final offer. Your employer has proposed a settlement because they want certainty and to avoid the cost and risk of a tribunal claim. This gives you negotiating leverage. Your solicitor can help you identify areas where the offer can be improved and conduct negotiations on your behalf.
Common negotiation points include increasing the overall financial payment, extending the period that your employer continues to pay you (a longer notice period or garden leave), improving the agreed reference, extending benefits such as private medical insurance or outplacement support, removing or narrowing restrictive covenants that limit your future employment, and ensuring a non-derogatory clause is mutual.
When negotiating, it helps to know the strength of your position. If you have a strong unfair dismissal or discrimination claim, your employer has a significant incentive to settle generously. If your employer has not followed proper procedures (such as failing to conduct a fair redundancy process), this strengthens your hand further. Your solicitor will help you quantify the value of your potential claims and use this as a basis for negotiation.
Be aware that settlement negotiations are conducted on a "without prejudice" basis, meaning they cannot be referred to in tribunal if negotiations break down. This protects both sides and encourages open discussion. However, there is an exception: if a conversation was specifically stated to be under Section 111A of the Employment Rights Act 1996, it is protected even if there is no existing dispute between you and your employer.
What Happens After You Sign
Once you sign the settlement agreement and your solicitor provides the required certificate confirming they have advised you, the agreement becomes legally binding. Your employer should process the settlement payment within the timeframe specified in the agreement, which is usually 14 to 28 days after signing.
You will receive a P45 from your employer, confirming the end of your employment and the tax paid during the tax year. The tax-free portion of your settlement (up to £30,000) should be reflected correctly on your P45 and the employer's records. If you believe the tax treatment is incorrect, raise this with your employer's payroll department promptly.
The agreed reference should be kept on file by your employer. If a prospective employer contacts them for a reference, they should provide the agreed wording and nothing more. If your former employer provides a reference that differs from the agreed wording, this would be a breach of the settlement agreement, and you could take legal action to enforce it.
You should be aware that signing a settlement agreement waives your right to bring the specified claims. You cannot change your mind later, even if you discover new information about your employer's conduct. This is why it is so important to understand your full entitlements before signing. However, a settlement agreement cannot waive certain rights, such as accrued pension rights, claims for personal injury that you are not aware of at the time of signing, and the right to enforce the agreement itself.
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Disclaimer: This page provides general information about the law in England and Wales. It is not legal advice and should not be treated as such. Every situation is different, and you should consult a qualified solicitor for advice specific to your circumstances.