How to use a settlement agreement to resolve an employment issue

Author: Claire Birkinshaw


Click on any of the hyperlinks to go to more detailed guidance below.

  • Be aware that a settlement agreement is a legally binding agreement made between an employer and an employee under which the employee agrees not to pursue a particular claim that he or she has in relation to his or her employment or its termination.
  • Take into account that there are a number of important legal formalities that must be complied with for a settlement agreement to be valid.
  • Be aware of the issues involved in settling more than one complaint.
  • Be aware that you can use a simple waiver and release form to settle contractual claims, but that a settlement agreement will be necessary for statutory claims.
  • Understand the rules on the admissibility of details of pre-termination negotiations as evidence in employment tribunal claims.
  • During negotiations ensure that the terms of the settlement agreement are expressed to be not binding until the agreement is signed by all parties.
  • Use the settlement agreement to cover other important issues such as restrictive covenants and confidentiality obligations.
  • Do not assume that all payments made under settlement agreements are tax-free.


It is relatively common practice, particularly among larger employers, for an employee to be presented with a settlement agreement as an alternative to the employer going through a long, drawn-out disciplinary, performance or redundancy procedure. Settlement agreements are also used by employers as a means of settling serious employee grievances, such as claims of constructive dismissal or unlawful discrimination.

Settlement agreements were known as compromise agreements prior to 29 July 2013. The terminology was changed under the Enterprise and Regulatory Reform Act 2013, but the effect of settlement agreements and the legal requirements for validity are the same as those for compromise agreements.

A settlement agreement is essentially a formal, legally binding agreement made between an employer and employee (or ex-employee) in which the employee agrees not to pursue particular claims in relation to his or her employment or its termination, in return, generally, for a financial settlement. Usually, settlement agreements come about because the employer wishes to "get rid" of the employee quickly and with the minimum of trouble, while at the same time avoiding the publicity and uncertain outcome of an employment tribunal or court case. Of course, if a dismissal has been effected fairly and following proper procedures, it may be that an employer will decide that there is no need for a settlement agreement.

This article considers how employment issues can be effectively and legally resolved under such an agreement.

For a settlement agreement to be legally binding, a number of important conditions must be fulfilled, these being that:

  • the agreement must be in writing;
  • it must relate to the particular complaint;
  • the employee must have received independent legal advice from a relevant adviser as to the terms and effect of the agreement and, in particular, its effect on his or her ability to pursue rights before an employment tribunal;
  • there must be in force, when the adviser gives the legal advice, a contract of insurance or professional indemnity insurance covering the risk of a claim by the employee in respect of loss arising as a result of the advice;
  • the agreement must identify the adviser; and
  • the agreement must state that the conditions regulating settlement agreements under the relevant legislation are satisfied.

The people who are eligible as "relevant advisers" are:

  • qualified lawyers;
  • officers, officials, employees or members of an independent trade union, provided that they have been certified in writing by the union as competent and authorised to give advice;
  • employees or volunteer workers at advice centres giving free legal advice, provided that they have been certified in writing by the advice centre as competent and authorised to give advice; or
  • Fellows of the Institute of Legal Executives employed by solicitors' practices.

Bearing in mind that an employee is required to seek independent legal advice on a settlement agreement, employers should give serious consideration to whether or not one is really necessary in the circumstances, particularly where they are confident that they have dealt with matters "by the book" or where the likelihood of the employee bringing a claim is low.

The employee's complaint(s)

A settlement agreement may be used to settle more than one complaint. In this case, the employer should make clear each of the complaints being settled and refer to the relevant statutory provisions because, as identified above, the agreement should relate to the particular complaint.

Where specific, actual complaints have been made or raised by an employee, they can be duly disposed of under the agreement. However, it is debatable to what extent an agreement can be used to settle disputes that have not yet arisen or claims that were not even remotely in the employee's contemplation when the agreement was signed. One partial solution is for the employer to include a warranty in the agreement whereby the employee undertakes to disclose all known claims at the date the agreement is entered into, so that these can then be settled in the agreement. Of course, this may not assist with future claims of which the employee is not yet aware, meaning that settlement agreements are not guaranteed to result in a clean break between the parties.

Contractual claims and statutory claims

A settlement agreement is necessary to obtain a valid waiver of an employee's statutory claims, for example unfair dismissal and discrimination. However, if an employer wishes to settle only contractual claims, there is no need for a settlement agreement. This is because an agreement to refrain from instituting proceedings in a contract claim is binding without the need for any special requirements to be satisfied. A simple waiver and release of claims will work. However, with statutory claims, any agreement by an employee to waive his or her statutory rights that is not in the form of a settlement agreement (or an Acas COT3 agreement) will be invalid and unenforceable. This means that the employee would still be eligible to lodge a claim in the employment tribunal, even though he or she might have already accepted a sum of money in apparent "full and final settlement".

Employers should also note that a settlement agreement is a "contract connected with employment" for the purposes of the employment tribunal's jurisdiction on contract claims. This means that an employee can bring a claim for monies due under the agreement should the employer subsequently fail to honour it for whatever reason. The agreement is contractually binding once signed by all the parties. This also means that if one party breaches the agreement, the other is then no longer bound by its terms. So, for example, if the employer fails to pay what has been agreed, the employee can pursue his or her claims in the employment tribunal or court.

Admissibility of pre-termination negotiations in tribunal claims

Under s.111A of the Employment Rights Act 1996, pre-termination negotiations between an employer and employee with a view to ending the employment under a settlement agreement are not admissible as evidence in most unfair dismissal claims. Prior to the introduction of these provisions, employees could claim that an offer from the employer of favourable exit terms if he or she was willing to resign and sign a settlement agreement constituted a fundamental breach of the implied term of mutual trust and confidence, enabling the employee to resign and claim constructive dismissal.

Pre-termination discussions are not protected under s.111A if the employee has been dismissed for an automatically unfair reason, for example taking maternity leave or asserting the right to the national minimum wage. In these circumstances, the employee can use the content of such discussions as evidence to support an unfair dismissal claim. Further, where something was said or done that, in the tribunal's opinion, was improper, the content of the discussions is protected only to the extent that the tribunal considers just. For example, if the employer's conduct during pre-termination negotiations amounts to bullying or intimidation, the tribunal can decide that the claimant can rely on such evidence.

The confidentiality of pre-termination negotiations applies only to unfair dismissal claims. Therefore, claimants can rely on what was said during pre-termination negotiations as evidence in other types of claim, for example a discrimination claim or a claim for breach of contract. Employers should therefore continue to make use of the "without prejudice" principle when negotiating with an employee to settle an employment dispute. For the without prejudice rule to apply, the employee must have genuinely consented to the meeting being held on a without prejudice basis, there must be a pre-existing dispute between the parties and the discussion must be a genuine attempt to settle the dispute. Where allegations of unlawful discrimination arise from without prejudice discussions, for example the employer says something along the lines of "we do not want you here because you are homosexual", the veil of privilege will always be lifted; these type of comments cannot be protected by the without prejudice label.

Employers should not be totally reliant on an employee's agreeing to a severance package, as many employees refuse to accept what is on offer. They should conduct the correct dismissal procedures at the same time as holding pre-termination negotiations. If settlement negotiations fail, the employer can still fall back on the formal procedures that have been followed. Nevertheless, it is still more likely than not that an employee will accept "resignation" instead of taking on the uncertainty of having to take a claim to employment tribunal, the financial risks associated with that and the risk of leaving without an acceptable reference.

The negotiation process

It is usually the employer (or its solicitors) that will produce the draft settlement agreement. The employer will then request that the employee take independent legal advice on it. This will usually result in a period of negotiation between the parties until they manage to agree on the terms of the settlement agreement. Once it has been agreed, two copies are produced for signature. Once the copies have been signed by both parties, the agreement becomes legally binding. Each party will keep one of the copies.

To protect themselves, employers should make clear that, until a settlement agreement is signed by all parties, no part of it is binding, ie its terms are entirely "subject to contract". It is not unknown for new information to come to light during the conduct of negotiations with the result that the employer no longer wishes to go ahead with favourable settlement terms. For example, if the employer discovers that the employee in question has been stealing from the company, the prospect of its paying the employee a significant sum of money may not seem quite so appealing as there will now be grounds for a gross misconduct dismissal.

Common settlement agreement clauses

In addition to the settlement of the employment dispute, it is common to see other clauses in a settlement agreement, including:

  • an agreement by both parties to keep the details of the settlement confidential and not to make detrimental statements about one another;
  • a requirement for the employee to return the employer's property, for example any documents, company car or computer hardware and software;
  • the provision of an agreed form of reference for the employee;
  • a requirement for the employee to resign as a director or as company secretary;
  • a requirement for the employee to transfer his or her shares in the company;
  • an agreement by the employer to contribute towards the employee's legal costs; and
  • a tax indemnity from the employee (see below).

Some of these clauses will be requested by the employee's legal adviser during the course of negotiation and the employer should be careful not to give too much away too early as this will restrict its ability to negotiate.

Sometimes employers seek to impose post-termination restrictive covenants or confidentiality obligations on an employee in a settlement agreement. Where these clauses simply restate what is already in the employee's contract of employment, there is no issue. However, where they are wholly new clauses, the employer must allocate a separate sum of money in consideration of these provisions in order for them to be valid. This sum is taxable as earnings from employment.

Finally, employers should consider inserting a clause stating that if the employee breaches any of the terms of the settlement agreement or brings a claim in respect of his or her employment or its termination, the severance payment will be repayable. HM Revenue and Customs accepts that a charge to tax will not arise on a repayment clause other than in very exceptional circumstances.

The taxation of termination payments

There is a widespread misconception that all payments made on the termination of employment are automatically subject to a tax exemption of £30,000. However, unfortunately, not all sums payable under a settlement agreement are tax-free. In determining what tax is payable in respect of termination payments, the key is to identify each element of the termination package and then consider the tax provisions applicable to the individual elements.

Outstanding wages, bonuses, commission and holiday pay are fully taxable, being payments made under the employee's contract of employment. Ex gratia (non-contractual) sums paid as compensation for loss of employment under the terms of the settlement agreement are taxable, but subject to the £30,000 tax-free exemption. This includes statutory and contractual redundancy payments, provided that they are made on account of genuine redundancy.

Where an employee receives a contractual payment in lieu of notice, the payment is chargeable to tax as earnings from employment. However, where there is no contractual entitlement to a payment in lieu of notice, a non-contractual payment will be regarded as compensation for loss of employment, making it subject to the £30,000 tax-free exemption. This is because in these circumstances the employer has breached the contract of employment, and the payment in lieu of notice is regarded as representing damages. Employers should be aware that even where the contract contains no pay in lieu of notice clause, a payment in lieu of notice could have become a contractual payment by virtue of custom and practice.

With the employee's legal costs, no tax charge will be imposed on a payment made directly from the employer to the employee's solicitor as long as the payment is made pursuant to a specific term in the settlement agreement and the payment is in discharge of the solicitor's costs incurred solely in connection with the termination of the employee's employment.

If in doubt, employers should seek specific advice on the tax treatment of the various payments being made under the terms of an agreement and should include a tax indemnity from the employee in the agreement. This will mean that the primary liability for any unpaid tax will rest with the employee, although the employer would need to enforce the indemnity. Legal advisers acting for employees frequently request the removal of a tax indemnity clause, arguing that it is for the employer to take a view on the tax treatment of the payments at the time the agreement is entered into. This is entirely a matter for negotiation and one on which an employer will take its own view.

The Government has announced that changes to the rules on taxation of termination payments will come into force from April 2018. Under proposals on which it has recently consulted, all termination payments that would have been treated as general earnings if the employee had worked his or her notice period will be subject to tax and national insurance; all payments in lieu of notice, whether contractual or not, will be subject to tax and national insurance; and the £30,000 exemption will apply to payments relating directly to the termination of the employment.