Settlement Agreements Explained

A settlement agreement is a written contract under which you agree to waive specified employment claims against your employer in exchange for agreed compensation. It is used to resolve an employment dispute — whether arising from dismissal, redundancy, discrimination, or any other matter — without the need for Employment Tribunal proceedings.

For a settlement agreement to be legally valid under the Employment Rights Act 1996, it must:

• Be in writing
• Relate to a particular complaint or proceedings
• Confirm that you have received independent legal advice from a relevant independent adviser (usually a solicitor with current professional indemnity insurance)
• Identify the independent adviser
• State that the statutory conditions are satisfied

Employers typically pay the employee's legal fees for taking advice on a settlement agreement — this is standard practice and something you should request if it is not offered.

Settlement agreements typically include a very broad waiver of claims. You may be waiving the right to bring claims for:

• Unfair dismissal
• Wrongful dismissal and unpaid notice pay
• Discrimination under the Equality Act 2010
• Unlawful deductions from wages
• Holiday pay
• Breach of contract
• Any other employment rights claims listed in the agreement

Certain rights cannot be waived by a settlement agreement — for example, personal injury claims not known about at the time of signing, accrued pension rights, and some statutory entitlements. Your legal adviser will identify these.

The financial amount offered in a settlement reflects the value of the claims you are waiving. If your potential claims are strong, you may be able to negotiate a higher figure. Do not feel pressured to accept the first offer — settlement negotiations are normal and expected.

The tax treatment of settlement payments is complex and depends on the nature of each element of the payment:

• Payments in lieu of notice (PILON): Taxable as income regardless of whether they are contractual or non-contractual, following changes in April 2018.
• Ex-gratia payments (genuine compensation for losing the job): The first £30,000 is exempt from income tax, provided it is a genuine payment for loss of employment — not salary, holiday pay, or contractual entitlements.
• Contractual payments: Fully taxable — for example, outstanding salary, accrued holiday pay, and any contractual bonus.

Your solicitor can advise on how the settlement should be structured to maximise the tax-free element. When negotiating, consider: the strength of your legal claims, the legal costs of pursuing them, the value of your time and stress, and the employer's likely reputational and financial exposure.

The independent legal advice requirement is not a formality — it is a strict legal condition of validity. A settlement agreement is only binding on you if you have received advice from a relevant independent adviser about the terms and effect of the agreement and specifically its effect on your ability to pursue the claims described in it. A relevant independent adviser is most commonly a solicitor with current professional indemnity insurance, but can also be a barrister, a certified trade union representative, or a certified advice centre worker.

The adviser must be genuinely independent — they cannot be someone acting for your employer. The advice must be given before you sign, not afterwards. It is standard practice for employers to contribute to the cost of the employee's legal advice — typically a fixed contribution of £500–£1,000 plus VAT. If the employer has not offered to contribute, ask. If the contribution offered does not cover the actual cost of advice on a complex agreement, negotiate for more.

The Acas COT3 as an alternative. The COT3 is a different mechanism for settling employment disputes and should not be confused with a settlement agreement. A COT3 is reached through the Acas Early Conciliation or conciliation process and is recorded by an Acas conciliator. Unlike a settlement agreement, a COT3 does not require independent legal advice — it is binding once both parties agree through the Acas conciliation service. However, COT3 settlements tend to be less detailed and comprehensive than settlement agreements, which makes them more suitable for straightforward claims than for complex departures with multiple issues. A COT3 can also settle live Tribunal claims — often used when a case has already been issued and the parties wish to resolve it before the hearing.

Tax treatment of termination payments in detail. The £30,000 tax exemption on termination payments is one of the most practically important aspects of settlement agreement negotiation. The rules, as amended in April 2018, are:

• Payments in lieu of notice (PILON): All PILON payments are fully taxable as earnings, regardless of whether the contract contained a PILON clause. This applies even to non-contractual PILON. PILON is calculated as the basic salary that would have been earned during the notice period — it does not include benefits in kind, bonus, or other elements unless the contract provides for these.
• Ex-gratia termination payments: Genuine payments for loss of employment — payments made purely because the employment is ending and not referable to any contractual entitlement or salary — benefit from the £30,000 exemption. The first £30,000 of such payments is free of income tax and employee National Insurance contributions. Amounts above £30,000 are subject to income tax but not (in most cases) National Insurance, following 2018 changes.
• Contractual entitlements: Outstanding salary, accrued but untaken holiday pay, and any contractual bonus payments are fully taxable as earnings — they cannot shelter under the £30,000 exemption even if they are paid as part of a settlement agreement. These should be clearly separated in the agreement from any ex-gratia element.
• Injury to feelings payments: Compensation for injured feelings in discrimination cases is generally exempt from tax if paid as part of a settlement of a discrimination claim and not treated as earnings. However, the tax treatment of injury to feelings payments is a nuanced area and your solicitor should advise specifically on any such element.

Structuring the settlement agreement to make the most of the £30,000 exemption is an important part of the negotiation process. Your solicitor will be able to advise on how the payment should be described in the agreement. HMRC has published detailed guidance on the taxation of termination payments which your solicitor will refer to.