A settlement agreement is a written contract between an employer and an employee (or former employee) that brings an end to an employment dispute or terminates an employment relationship. Settlement agreements are sometimes used when an employee is being made redundant, when there is a dispute between the employer and employee, or when the employment relationship has broken down. The agreement sets out what the employer will pay the employee, what the employee agrees to in return, and any other terms. Settlement agreements are legally binding and can prevent the employee from taking legal action.
Settlement agreements used to be called “compromise agreements” and some people still use that term, but the current name is “settlement agreement.”
What makes a settlement agreement legally binding?
For a settlement agreement to be legally valid and binding, it must meet strict conditions. These are set out in law (primarily section 203 of the Employment Rights Act 1996). The conditions are:
1. It must be in writing. An oral agreement or a vague understanding is not enforceable. The agreement must be a formal written document.
2. It must relate to a specific complaint or claim. The agreement must state what legal claim it is settling. For example, it might settle a claim for unfair dismissal, redundancy pay, discrimination, or breach of contract. The agreement cannot simply state that it is “in full and final settlement of all claims” without specifying what claims are covered.
3. The employee must receive independent legal advice. This is the most important requirement. Before signing, the employee must be advised by a qualified independent adviser. The adviser must be:
- a lawyer (solicitor or barrister)
- a certified trade union representative (if the employee is a union member and the union has certified its representatives)
- some other professional specifically designated by law (such as an adviser at a citizens advice bureau)
The adviser must advise the employee on the terms of the settlement agreement and the implications of signing it. The employee must not receive this advice from the employer or anyone acting for the employer.
4. The adviser must be insured. The adviser must have insurance to cover the cost of defending a claim that the advice was negligent. This requirement protects the employee and ensures the adviser takes the advice seriously.
5. The agreement must name the adviser. The settlement agreement must state the name and profession of the person who gave advice (for example, “Jane Smith, solicitor”).
6. The agreement must state that the conditions have been satisfied. A statement such as “The employee has received independent legal advice from X” must appear in the agreement.
If any of these conditions is not met, the agreement may not be legally binding.
Protected conversations and without prejudice
Before proposing a settlement agreement, employers often have discussions with the employee about a possible agreement. These discussions may be protected in certain ways so that later, if the matter goes to an employment tribunal, the discussions cannot be used as evidence against the employer.
Protected conversations under section 111A of the Employment Rights Act 1996. If an employer has a protected conversation with the employee (a discussion aimed at reaching a settlement or agreed exit), any statements made during that conversation cannot be used as evidence in an ordinary unfair dismissal claim. The protection applies only to unfair dismissal claims (not discrimination, whistleblowing, or other claims). The protection can be lost if either party behaves improperly during the discussion.
Without prejudice. An older form of protection is the “without prejudice” privilege. If a discussion is marked “without prejudice,” neither party can use what was said in the discussion as evidence later in legal proceedings. This protection can apply to many types of claim, but it does not apply if one party behaves improperly or if the discussion is about settling a claim that has already been formally raised.
Employers often start settlement discussions as protected conversations and then, once the employee has received legal advice, formalize the agreement in writing.
Typical terms of a settlement agreement
Settlement agreements vary depending on the circumstances, but they typically include:
Payment. The employer agrees to pay the employee a sum of money. This might be:
- statutory redundancy pay (if the redundancy is genuine)
- enhanced redundancy pay (more than the statutory amount)
- compensation for an alleged breach of contract, discrimination, or other wrong
- payment in lieu of notice (pay for the notice period instead of working it)
- payment for unused holiday
Employment reference. The employer agrees to provide a reference to future employers if requested. The reference should be factual and fair; some agreements specify that the reference will say only that the employee worked for the employer in a certain role for a certain period.
Confidentiality and non-disparagement. The employee agrees not to disclose the terms of the settlement agreement to anyone (except, usually, family members, tax advisers, and legal advisers). The agreement may also require that neither party says anything negative about the other (though this can sometimes be difficult to enforce).
Agreement not to pursue legal claims. The employee agrees not to pursue any claim against the employer in an employment tribunal or court. This is the core benefit to the employer. The agreement specifies exactly which claims are waived (for example, unfair dismissal, discrimination, wrongful dismissal, breach of contract).
Statement about the agreement. Many agreements include a joint statement that the employer and employee are settling their differences amicably and that the settlement is not an admission of any wrongdoing by the employer.
Employer’s liability insurance or other indemnity. If the settlement is related to an injury or accident, the agreement might state that the employee cannot pursue a claim against the employer’s insurance or will not pursue such a claim.
Tax on settlement agreements
Up to £30,000 of a genuine termination payment (such as a redundancy or settlement payment) is tax-free in the hands of the employee. This exemption applies under section 403 of the Income Tax (Earnings and Pensions) Act 2003.
The key points are:
- The £30,000 exemption applies to a genuine termination payment that is not contractually required.
- Statutory redundancy and ex gratia payments (discretionary payments) both count towards the £30,000 limit.
- If the employee receives statutory redundancy of £10,000 and a settlement payment of £25,000, only £20,000 of the settlement payment is tax-free (because £10,000 was already used).
- Amounts above £30,000 are subject to income tax.
- Notice pay (pay for the notice period, whether worked or in lieu) is always taxed in full as earnings; it does not qualify for the exemption.
- Holiday pay and bonuses owed under the contract are also taxed in full.
The employer should clearly break down the settlement payment so that the employee and their tax adviser know which parts are tax-free and which are taxable.
Using settlement agreements fairly
Settlement agreements should be used fairly and not as a tool to avoid following proper procedures. For example:
- An employer should not use a settlement agreement to avoid following a fair disciplinary procedure if the employee can be dismissed for misconduct.
- An employer should not offer a settlement agreement to an employee solely because of pregnancy, disability, or another protected characteristic, as this could be discrimination.
- An employer should not pressure an employee to sign an agreement or threaten them with redundancy if they do not.
If a settlement agreement is reached because the employment relationship has broken down, both parties should have had a fair opportunity to express their views and the employer should have explained the options.
When to use a settlement agreement
Settlement agreements are most commonly used in these situations:
- Redundancy. To confirm the agreed redundancy terms and obtain a release from claims.
- Performance issues. If an employee’s performance is poor but does not amount to a disciplinary issue, a settlement agreement can allow them to leave with agreed compensation.
- Relationship breakdown. If the relationship between the employer and employee has irretrievably broken down, a settlement agreement can bring about an amicable exit.
- Dispute resolution. If there is a disagreement about pay, conditions, or conduct, a settlement agreement can resolve it without going to tribunal.
Key points
- A settlement agreement must be in writing, relate to a specific claim, and be entered into only after the employee has received independent legal advice.
- The adviser must be qualified, insured, and must be independent of the employer.
- Typical terms include payment, a reference, confidentiality, and a release of claims.
- The first £30,000 of a genuine termination payment is tax-free; amounts above that are taxed.
- Settlement agreements should be used fairly and only where there is a genuine settlement of a dispute or an agreed exit.
- Protected conversations under section 111A ERA 1996 allow employers to discuss settlement without the discussion being used as evidence in an unfair dismissal claim.
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