Settlement agreements have become a common feature of the employment landscape in the UK. Formerly known as a compromise agreement, a settlement agreement is a legally binding contract between an employer and an employee in which the employee agrees not to pursue certain claims (usually those arising from their employment or its termination) in return for financial or other benefits.

Settlement agreements are most frequently used when employment is coming to an end or when there is a dispute, such as performance-related disputes, grievances, or discrimination claims, or where there is no dispute and both employer and employee wish to end the employment amicably.

As legally binding contracts with lasting consequences, settlement agreements require careful handling and informed negotiation. For the agreement to be legally valid and enforceable, the employee must receive independent legal advice from a qualified and insured adviser (usually a solicitor).

Common pitfalls and important considerations

When receiving advice on and negotiating a settlement agreement, both parties will need to understand the strength of their legal position and their leverage. The employer will want to protect its business interests, including potential financial cost, the risks of litigation, and the risk of reputational damage; the employee will want fair compensation and to protect their future career.

Issues that require careful consideration include:

  • Timing: Pressure to sign a settlement agreement can result in overlooking important terms. Negotiations often take place under time pressure, but it is important for the employee not to rush and seek a time extension where needed.
  • Waiver of claims: The employee will be agreeing not to bring specified employment-related claims, such as unfair dismissal or discrimination. The wording will determine whether the waiver covers only known employment law claims or future known claims. If the employer attempts to waive all possible claims (including those that cannot legally be waived), this may render the agreement unenforceable or subject to being challenged.
  • Compensation: There will often (but not always) be a termination payment or ex gratia sum. There will also be contractual entitlements such as notice pay, accrued holiday, or bonus. The employee should consider the value of the financial package as a whole if garden leave, bonus entitlement, pension contributions, or outplacement support are being offered.
  • Ambiguous payments or dates: Payments should be specified, with clarity on tax treatment and timing.
  • Tax: Up to £30,000 of ex gratia compensation may be paid free of tax and NICs if structured properly, and so structuring payments properly can maximise net benefit for the employee while remaining compliant with HMRC rules. If tax is not properly addressed, the employer can be left liable for unexpected PAYE or NIC demands from HMRC.
  • Non-disparagement: A non-disparagement clause restricts both the employee and employer from speaking negatively about each other, including on social media, to protect reputations. If drafted correctly, such a clause can give comfort to both parties.
  • Restrictive covenants: Restrictive covenants are clauses that prevent a departing employee from engaging in activities that could harm the business, such as poaching clients or colleagues, using confidential information, or competing unfairly. In the settlement agreement, existing post-termination restrictions (as set out in the contract of employment) may be reaffirmed or, in some cases, revised. It will be in the employee’s interests to remove or water down these restrictions.
  • Confidentiality: A confidentiality clause will prevent disclosure of the settlement agreement’s terms or the circumstances leading to it. However, a confidentiality clause must not prevent whistleblowing or reporting of unlawful conduct (i.e. making protected disclosures). If so, this may attract scrutiny by regulators and be a reputational risk for the employer.
  • Return of property: This will set out any company property to be returned, such as IT equipment, documents, or data.
  • Reference: For the employee, a verbal promise of a reference by the employer is not enough; it should be written into the agreement. For the employer, agreeing informally to provide a reference without recording its exact wording may create disputes later. Attaching the exact reference (or template wording) to the settlement agreement will avoid disputes later.
  • Legal contribution to costs: Employers usually contribute towards the employee’s legal advice costs, typically between £350 and £750 plus VAT depending on complexity. Offering to pay too little towards an employee’s legal advice can delay the signing of the settlement agreement.
  • Failure to follow process: Settlement discussions must be conducted carefully to avoid claims of coercion or unfair treatment.

Seeking independent legal advice will be a legal requirement for the employee. Without proper advice, an employee risks waiving valuable claims for inadequate compensation, accepting unenforceable or overly onerous clauses, misunderstanding the tax consequences of payments, or losing rights without realising it, such as share options or bonus entitlements.

For the employer, sound legal advice and drafting will help ensure that the employer meets its legal obligations, complies with good practice, protects its legitimate business interests and reputation, and minimises the risk of subsequent employment claims.

Our employment lawyers regularly advise on settlement agreements for both employers and employees. By ensuring agreements are fair, compliant, and carefully tailored, we help clients achieve certainty and peace of mind at what can otherwise be a difficult time.