Settlement Agreements
A complete guide for employees - what settlement agreements are, what you need to check, and how to ensure you receive the best possible outcome.
What is a settlement agreement?
A settlement agreement (formerly known as a compromise agreement) is a legally binding contract between an employer and an employee. It is typically used to bring the employment relationship to an end on agreed terms, or to resolve an existing workplace dispute without the need for employment tribunal proceedings.
Under the terms of a settlement agreement, the employee agrees to waive their right to bring certain legal claims against the employer — most commonly claims for unfair dismissal, wrongful dismissal, or discrimination. In exchange, the employer makes a financial payment and may agree to other benefits such as an agreed reference, extended notice pay, or the retention of certain company benefits.
Settlement agreements are governed by section 203 of the Employment Rights Act 1996 and must meet specific legal requirements to be valid. The most important of these is that the employee must receive independent legal advice from a qualified solicitor or other authorised adviser before signing.
Why do employers use settlement agreements?
Employers use settlement agreements for a variety of reasons. The most common include:
Redundancy situations: Where an employer wishes to make an employee redundant and wants certainty that no claims will follow, particularly where the redundancy process may not have been followed perfectly.
Performance or conduct issues: Where an employer wishes to part ways with an employee but wants to avoid the time and cost of a formal disciplinary or performance management process.
Workplace disputes: Where there has been a breakdown in the working relationship, a grievance, or allegations of discrimination or harassment, and both parties wish to draw a line under the matter.
Business restructuring: Where roles are being reorganised and the employer wishes to manage departures efficiently and with legal certainty.
Senior exits: Where a senior employee is leaving and the employer wishes to protect confidential information, client relationships, and business interests through carefully drafted restrictions.
It is important to understand that whilst the employer initiates the process, a settlement agreement is a negotiated arrangement. You are not obliged to accept the initial offer, and in many cases there is significant scope to improve the terms.
Legal requirements for a valid settlement agreement
For a settlement agreement to be legally binding and effective in waiving your employment rights, it must satisfy the following requirements under section 203 of the Employment Rights Act 1996:
The agreement must be in writing.
It must relate to a particular complaint or proceedings.
The employee must have received advice from a relevant independent adviser.
The adviser must be identified in the agreement.
The adviser must have a current contract of insurance or professional indemnity insurance covering the advice.
The agreement must state that the conditions regulating settlement agreements under the Employment Rights Act 1996 are satisfied.
If any of these requirements are not met, the agreement may not be legally effective in waiving your employment rights — even if you have signed it. This is why the independent legal advice requirement is so important.
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Key facts
Must be in writing to be valid
Independent legal advice is required by law
Employer usually pays your legal fees
First £30,000 may be tax-free
You can negotiate the terms
You are never obliged to sign
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“I received advice on a Voluntary Exit Scheme agreement and was very impressed with the service. The review was thorough, clear, and gave me confidence before signing. I would highly recommend their employment law support.”
The independent legal advice requirement
The requirement for independent legal advice is a fundamental safeguard for employees. It ensures that before you waive your employment rights, you have had the opportunity to understand what you are giving up and whether the terms offered are fair.
Your adviser must be independent — meaning they must not act for the employer and must be advising solely in your interests. They must advise you on the terms and effect of the agreement, including which claims you are waiving and whether the financial offer is reasonable.
At Birch Law, we provide independent legal advice on settlement agreements every day. We will review every clause, explain your rights, advise on the fairness of the offer, and — where appropriate — negotiate improvements on your behalf. In most cases, your employer will make a contribution towards our fees, meaning you pay nothing.
What should you check before signing?
Before signing a settlement agreement, there are a number of important points that should be carefully reviewed. Our solicitors will go through all of these with you, but here is an overview of the key areas:
The financial payment
Is the total sum fair given your circumstances, length of service, and the strength of any potential claims? Are all elements clearly identified — ex gratia payment, notice pay, holiday pay?
Holiday pay
Are you being paid for all accrued but untaken holiday up to the termination date? This is a legal entitlement and should not be overlooked.
Reference wording
Is there an agreed reference? What does it say? A well-worded reference can make a significant difference to your future employment prospects.
Restrictive covenants
Are there post-employment restrictions on working for competitors, soliciting clients, or poaching colleagues? Are these reasonable in scope and duration?
Notice pay
Are you receiving your full contractual notice pay? Is it being paid as a payment in lieu of notice (PILON) or as garden leave? The distinction matters for tax purposes.
Bonus payments
Are you entitled to any bonus payments that fall due before or after the termination date? Bonus provisions in settlement agreements are often contentious and should be carefully reviewed.
Confidentiality obligations
What are you agreeing to keep confidential? Does the confidentiality clause prevent you from discussing the circumstances of your departure with family, friends, or future employers?
Tax treatment
How will the payments be taxed? The first £30,000 of a genuine termination payment is usually tax-free, but other elements may be taxable.
Common clauses in settlement agreements
Settlement agreements typically contain a number of standard clauses. Understanding what each clause means is essential before you sign.
Termination date
The date on which your employment ends. This affects your notice period, holiday entitlement, and the timing of any payments.
Confidentiality clause
Restricts what you can say about the agreement and, often, the circumstances leading to it. The scope of this clause should be carefully reviewed.
Reference wording
An agreed reference is one of the most valuable elements of a settlement agreement. The precise wording matters enormously for your future career.
Financial payment
The total sum payable, broken down by type — ex gratia payment, notice pay, holiday pay, and any other sums. Each element may be taxed differently.
Restrictive covenants
Post-employment restrictions on working for competitors, soliciting clients, or poaching colleagues. These must be reasonable to be enforceable.
Claims waived
A list of the employment tribunal claims you are agreeing not to bring. You should understand exactly which claims are being settled before signing.
Tax implications of settlement agreements
The tax treatment of settlement agreement payments is an important consideration. The rules can be complex, and getting them wrong can result in an unexpected tax liability. Here is a summary of the key principles:
Ex gratia termination payments: Genuine payments made in connection with the termination of employment — such as an ex gratia payment — benefit from a £30,000 tax-free exemption. Amounts above £30,000 are subject to income tax and, since April 2020, employer's National Insurance contributions.
Payment in lieu of notice (PILON): All PILON payments are subject to income tax and National Insurance contributions, regardless of whether your contract contains a PILON clause. This changed following the Finance Act 2018.
Holiday pay: Payments for accrued but untaken holiday are treated as earnings and are subject to income tax and National Insurance contributions in the usual way.
Bonus payments: Bonus payments that would have been payable in the ordinary course of employment are generally taxable as earnings. However, the position can be more nuanced depending on the terms of your bonus scheme.
Legal fees paid by employer: Where your employer pays your legal fees directly to your solicitor, this is not treated as a taxable benefit provided the payment is made directly to the solicitor and relates solely to advice on the termination of your employment.
Important: Tax law is complex and the position in your specific case will depend on your individual circumstances. Birch Law will advise you on the tax treatment of the payments in your agreement as part of our review.
Restrictive covenants and post-employment restrictions
Restrictive covenants are clauses in your employment contract or settlement agreement that restrict what you can do after your employment ends. Common types include:
Non-compete clauses: Prevent you from working for a competitor for a specified period after leaving.
Non-solicitation clauses: Prevent you from approaching or dealing with your former employer's clients or customers.
Non-poaching clauses: Prevent you from recruiting your former colleagues to a new employer.
Confidentiality obligations: Prevent you from disclosing confidential business information after leaving.
Garden leave provisions: Require you to remain employed (and paid) but not to work during your notice period, preventing you from starting a new role immediately.
Restrictive covenants must be reasonable to be enforceable. They must go no further than is necessary to protect the employer's legitimate business interests. Restrictions that are too wide in scope, duration, or geographical area may be unenforceable.
We will review any restrictive covenants in your agreement and advise you on their enforceability. Where restrictions are unreasonably broad, we will negotiate to have them narrowed or removed.
Negotiating Your Settlement Agreement
One of the most important things to understand is that a settlement agreement is a negotiated document. The initial offer from your employer is rarely the final word. There is almost always scope to negotiate improvements — whether that is a higher financial payment, better reference wording, or more favourable post-employment restrictions.
At Birch Law, we negotiate settlement agreements on behalf of employees every day. We know what is reasonable, what employers will typically agree to, and how to present your position effectively. Common areas where we achieve improvements include:
Increased financial payment — particularly where there are potential discrimination or whistleblowing claims
Improved reference wording — agreed letters of reference that accurately reflect your contribution
Extended notice pay or garden leave
Bonus payments that might otherwise be withheld
Narrowed or removed restrictive covenants
Outplacement support or career coaching
Retention of company equipment such as laptops or mobile phones
Agreed announcements to colleagues and clients
Our approach is always to achieve the best possible outcome for you whilst maintaining a constructive relationship with your employer where that is in your interests.
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