What it is:
Severance pay refers to a payment from a company to an employee who is being discharged.
How it works (Example):
Under certain circumstances, employers compensate an employee who is being discharged with a sum of money called severance pay. The specific amount may be related to the employee's salary and length of time with the company. In most cases, severance pay is paid to an employee who is being laid off due to internal changes within a company.
To illustrate, suppose Bob is one of two internal accountants for company XYZ. Due to restructuring, XYZ now needs only one accountant, and Bob's position is subsequently eliminated. Bob is laid off, as a result, and is given severance pay by XYZ when he leaves.
Why it Matters:
In many cases, employees are made to leave a given company due to internal changes that eliminate their jobs. Severance pay is a compensatory measure that ensures that laid-off employees are compensated fairly not only for work done since their last pay cycle, but also for covering any expenses that may be incurred through no fault of their own between the time they leave their current job and find another position.