The £30,000 tax-free termination payment is the most widely known figure in employment tax and the most widely misunderstood. It is not an allowance to be handed to a departing employee; it is what remains exempt after everything that counts as earnings has been stripped out — and since post-employment notice pay was introduced, the amount that survives to reach the exemption is often far smaller than the parties assumed when they shook hands.
Three buckets, in order
Every termination package divides into three categories, and the order of the analysis decides the tax:
- Earnings. Pay for work done, accrued holiday and contractual bonuses — all taxed as normal employment income with full PAYE and National Insurance. Note the common trap in the other direction: a payment is not earnings merely because the contract provided for it. Following Mairs v Haughey, a genuine redundancy payment sits in the termination regime and reaches the £30,000 exemption even where it is contractual. What the contract cannot save is pay in lieu of notice, which the PENP rules catch whether it was contractual or not;
- Post-employment notice pay (PENP). The statutory calculation of the basic pay the employee would have received during any unworked notice period — taxed as general earnings and expressly denied the £30,000 exemption;
- The relevant termination award. What is left — genuine compensation for loss of employment, statutory and enhanced redundancy pay — which is where the £30,000 exemption applies.
The second bucket is the one that changed the landscape. Before it existed, a payment in lieu of notice could sometimes fall within the exemption if the contract was silent on the point, and a great deal of drafting effort went into keeping contracts silent. Section 402D ITEPA now requires the employer to calculate PENP whether or not there is a contractual or non-contractual payment in lieu of notice. The statutory formula works from basic pay in the last pay period before notice, the number of unworked notice days, and the length of the pay period, less any contractual PILON already taxed as earnings. The result is taxable in full, and no amount of labelling in the settlement agreement changes it.
What the £30,000 exemption actually covers
Once earnings and PENP are out, the balance is exempt up to £30,000. Statutory redundancy pay counts towards the limit even though it is itself compensation rather than earnings — a point that catches out employers offering an enhanced package on top of statutory entitlement. The exemption is per termination, not per tax year, and it is not indexed: £30,000 has been the figure since 1988, which means it now covers materially less of a typical senior package than it once did.
Above £30,000 the treatment is asymmetric, and this is the part finance teams miss when costing an exit. The excess is subject to income tax through PAYE and to employer Class 1A National Insurance at 15% — but not to employee National Insurance. So a £60,000 termination award costs the employer roughly £4,500 in Class 1A on the £30,000 excess, on top of the award itself. Budget the gross cost, not the headline figure.
The exemptions that survive intact
A few categories fall outside the charge altogether, and they are worth knowing because they are genuinely valuable where they apply:
- Injury and disability. Payments on account of injury or disability that genuinely prevents the employee from carrying on the employment are exempt without limit — but injured feelings arising from the termination itself do not qualify, and HMRC scrutinises this route closely;
- Death. Payments made on the death of an employee are exempt;
- Employer pension contributions. A contribution into a registered pension scheme as part of the settlement is not a termination payment at all — it is normally free of income tax and National Insurance for both parties, subject to the annual allowance, which makes it the most efficient component available in most packages;
- Foreign service relief, now limited to seafarers and to employees non-resident in the year of termination in defined circumstances, rather than the broad relief it once was.
Payments for restrictive covenants, by contrast, are taxable in full as earnings. So is anything that is really deferred remuneration wearing a compensation label. The test HMRC applies is what the payment is for, not what the agreement calls it.
Settlement agreements and payroll mechanics
Two practical points cause more post-completion trouble than the tax analysis itself.
First, the payroll timing. Where a payment is made after the P45 has been issued, it must be taxed using code 0T on a week 1/month 1 basis — no personal allowance, and the higher and additional rate bands applied to that payment alone. The employee frequently over-pays at that point and reclaims on their tax return, which is administratively correct but produces an angry phone call if nobody warned them. The cleaner route, where the timetable allows, is to make the payment in the final payroll run before the P45.
Second, the agreement's tax indemnity. Most settlement agreements make the employee liable for any further tax HMRC assesses on the payments. That protects the employer's balance sheet but not its relationship or its reputation, and it does nothing to cure an incorrect analysis. The better protection is getting the calculation right before the numbers go into the document — because once the agreement is signed at a stated net figure, the cost of an error lands on the employer in practice regardless of the indemnity.
Costing an exit properly
The sequence that avoids surprises: calculate PENP first and treat it as a fixed, fully taxable cost; identify anything contractual and add it to earnings; measure what is genuinely left as compensation against the £30,000; add employer Class 1A at 15% on the excess; and test whether part of the package is better delivered as a pension contribution. Do that before negotiating, and the number offered to the employee is one the business can actually afford. Do it afterwards, and the gap comes out of the employer's side.
Acumon advises on termination packages as part of employment tax work, handles the payroll treatment through PAYE services, and deals with HMRC where a historic settlement is questioned. If an exit is being negotiated this quarter, the PENP calculation is the first number to run — not the last.