Settlement Payment

A settlement payment (sometimes called a settlement-agreement payment or, historically, a compromise agreement) is paid under a written agreement that satisfies section 203 of the Employment Rights Act 1996. In return for the lump sum and any non-cash consideration (e.g. an agreed reference, retention of a laptop), the employee waives their right to bring most statutory and contractual claims against the employer. The employee must take independent legal advice, and the legal fees (typically £500-£1,500) are usually paid by the employer on top of the settlement.

For tax purposes, settlement payments are dissected into elements. Pay during the notice period (PILON) and any unpaid bonuses or commission are taxable in full as earnings. Genuine ex-gratia compensation for loss of office is taxed under the section 401 ITEPA termination payment rules: the first £30,000 is income-tax free, the rest is taxed at the employee's marginal rate, and (since 2020) the excess over £30,000 also attracts employer's Class 1A NIC at 15%. Restrictive-covenant payments are fully taxable. Legal fees paid by the employer direct to the solicitor are tax-free.

Worked example: Erin signs a settlement on 30 June 2026, walking with: £8,000 PILON (her contract has 3 months' notice), £2,000 holiday pay, and £40,000 ex-gratia compensation. The £8,000 and £2,000 are taxed as earnings. The £40,000 is split: £30,000 tax-free, £10,000 taxed at 40% (as her annual income is in the higher rate band) plus 15% Class 1A on the employer side - net to Erin from the £40,000 ex-gratia portion is £30,000 + £6,000 = £36,000.