Tax implications of settlement agreements

The tax implications of payments in settlement agreements are discussed in this article in three main parts:

Part One is about payments that can be made tax free and Part Two details taxable payments. In Part Three, we explain how an ‘ex gratia’ payment exceeding £30,000 is taxed in a settlement agreement and illustrate how the tax is calculated.

Settlement agreements

In essence, settlement agreements are legal documents which set out the terms and payments you will receive when you have settled a dispute with your employer and want to leave your employment. 

They are entered into voluntarily and when your settlement agreement has been concluded, your dispute with your employer is legally settled once and for good. 

See our main guide on settlement agreements for more detailed information and try our free settlement agreement compensation calculator (below) if you want to find out how much your settlement claim is worth.

Settlement agreements: tax implications

Some of the payments made in settlement agreements are taxable in much the same way as your salary is, whilst others can be paid free of tax. 

Tax-free payments are one of the main financial advantages of a settlement agreement and although successive governments have whittled them down over the years, they are still worth having. 

This is especially true when compared with employment tribunal awards which are fully taxed. It is certainly worth investigating what the tax implications of your settlement agreement are before you sign it.

Part One

What settlement agreement payments can be paid tax free?

Compensation and ex gratia payments below £30,000

Compensation payments and ex gratia (or ‘goodwill’) payments above any that may be included in your contract of employment are tax-free up to £30,000. 

If they are over £30,000 they are taxable and the final part of this article focuses on those payments and how to calculate tax on them.

See also our article on ex gratia payments and how and when you can get one.

Redundancy payments

Redundancy pay is technically compensation for your job loss, so whether it is statutory redundancy pay or contractual redundancy pay, it is paid free of tax within the overall tax-free allowance of £30,000 referred to above.

Our practical guide on redundancy provides further information.

Payments made into a pension fund

Termination payments made directly into a pension fund can usually be made free of tax.  We have a separate practical guide dealing specifically with tax on pension payments and settlement agreements for more detailed information on this topic

Disability or injury payments

Where a disability or injury occurs at work, payment can be made free of tax.

Injury to feelings payments

There is a category of tax called ‘disability exemption’ which applies when an employee is compensated for damages resulting from a psychiatric injury caused by unlawful discrimination at work.

If the injury happened before your employment ended, then it will not be subject to tax, but if the injury was actually caused by the termination, then it will be taxable.

Legal fees for reviewing and signing off a settlement agreement

Payment made to a solicitor for reviewing and advising you on your settlement agreement before it becomes legally binding does not involve any tax payment on your part.

This is because the payment is made directly by your employer to your solicitor and your settlement agreement will include a clause confirming that. Our article on concluding a settlement agreement tells you more about this subject.

Alex Monaco

Top Tips

Alex Monaco

  1. If you are receiving no other income in the month it may be preferable to be paid before your P45 is issued

  2. Consider filing a tax return to ensure you don’t end up overpaying tax

  3. Take specialist advice on your position

Part Two

What settlement agreement payments are subject to tax?

Settlement payments which are taxable are as follows:

Payment of your salary up to your leaving date

Not surprisingly, the salary and associated benefits normally paid to you, and included in your settlement payment, are subject to tax and national insurance.

Payment for holiday owing but not taken by the time your employment ends

Employers have to pay you for any holiday which has accumulated, but which you haven’t taken by the date of your departure, and this too is taxable.

Payments for restrictive covenants added to your settlement agreement

Restrictive covenants are also sometimes called post-termination restrictions, or non-compete restrictions and are commonly found in contracts of employment. 

As their names imply, these restrictions prevent or restrict you from doing things after you have left your employment, that could have a detrimental effect on your (previous) employer’s business. 

For example, they can prevent you from setting up a nearby business in direct competition with your employer, or from poaching their staff and customers. Our article on restrictive covenants gives further details.

If you already have such terms in your employment contract, these will normally be carried over into your settlement agreement. 

Sometimes, however, an employer wants to revise them or add new ones, and to be legally binding, they have to pay you for agreeing to that and also to abide by them. 

Although the sums paid to you are invariably modest, they are nevertheless subject to income tax (and national insurance contributions too).

Pay in lieu of notice (PILON)

Your employer is required to account to HMRC for any basic pay that you would have received if you had worked your notice. 

This basic pay is treated as earnings and as such is subject to tax and NI contributions. See our article on PILON for more information.

Part Three

What tax is payable on ex gratia payments over £30,000 in settlement agreements?

This final section is a bit financially technical in places, but it’s included nonetheless for those of you who are at ease dealing with financial data.

It presents the basic rules for calculating the tax, then sets our a worked example and concludes with a discussion of when it might be most advantageous for the payments to be made.

The basic rules for calculating tax on ex gratia payments over £30,000

  • Employers must use the OT tax code (rather than BR) in relation to ex gratia payments over £30,000 which are not included in your P45. This could apply if for example you are dismissed, issued with a P45, and then your lawyer negotiates a high payout for you by way of a settlement agreement.
  • The regulations state that the OT tax code is to be applied on a “non-cumulative” basis. For an employee paid on a monthly basis, this means that only 1/12th of the basic rate band (and, if relevant, 1/12th of the higher rate (40%) band) is available in the month of payment.
  • So, if the termination (or other) payment is more than the appropriate proportion of the 20% band, the excess will be taxed under PAYE at 40%, and if the payment is also more than the available 40% band, the excess will be taxed under PAYE at 45%
  • Firstly, the employer will have to operate PAYE on the basis that none of the personal allowance is available.
  • Secondly, “monthly” means tax months, rather than calendar months. Tax months run from the 6th of one calendar month through to the 5th of the next (as each tax year starts on 6 April). This means that payments made on, say, the 7th of one calendar month and the 2nd of the next would fall within the same tax month, with the effect that only one month’s bands would be available to share between the two payments.
  • Finally, there is a risk that the amount of PAYE deducted is more than the actual income tax liability. If you have little other taxable income in the tax year, you could have too much PAYE deducted from the termination payment and have to reclaim some tax through your tax return.

Worked example of calculating tax on an ex gratia payment over £30,000

The example below uses tax band figures from 2022/23.

The PAYE that has to be applied to any post-P45 payment in the first month of the 2022/2023 tax year (month 1) will be roughly as follows:

  • The first £4,189.67 or the whole payment if it is less than this amount, is taxed at 20%, which means a PAYE deduction of up to £837.83 (£4,189.67  is the 20% band for 2022/23 for month 1, found by dividing by 12 the 20% band for the year, £50,270).
  • The next £8,310.75 is taxed at 40%, which means a PAYE deduction of up to £3,324.30 (£8,310.75 is the 40% band for month 1, found by dividing by 12 the 40% band for the year, £150,000 – £50,270).
  • Any amount above £12,500 is taxed at 45% (£12,500 is the combined 20% and 40% bands for month 1, found by dividing £150,000 by 12).


This would mean that if, after the issue of the P45, an ex-employee receives a termination payment:

Of £40,000, £3,161.96 would be withheld as PAYE. The PAYE is calculated as follows:

  • £30,000 tax-free
  • £4189.67 @ 20% = £837.83
  • £5,810.33 @ 40% = £2,324.13


Of £50,000, £7,537.13 would be withheld as PAYE. The PAYE is calculated as follows:

  • £30,000 tax-free
  • £4,189.67 @ 20% = £837.83
  • £8,310.75 @ 40% = £3,324.30
  • £7,500 @ 45% = £3,375

 When would it be best for an ex gratia payment over £30,000 to be paid?

The relative merits (from a cash-flow perspective) of pre- or post-P45 payment will need to be assessed individually in each case.

However, if an employer makes more than one post-P45 payment to an employee in a tax year, each separate payment will be subject to PAYE independently, and it will not take account of the earlier payments when working out PAYE on the later payments, paid in a different month.

The key date is when the employee becomes entitled to the amount: simply delaying payment of portions of an amount to which the employee is already absolutely entitled will probably make matters worse as the employer will have to account for PAYE on the full amount on the date of entitlement.

This appears to mean that if a termination payment is paid in a series of monthly instalments then each instalment would be treated in the way described above, and so could be brought (at least in part) within the monthly non-cumulative 20% band (or 20% and 40% bands).

In addition, there may be a cash-flow advantage for an additional rate taxpayer, who does not get a personal allowance in any event and who is likely to suffer tax on a pre-P45 termination payment entirely at the additional rate (assuming that in the tax month of payment, the employee has already received salary payments that have used up the basic and higher rate allowance).

If the payment is made in a subsequent tax month, and following the P45, an additional rate taxpayer will get another chunk of basic rate and higher rate allowance because of the OT calculation, and this won’t be reversed until the taxpayer completes a self-assessment tax return for the relevant tax year.

See also our helpful guides below for further discussion of related topics