What is a Settlement Agreement?
Settlement agreements are often used as an alternative to the employer
going through a lengthy disciplinary, performance management or redundancy
procedure. Settlement agreements may also be used by employers as a means
of settling serious employee grievances, such as claims of constructive
dismissal or unlawful discrimination.
Up until 29 July 2013, settlement agreements were known as compromise
agreements. As of that date, the terminology was changed, but the effect of
settlement agreements and the legal requirements for validity remain the
same as for compromise agreements.
Essentially, a settlement agreement is a formal, legally binding agreement
made between an employer and employee (or ex-employee) where the employee
agrees not to pursue particular claims in relation to his or her employment
or its termination e.g. unfair dismissal or discrimination claims. In
return, the employee generally receives a financial settlement and an
agreed form of reference. A settlement agreement must be entered into
voluntarily. In most cases, settlement agreements are used because the
employer wishes bring an employee’s employment to an end quickly and with
the minimum of trouble, while avoiding the expense and uncertain outcome of
an employment tribunal.
What has to be included in a Settlement Agreement?
A number of important conditions have to be fulfilled, for the agreement to
be legally binding:
the agreement must be in writing;
it must relate to the particular complaint;
the employee must have received independent legal advice from a
‘relevant adviser’ as to the terms and effect of the agreement and, in
particular, its effect on the employee’s ability to pursue rights
before an employment tribunal. A ‘relevant adviser’ includes:
- a qualified lawyer;
- officers of an independent trade union, provided that they have been
certified in writing by the union as competent and authorised to give
- voluntary workers or employees at free legal advice centres provided
that they have been certified in writing as competent and authorised to
give such advice; and
- Fellows of the Institute of Legal Executives (ILEX) employed by
there must be a contract of Insurance or professional indemnity
insurance in force covering the risk of a claim by the employee in
respect of loss arising as a result of the advice, at the time the
legal adviser gives the advice;
the settlement agreement must identify the adviser; and
the agreement must state that the conditions regulating settlement
agreements under the relevant legislation are satisfied.
The agreement is contractually binding once it has been signed by both
parties so, if one party breaches the agreement, the other is no longer
bound by its terms. For example, if the employer does not pay what has been
agreed in the settlement agreement, the employee can take his or her claims
to the employment tribunal or court.
Since 29 July 2013, pre-termination negotiations (known as 'protected
conversations') between an employer and employee with a view to ending the
employment under a settlement agreement have not been admissible as evidence in
most unfair dismissal claims. The idea is to extend the traditional
"without prejudice" rule to circumstances where no dispute exists between
employer and employee. However, the confidentiality of pre-termination
negotiations applies only to unfair dismissal claims. Pre-termination
discussions are not protected if the employee has been dismissed for an
automatically unfair reason, for example taking maternity leave. In
addition, where something ‘improper’ is said or done, the content of the
discussions is protected only to the extent that the tribunal considers
just. Improper conduct would include bullying or harassment. Further advice
on pre-termination (protected) conversations can be found on the ACAS
website and employers should proceed with caution in using such
conversations to end employment disputes.
Employers should be aware that an employee can rely on what was said during
pre-termination negotiations as evidence in other types of claim, for
example a discrimination or whistle-blowing claim. Employers should,
therefore, continue to use "without prejudice" discussions in negotiating
with an employee to settle an employment dispute. For the “without
prejudice” rule to apply, the employee must have genuinely agreed to the
meeting being held on a without prejudice basis, there must be a
pre-existing dispute between the parties and the discussion must be a
genuine attempt to settle the dispute.
The Negotiation Process
Usually, the employer (or its solicitors) will produce the draft settlement
agreement. The employer will then request that the employee take
independent legal advice on it. Employees should be given a reasonable
amount of time to consider the proposed conditions of the settlement
agreement; the ACAS Code of Practice on settlement agreements specifies a
minimum of 10 calendar days. Employers should note that settlement
agreements are voluntary and parties do not have to agree to them or enter
into discussion about them.
There will generally be a period of negotiation between the parties until
they manage to agree on the terms of the settlement agreement or they both
conclude no agreement can be reached. If a settlement agreement is not
reached, resolution may be pursued through a performance management,
disciplinary or grievance process, whichever is the most appropriate. If
both parties agree on the settlement agreement, two copies are produced for
signature. Once the copies have been signed by both parties, the agreement
becomes legally binding. Each party will keep one of the copies.
In order to protect themselves, employers should state that, until a
settlement agreement is signed by all parties, no part of it is binding.
The Taxation of Termination Payments
Not all payments made on termination of employment under a settlement
agreement are tax-free.
Outstanding wages, bonuses, commission and holiday pay are fully taxable,
as are payments made under the employee's contract of employment. Ex gratia
(non-contractual) sums paid as compensation for loss of employment under
the terms of the settlement agreement are taxable, but subject to the
£30,000 tax-free exemption. This includes statutory and contractual
redundancy payments, provided that they are made on account of genuine
Where an employee receives a contractual payment in lieu of notice, the
payment is chargeable to tax as earnings from employment. In the absence of
a PILON clause, it used to be possible to make payment in lieu of notice
tax-free. However, since 6 April 2018, all payments made in lieu of notice,
whether contractual or not, have been subject to tax and Class 1 national
Employers should seek specific advice on the tax treatment of the various
payments being made under a settlement agreement.