Settlement agreements: what they are, and when a small employer should actually use one

Most small employers meet a settlement agreement in the worst possible circumstances. Something has gone wrong with an employee, somebody has said the word 'tribunal', and an adviser mentions that a settlement agreement could make the problem go away. It usually can. But it is a specific legal instrument with strict conditions attached, and used carelessly it either fails to protect you or costs a great deal more than the problem it was solving.

Here is what one actually is, what it costs, and the situations where it earns its money.

What a settlement agreement actually is

An employee cannot normally sign away their statutory employment rights. A friendly 'we agree not to sue each other' clause in a leaving letter is worth nothing, because section 203 of the Employment Rights Act 1996 makes any attempt to contract out of the Act void. The settlement agreement is the narrow exception Parliament carved out of that rule — and it only works if the conditions are met exactly.

It has to be in writing. It has to relate to particular complaints or proceedings rather than waiving everything in the world. The employee must have received advice from a relevant independent adviser — a qualified solicitor, a certified trade union official, or a certified advice-centre worker — and that adviser must be named in the agreement and covered by professional indemnity insurance. The agreement must state that those conditions are satisfied. Miss any of it and you have paid for a waiver that does not waive.

In practice the shape is always the same: the employment ends on agreed terms, the employee gives up the listed claims, and they receive something above their strict contractual entitlement in return. The employer normally contributes to the employee's legal fees — a few hundred pounds plus VAT is the usual courtesy, and it is in your interest, because an unadvised employee cannot sign a valid agreement.

The protected conversation, and its very real limits

Section 111A of the same Act allows a pre-termination conversation to be treated as confidential and inadmissible in an ordinary unfair dismissal claim, even where no dispute exists yet. That is the provision that lets you say 'this isn't working, shall we talk about an exit?' without the sentence being read back to you in a tribunal.

The limits matter more than the protection. Section 111A does not cover discrimination claims, automatically unfair dismissal claims such as whistleblowing, breach of contract, or unlawful deduction from wages. So if there is any hint that the underlying issue touches a protected characteristic — pregnancy, disability, age, race — the 'protected' conversation is not protected at all, and everything you say is evidence.

It also falls away if you behave improperly. Telling someone they must sign today or be dismissed tomorrow is the textbook example. The Acas code on settlement agreements suggests giving at least ten calendar days to consider a written offer, and that is the standard a tribunal will measure you against.

What it costs, with the numbers on the table

Take an illustrative case: an employee on £32,000 with two years' service and one month's contractual notice. You offer a clean exit.

Notice pay is roughly £2,666 and is fully taxable with National Insurance, whether you call it notice or not — the post-employment notice pay rules exist precisely to stop notice being relabelled as compensation. Accrued untaken holiday of, say, £600 is also taxable. On top you offer £6,000 of genuine termination compensation, which falls inside the £30,000 exemption in section 401 of ITEPA 2003 and is paid without deduction. Add a £500 plus VAT contribution to their solicitor, and budget at least as much again for your own adviser drafting the thing properly.

That is roughly £9,800 of cash out, and about £3,300 of it was money you owed anyway. The number worth comparing it against is not zero — it is the cost of defending a claim you might well win, plus the management hours, plus the risk. Anything you pay above £30,000 attracts employer National Insurance at 15%, which is the point at which large settlements get noticeably more expensive than they look.

A settlement agreement buys certainty. It does not buy back the process you skipped.

When it is the right tool

It works best where the relationship is genuinely finished and a fair process would still leave you exposed: a long-running personality breakdown, a senior hire who was wrong for the role from month one, a redundancy where you want the claims waived alongside the statutory payment, or a live dispute you would rather not litigate even with a decent case. It also works where confidentiality genuinely matters to both sides — though you cannot gag someone from whistleblowing, reporting a crime, or co-operating with a regulator, and a clause that tries to will not help you.

When it is the wrong tool

It is the wrong tool when it is being used to buy your way out of management you never did. If nobody ever told the employee their work was below standard, a settlement fixes this one case and teaches you nothing — start instead with a written warning done properly. It is the wrong tool when the sums are small enough that a fair process would cost less. And it is the wrong tool when the real problem is repeatable, which is usually a hiring problem rather than an exit problem; the real cost of a bad hire is mostly paid before anyone reaches for a settlement.

One more caution: if the exit is a redundancy, a settlement agreement sits on top of a proper consultation, it does not replace one. The redundancy conversation still has to happen.

The checklist before you open the conversation

Take advice before you speak, not after. Write down the actual reason for the exit and check it does not touch a protected characteristic. Decide your ceiling in advance, including your own legal costs. Put the offer in writing with a ten-day window. Be specific about which claims are waived. Check the post-employment notice pay calculation before you label anything tax free. Agree the wording of the reference inside the agreement itself, so nobody argues about it later. And diarise the payment dates — a settlement you fail to pay on time is a breach of contract that can revive the whole problem.

Common questions

Do I have to pay for the employee's legal advice?

Strictly, no — the law requires the employee to have taken independent advice, not that you fund it. In practice almost every employer contributes, and it is sensible to. Without advice the employee cannot sign a valid waiver, so refusing to help pay simply stalls the deal you want. A contribution of a few hundred pounds plus VAT is customary, paid directly to the solicitor on production of an invoice, and the agreement should say the payment is conditional on a signed adviser's certificate. If the negotiation becomes complicated the employee may have to fund the extra themselves, which is normal and does not affect validity.

Can I have a protected conversation if there is no dispute yet?

Yes — that is exactly what section 111A of the Employment Rights Act 1996 was designed for. Unlike the older without-prejudice rule, it applies even where no dispute has arisen, so you can raise an exit before anything formal has started. The protection is narrower than people assume. It only makes the conversation inadmissible in an ordinary unfair dismissal claim, not in discrimination, whistleblowing, wages or breach of contract claims, and it disappears entirely if you behave improperly — pressuring someone to sign on the spot being the classic example. Put the offer in writing and give at least ten calendar days to consider it.

Is the first £30,000 of a settlement always tax free?

No, and this is the most expensive misunderstanding in the area. The £30,000 exemption applies only to genuine compensation for the loss of employment. Anything that is really earnings stays taxable: unpaid wages, accrued holiday, contractual bonuses, and notice pay. The post-employment notice pay rules calculate the notice element from your payroll figures regardless of what the agreement calls it, so relabelling notice as compensation does not work. Above £30,000 the excess is taxable on the employee and attracts employer National Insurance at 15% on your side, so model the gross cost before you name a figure.

Can the employee still bring a claim after signing?

For the claims properly listed in the agreement, no — that is the point of the statutory waiver, and a tribunal will strike out a claim covered by a valid agreement. Three things survive it. Accrued pension rights are normally excluded and should be stated as such. Personal injury claims the employee does not yet know about are usually carved out. And protected disclosures — whistleblowing — cannot be contracted away at all, nor can a duty to co-operate with a regulator or the police. If any of the statutory conditions were missed, for example the adviser was not properly identified, the waiver itself fails and every claim remains live.