Settlement Agreements for Employers: A Practical Guide
3 August 2026 · By Oliver Tasker
A settlement agreement can be one of the most useful tools available to a business dealing with a difficult employment situation. But (there's always a but) only if it's used at the right time, drafted properly (not AI!) and handled with care. Get it right, and you draw a clean, legally binding line under a dispute or exit. Get it wrong and you can end up paying twice both in money and time: once for the settlement and again defending the tribunal claim you thought you'd avoided.
What is a settlement agreement?
A settlement agreement is a legally binding contract between an employer and an employee, usually used to end the employment relationship on agreed terms. In exchange for a payment (and often an agreed reference), the employee gives up their right to bring most types of tribunal claim relating to their employment or its termination. To be valid, the employee must receive independent legal advice on the terms before signing, which is why employers typically contribute towards the employee's legal fees.
When should employers use a settlement agreement?
Settlement agreements come up most often in a handful of scenarios:
Ending employment following a breakdown in the relationship, where dismissal would carry a real tribunal claim risk.
Resolving a workplace grievance or dispute without a lengthy, disruptive formal process.
Redundancy situations where an enhanced package secures a quicker, cleaner exit.
Performance or conduct issues where the evidence is weaker than the business would like.
Long term absence cases where a fair process to dismissal would be slow and uncertain.
In each case, the appeal is the same: certainty. A signed settlement agreement closes off the risk of an employment tribunal claim rather than leaving it hanging over the business for months. It can save time and money.
What should a settlement agreement include?
A well drafted settlement agreement should deal with more than just the headline payment figure. Businesses should make sure it addresses:
The termination date and any notice or garden leave arrangements.
The settlement payment, and how much (if any) can be paid tax-free.
Treatment of bonus, commission, holiday pay, and any share or pension entitlements.
Confidentiality and any agreed reference wording.
Return of company property and logistics of keeping any items.
Ongoing restrictive covenants - whether new or under the current contract of employment.
A full and final waiver of claims, tailored to the specific risks in that case (very important).
Generic settlement agreement templates pulled from the internet or drafted by AI often miss one or more of these and a gap in the drafting can leave the business exposed on exactly the point it was trying to protect.
How much should you offer in a settlement agreement?
There's no fixed formula and the right figure depends on the strength of the employee's potential claims, their length of service, salary, the exact issue (e.g. conduct, capability or redundancy) and how quickly the business needs certainty. A settlement offer is really a reflection of litigation risk: weigh the likely tribunal award and legal costs of fighting a claim against the cost of settling now and negotiate from there.
Are settlement agreement payments taxable?
Up to £30,000 of a genuine termination payment can usually be paid free of tax and National Insurance, but this exemption doesn't cover everything. Payments in lieu of notice, holiday pay and contractual bonuses (i.e. normal earnings) are typically taxable in the normal way. Getting the tax treatment wrong is a common and costly mistake, so this is worth checking carefully before any figure is agreed with the employee.
Common settlement agreement mistakes employers make
The most frequent pitfalls are rushing the first conversation without a clear strategy, failing to protect discussions under the "without prejudice" or protected conversation rules, offering a figure before understanding the actual litigation risk, and using a one-size-fits-all template that doesn't reflect the specific claims being settled.
Key takeaway for employers
A settlement agreement is only as good as the process and drafting behind it. Approached properly, it's an efficient way to manage risk and part ways on clear terms. Approached carelessly, it can create new problems and a tribunal claim on the horizon.
As ever, if you're considering a settlement agreement or need one drafted, get in touch with Oliver Tasker today:
📞 Call: 01522 776270 ✉️ Email: oliver@impactemploymentlaw.co.uk
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