How to draft an employment settlement agreement in 6 simple steps

A settlement agreement is a valuable tool for resolving any outstanding issues and preventing future disputes when an employer-employee relationship is coming to an end. This legally binding contract offers both parties the opportunity to settle any potential claims, providing the employee with financial and/or non-financial benefits in exchange for waiving their right to pursue legal action.

In this guide, we’ll walk through the steps UK employers should take to create a clear, fair, and legally compliant settlement agreement.

What is a settlement agreement?

An employment settlement agreement (previously known as a compromise agreement) is a legally binding contract between an employer and an employee. In exchange for certain benefits, the employee agrees not to pursue any legal claims arising out of their employment or its termination.

Settlement agreements give employers peace of mind by protecting them from future claims such as unfair dismissal or discrimination. They are often used when an employee is leaving the company and both parties want to settle any potential legal disputes amicably.

Settlement agreements are common in cases of redundancy, dismissal, or where both parties agree to end the employment relationship.

Why UK employers need settlement agreements

Settlement agreements provide many key advantages for employers, including:

• Cost-effective protection: Settlement agreements are typically finalised within a few weeks, whereas defending a claim at an Employment Tribunal can be a lengthy and costly process. With a settlement agreement, you retain control over the compensation paid to the employee. In contrast, if the employee brings a claim and is successful, the compensation amount is determined by the Employment Tribunal.

• Clarity and certainty: The settlement agreement clearly defines the terms of the settlement, providing peace of mind that the matter is fully resolved and the employee will not pursue any future claims related to their employment. A key element of this is the waiver of claims (see Step 5 for more information), where the employee agrees not to bring any legal claim, such as those for unfair dismissal, discrimination, or breach of contract, against your business.

• Maintaining confidentiality: Settlement agreements often include clauses that protect your company's confidential information and prevent the employee from making adverse comments that may bring the business into disrepute.

With these benefits in mind, let’s walk through the key 6 steps to creating an effective settlement agreement.

6-step guide to creating a settlement agreement

Step 1: Start with basic information

Every settlement agreement should start with the basics. Clearly identify the parties involved, i.e. both the employer and the employee.

You’ll also need to specify the following key dates in the settlement agreement:

• The date of the employee’s employment agreement;

• the employee’s termination date; and

• the effective date of the agreement, which is typically when all parties have fully signed the settlement agreement.

Including these dates outlines a clear timeline of events, which is crucial not only for legal purposes but also for ensuring everyone is clear about the terms of the settlement agreement.

Step 2: Detail the settlement terms

The settlement terms are the heart of the settlement agreement. This section will outline the financial and non-financial benefits the employee will receive upon signing the settlement agreement.

Common elements that you will typically find in a settlement agreement include:

• Severance pay: specify the amount of severance pay, whether it’s a lump sum or paid in instalments, and the payment date(s).

• Unused holiday pay: state whether the employee will be compensated for any unused holiday entitlement or paid time off (PTO).

• Bonuses and share options: if applicable, mention any outstanding bonuses or share options the employee may be entitled to.

• Garden leave: Indicate if the employee will be placed on garden leave. Garden leave involves the employee remaining on the company's payroll and receiving their usual salary and benefits during their notice period, but they are not required to come to work. If applicable, specify the duration of garden leave and any conditions that apply, such as restrictions on starting new employment or engaging in competitive activities.

All payment terms and non-financial benefits should be clearly outlined in the settlement agreement to avoid any misunderstandings.

What is pay in lieu of notice?

It’s important to clarify if the employee will work their notice, or, if allowed under the terms of their employment agreement, they will receive a sum equivalent to their contractual notice (known as “pay in lieu of notice” or "PILON").

Please note: you cannot pay PILON if it is not included in the employment agreement, so ensure you review the agreement first.

Step 3: Costs

One of the key considerations in any settlement agreement is the cost, particularly in relation to the employee’s legal advice. While there is no legal requirement for employers to cover this expense, it is common practice for them to contribute towards it. This is because, for the settlement agreement to be legally binding, the employee must receive independent legal advice regarding the terms and effect of the agreement. This advice must come from a qualified solicitor, trade union representative, or authorised advice provider.

It is therefore a good idea to clarify within the settlement agreement how much the employer will contribute towards the employee’s legal fees. For most employees, employers typically offer around £500 plus VAT to cover the legal fees. However, this contribution may be higher in cases involving senior executives or where the agreement requires more complexity.

Step 4: Include a waiver of claims

A critical component of any settlement agreement is the waiver of claims. This clause ensures that the employee waives their right to bring certain legal claims against the employer. These claims might include:

• Unfair dismissal

• Discrimination

• Breach of contract

• Unlawful deduction of wages

Please note that it is not enough to state that the settlement agreement waives 'all claims' or 'all potential claims' in general. It's crucial to include a list of the particular claims you're agreeing to settle. Including a comprehensive list of claims waived by the employee ensures that both parties clearly understand the scope of the waiver and provides broad protection from the employer against such claims being brought in the future.

Step 5: Address confidentiality and terms to prevent reputational damage

If your business has sensitive information that you would not want to be leaked to the public, it is imperative to include confidentiality obligations in your settlement agreement that protect your company’s confidential information. These clauses typically cover:

• Confidentiality: these terms prohibit the employee from disclosing sensitive business information, such as trade secrets, client lists, or financial data.

• Prevention of derogatory statements: these terms pevent the employee from making negative or harmful statements about the company, its directors, shareholders or other employees.

Confidentiality clauses are particularly important in industries where the protection of sensitive information is critical. By clearly outlining these terms, you can safeguard your company’s reputation and ensure a smoother, more professional settlement process.

Step 6: Include non-compete and non-solicitation clauses (if applicable)

Depending on the nature of your business, you may wish to include restrictive covenants, such as non-compete and non-solicitation clauses in your settlement agreement. These clauses can provide essential protection for your business after the employee has left, especially if they had access to sensitive information or key clients.

• Non-compete clauses: These prevent the employee from joining a competing business or starting their own venture in the same industry for a defined period of time, within a specific geographical area. These types of clauses must be reasonable and not overly restrictive, as courts may not enforce them if they are deemed too limiting on the employee’s ability to find new employment.

• Non-solicitation clauses: These prevent the employee from contacting or soliciting your clients, customers, or other employees to move to a competing business. This type of clause is especially important if the employee held a client-facing role or had access to key business relationships.

While these clauses can offer peace of mind and protection for your business, they must be carefully drafted to ensure they are enforceable under UK law. The restrictions must be reasonable in terms of duration, geographic scope, and the business interests they protect. Overly broad or punitive restrictions are unlikely to hold up in court.

If you plan to include such clauses, make sure they are tailored to the specific risks your business faces and that they strike a fair balance between protecting your business and allowing the employee to move on in their career.

Conclusion

Creating a settlement agreement that’s legally sound and fair to both parties is essential for UK employers. By following this step-by-step guide, you can ensure that your agreement protects your business, complies with UK employment laws, and provides clarity for the departing employee.

For more guidance on settlement agreements and employment matters, visit the Acas website which contains many helpful resources.

How can Docue help you with your settlement agreements?

Docue’s settlement agreement template is user-friendly and allows you to create a tailored settlement agreement in minutes.

With lawyer-drafted guidance notes throughout the process, you can confidently draft agreements that protect your business while ensuring legal compliance. Docue also offers a secure e-signature feature, allowing you to collect signatures efficiently and conveniently.

Additionally, all your agreements and other important documents can be safely stored using Docue’s secure storage feature, Docue Drive.

Sign up today to streamline the creation of your settlement agreements with Docue.