Severance pay: 3 checks for federal labor pricing

Key takeaways

• Match each payment to separation and payroll records.
• Check replacement-contractor service credit and employment conditions.
• Document the classification and any normal turnover allocation.

Start with the definition

Estimators often treat severance as one more line in a layoff budget. On federal work, that habit can put a cost into a labor rate that the government will not accept. Before any severance dollar goes into a rate, you need to know whether the cost principles treat it as allowable. The main reference for that question is the compensation for personal services principle in the Federal Acquisition Regulation, FAR 31.205-6.

The principle begins with a definition, and that definition does most of the sorting. It says that "Severance pay is a payment in addition to regular salaries and wages by contractors to workers whose employment is being involuntarily terminated." Two conditions sit inside that sentence. The payment has to be on top of regular pay, and the worker has to be involuntarily terminated. A payment that fails either condition is not severance under this principle, and the rules below are the wrong test for it.

This post gives you three rules to check, in order, before you decide whether severance can enter the labor rate. Each rule is a question you can answer from paperwork you should already have. None of them replaces your contract, your cost accounting practices, or the advice of your accountant and contracting officer. This is planning guidance, not legal advice. Owners who approve layoffs should read it too, because the answers change how much of a workforce reduction you can recover through the labor price.

Rule 1: confirm the payment is severance

Start with the payment itself. Pull the separation records and the payroll entries for each person involved. You are looking for two things.

First, was the separation involuntary? The definition covers workers whose employment is being involuntarily terminated. A resignation, a voluntary buyout where the employee chose to leave, or a retirement is not automatically severance. Keep the separation letter, the reason code, and any documents that show who started the exit. If the file says the worker chose to leave, do not label the payment as severance because the label helps the rate.

Second, was the payment in addition to regular wages? The definition describes severance as a payment in addition to regular salaries and wages. Final wages and pay for time already worked are not the same thing as a lump sum on top of pay. Sort each item on the final check into its own line, so the severance line holds only what fits the definition.

Retirement incentives need a separate look. The same section says that "Payments for early retirement incentive plans are covered in paragraph (j)(6) of this subsection." If a payment came from an early retirement incentive, do not test it against the severance definition alone. Read paragraph (j)(6) in the same FAR section and treat that payment as its own item.

The practical test is simple. If you cannot point to an involuntary termination and a payment made on top of regular pay, you do not yet have a severance line. Stop there, classify the item correctly, and only then move on.

Rule 2: check employment continuity

A payment can look like severance and still fall outside the definition in a transition between employers. The cost principle addresses this case directly. It says: "Payments made in the event of employment with a replacement contractor where continuity of employment with credit for prior length of service is preserved under substantially equal conditions of employment, or continued employment by the contractor at another facility, subsidiary, affiliate, or parent company of the contractor are not severance pay and are unallowable." You can read the full text on the FAR 31.205-6 page.

Read that sentence carefully, because it names two separate situations.

The first is a replacement contractor. Suppose a follow-on contract goes to a new employer, and that employer hires some of your workers. If those workers keep credit for their prior length of service, and their conditions of employment stay substantially equal, a payment tied to that transition is not severance pay. The same text also says it is unallowable. The payment is removed from the severance category and barred from the cost, so you cannot route it into the rate under a severance label.

The second is continued employment inside your corporate family. If the contractor keeps the worker employed at another facility, a subsidiary, an affiliate, or a parent company, the payment is again not severance pay and is unallowable. The principle treats continued employment at one of those related entities as not severance pay, so a placement inside the group is not a termination for this purpose.

For estimating, the action is to check the employment facts before you price. For each affected worker, ask four questions. Did the worker become employed by a replacement contractor? Did the worker keep credit for prior service? Are the conditions of employment substantially equal? Did anyone in the corporate family, including a parent, subsidiary, or affiliate, keep the worker on? If the answer to the continuity questions is yes, do not carry that payment into the rate as severance.

Do not settle whether conditions are substantially equal with a rule of thumb. Write down how you compared the old and new conditions, including pay, hours, benefits, and location, and bring that comparison to the people who make the call. A vague note such as "roughly the same" will not hold up well if the cost is questioned later.

Rule 3: separate normal turnover from abnormal or mass severance

The third rule decides how the cost is spread across the plant and whether you can set money aside for it in advance. The cost principle separates severance by pattern, and the two patterns get different treatment.

For normal turnover, the text says that "Actual normal turnover severance payments shall be allocated to all work performed in the contractor’s plant." The allocation runs to all work performed in the plant, not only to the contract you are pricing. A labor rate for one contract should therefore carry only its share of plant-wide turnover severance, using the allocation method your accounting system already uses. Work with your accountant on that method, and make sure the allocation base is documented before you price the job.

For abnormal or mass severance, the text says: "Abnormal or mass severance pay is of such a conjectural nature that accruals for this purpose are not allowable."

Do not invent a cutoff and present it as a rule. The classification is a judgment you need to document. Talk it through with your accountant and the contracting officer before you rely on it. If a reduction looks like a mass event, flag it for classification review before pricing it as normal turnover.

A useful habit is to keep two files. One holds the actual normal turnover payments, with the allocation base beside them. The other holds any abnormal or mass event, with the classification memo and the approval trail. Keeping them apart stops a large event from quietly sliding into the turnover pool, and it helps you identify unallowable accruals for abnormal or mass severance.

One more limit for overseas service work

A narrower rule applies to some overseas work. The same section addresses severance payments to foreign nationals employed under a service contract performed outside the United States. The text says that "the costs of severance payments to foreign nationals employed under a service contract performed outside the United States are unallowable to the extent that such payments exceed amounts typically paid to employees providing similar services in the same industry in the United States." The FAR 31.205-6 page has the full wording.

Compare each severance payment with what employees providing similar services in the same industry in the United States are typically paid. The portion exceeding that benchmark is unallowable; the remaining portion still needs the other checks. Document the source you used and how you matched the services. Ask your contracting officer or accountant to confirm the method if the amounts are large.

Put the three rules together

Run each severance item through the rules in order. The sequence matters, because an early answer can end the review.

Notice what this sequence does to a typical layoff. A worker who was let go outright may pass rule one and then face rule three. A worker who moved to a sister company may fail rule two before you ever reach the classification. An estimator who skips straight to the dollar amount is likely to price a cost that gets questioned later.

Keep this review beside your other public bid labor checks. Use a construction estimate audit to review the wider estimate before bidding.

Illustrative example: a replacement contractor

Consider a simple case. Imagine a contract ends and a follow-on goes to a new employer. That employer hires ten workers from the old crew and says it will credit their prior service. Assume their conditions of employment stay substantially equal.

Under this hypothetical, the payments to the ten transferred workers fall under rule two. If the transition conditions are met, those payments are not severance pay and are unallowable, so they do not belong in your rate as severance.

The example is invented to show the order of the checks. Your own facts may come out differently, and the answer depends on the contract and the records you actually have.

What to put in a severance log

Good estimating depends on good records, so set up a severance log before you need it. For each separation, record the worker, the date, the reason for separation, the payment type, the amount actually paid, and the contract or contracts it touches. Add a column for the rule results, so you can see at a glance which items passed each check.

Keep actual paid amounts separate from forecasts. Keep early retirement incentive payments in their own bucket, so they are not mixed with ordinary severance.

For each transition to a replacement contractor, file the comparison of employment conditions and the record of prior service credit. For each affiliate or parent company placement, file the document that shows the continued employment. Those files are what you will show if the cost is questioned.

Finally, record the allocation base for normal turnover. Note the method, the period it covers, and who approved it. A rate built on an undocumented base is hard to defend, even when the underlying numbers are right.

How to explain this to an owner

Owners often ask a simple question: can we recover the cost of the layoff through the labor rate? The honest answer is that you can recover only the part that passes the checks, and only in the form the rules allow. Some payments will be removed, some will be spread across the plant, and some cannot be reserved in advance at all.

It helps to set expectations early. If a layoff is planned, tell the owner that the severance recovery depends on the employment facts, the classification, and the allocation. Ask them to share the separation decisions as they happen, so the records are built at the time of each decision and not reconstructed later. A change in who keeps a worker, or where that worker is placed, can change the answer.

Owners should also understand that a rate may move after review. If an accountant or contracting officer reclassifies an item, the amount that enters the rate can shrink. Plan for that possibility rather than treating the first estimate as final.

Common mistakes to avoid

Several errors come up again and again. The first is labeling every end-of-job payment as severance. A payment on a transition or a retirement incentive may belong somewhere else entirely.

Another mistake is ignoring the corporate family. A worker moved to an affiliate or a parent company can change the outcome completely, so check placements across the group before you price.

Avoid assuming a reduction is normal without evidence. If you cannot explain why an event is normal turnover, flag the classification for review before including it in that pool. Also check whether the overseas comparison applies when foreign nationals are employed under a service contract performed outside the United States.

Keep the review in order

Run this review before the labor rate is set, and again if the facts change. A layoff that starts as normal turnover can grow into a mass event. A transfer that looked clean can turn out to involve an affiliate. Each change can move a payment from allowable to unallowable, or from one allocation pool to another.

Above all, keep the paperwork that supports each answer. The rules are clear about what is severance, what is unallowable, and what must be allocated, but the rules only help you if you can show which facts applied to which worker. Good records turn a hard pricing question into a defensible one, and that is what keeps a federal labor rate on solid ground.

Today, pull the separation record and payroll entry for one payment, then document its employment-continuity check and classification before changing the rate.

Questions about severance pay

Does a replacement contractor hiring a worker always exclude severance?

The exclusion applies when employment continuity preserves prior-service credit under substantially equal employment conditions. Check both conditions in the transition records.

Can normal turnover severance go entirely to one contract?

Actual normal turnover severance must be allocated to all work performed in the contractor’s plant. Document the allocation base before pricing.

Can you accrue abnormal or mass severance?

Accruals for abnormal or mass severance are unallowable. Keep that treatment separate from the normal turnover allocation.