Answers · UK 2025/26

What is a settlement agreement, and is the payout tax-free?

A settlement agreement is a legally binding contract, usually ending employment, in which an employee agrees not to pursue certain claims against their employer (such as unfair dismissal) in exchange for a payment. Only the genuine compensation element for loss of employment is potentially tax-free up to £30,000 — any element representing notice pay (PENP), unpaid salary, holiday pay, or bonuses due remains fully taxable as earnings.

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A settlement agreement (formerly known as a compromise agreement) is a formal, legally binding document, most commonly used when an employment relationship is ending, under which an employee agrees to waive their right to bring specified employment tribunal claims against their employer — such as unfair dismissal, discrimination, or breach of contract claims — in return for an agreed sum of money and, often, other terms such as an agreed reference or confidentiality obligations. For a settlement agreement to be legally valid and binding on the employee's ability to bring a claim, the employee must receive independent legal advice from a qualified adviser (usually a solicitor) on the terms and effect of the agreement, and employers conventionally contribute a fixed sum (commonly £350-£750) towards the employee's legal costs for obtaining this advice. Whether the settlement payment is tax-free depends entirely on what each element of the payment actually represents, not simply on the fact that it is described as a settlement payment: any element that represents Post-Employment Notice Pay (PENP, broadly notice period pay the employee would have earned anyway) is always fully taxable as earnings; any element representing unpaid salary, accrued but untaken holiday pay, or a contractual bonus that was already due is also fully taxable as normal earnings; but the remaining genuine compensation element — an ex-gratia payment specifically for the loss of the job and the associated claims being waived, not linked to any contractual entitlement — can benefit from the £30,000 tax-free termination payment exemption, with only the excess above £30,000 taxed as income (and Class 1A employer-only National Insurance, not employee NI, applying above £30,000 on that excess). Settlement agreements typically break down the total payment into these separate components explicitly in the agreement itself, and it is worth an employee checking this breakdown carefully (ideally with their solicitor during the mandatory advice process) since the actual tax treatment depends on the true nature of each payment element, not simply how convenient the employer's chosen labelling might be for either party. Use the Redundancy Pay and Income Tax calculators to estimate your net settlement payment.