Settlement Agreement Tax 2026/27: Complete Guide

What Is a Settlement Agreement?

A settlement agreement is a legally binding contract between an employer and employee, usually ending the employment relationship, under which the employee agrees not to pursue certain legal claims (such as unfair dismissal or discrimination) in exchange for a payment and, often, an agreed reference. For the agreement to be legally valid, the employee must receive independent legal advice on its terms before signing, which the employer typically pays a contribution towards.

Settlement agreements commonly bundle together several distinct types of payment — notice pay, accrued but untaken holiday pay, a discretionary bonus, and a genuine compensation or "ex gratia" element — each of which is taxed differently under HMRC rules.

The £30,000 Exemption

The first £30,000 of a genuine termination payment — broadly, compensation for loss of employment rather than payment for work already done — can be paid free of Income Tax and employee National Insurance. This exemption applies to the ex gratia or compensatory element of a settlement, not to the whole package, and any amount above £30,000 is taxed as earnings through PAYE in the normal way.

Critically, the £30,000 exemption does not automatically apply to every payment described as "compensation" in a settlement agreement — HMRC looks at the true nature of each payment, and disguising what is really notice pay or a contractual bonus as tax-free compensation does not change its underlying tax treatment.

PENP: Post-Employment Notice Pay

Post-Employment Notice Pay (PENP) is a specific calculation HMRC introduced to stop employers labelling notice pay as tax-free compensation. Where an employee leaves without working their full contractual notice period, PENP calculates the basic pay they would have earned during any unworked notice, and that amount must always be taxed as earnings (subject to Income Tax and employee National Insurance) rather than treated as part of the £30,000 exempt compensation.

Only any amount paid above the PENP figure can potentially qualify for the £30,000 exemption as genuine compensation, meaning the exempt element is often smaller than the headline settlement figure suggests once PENP has been calculated and taxed separately.

What Is Always Taxable

• PENP (notice pay for any unworked notice): Always taxed as earnings through PAYE
• Accrued but untaken holiday pay: Taxed as normal earnings, not covered by the £30,000 exemption
• Contractual or discretionary bonuses already earned: Taxed as earnings even if paid as part of the settlement
• Payments in lieu of benefits (such as private medical insurance) during notice: Generally taxable if they form part of PENP

Only the genuine ex gratia compensation element, above and beyond these taxable components, can benefit from the £30,000 exemption.

Employer National Insurance on Termination Payments

Since April 2020, employers pay Class 1A National Insurance on the portion of a termination payment that exceeds £30,000, even though the employee themselves does not pay employee National Insurance on that same excess. This creates an additional cost for employers on larger settlement payments that did not previously exist, and is a factor many employers now build into settlement negotiations.

The employee's own National Insurance position remains more favourable than the employer's: genuine compensation above £30,000 is subject to Income Tax but not employee National Insurance, while the employer bears the Class 1A charge on that same excess.

Worked Example

Marcus is offered a settlement agreement worth £45,000 in total, described as "compensation for loss of office". His contractual notice period is 3 months, which he does not work, and his basic salary during that period would have been £9,000. HMRC's PENP calculation means £9,000 of the £45,000 is treated as taxable notice pay through PAYE, regardless of how the agreement labels it.

The remaining £36,000 can potentially benefit from the £30,000 exemption, meaning £30,000 is paid tax and employee-NIC free, and only £6,000 of that remaining balance is taxed as earnings. Marcus's employer also pays Class 1A National Insurance on that £6,000 excess above the £30,000 threshold.

Common Pitfalls

• Assuming the whole settlement figure is tax-free up to £30,000. PENP, holiday pay and earned bonuses must be taxed as earnings first, before any remaining balance can use the exemption.
• Relabelling notice pay as "compensation". HMRC\u2019s PENP calculation looks at the substance of the payment, not the label used in the agreement.
• Not getting independent legal advice. A settlement agreement is not legally binding without the employee receiving independent legal advice on its terms.
• Forgetting employer Class 1A NIC changes negotiation dynamics. Employers may push back on larger "compensation" labels knowing they bear extra NIC cost above £30,000.
• Overlooking discrimination-related injury to feelings awards. These can sometimes be treated differently for tax purposes, but only in specific circumstances tied to a genuine discrimination claim, not simply relabelled compensation.