Managing costs

A guide to employment termination payments (ETP)

Find out about payments by an employer to an employee upon the termination of employment.

Employment termination can occur for many reasons, including redundancy or resignation. Regardless of how or why an employee is terminated, employers need to be aware of the different obligations around termination pay as opposed to regular income payments.

Employment termination payments (ETP) are made from an employer to an employee upon the termination of employment. Employment termination payments form part of an employee’s final pay and are usually paid out as a lump sum. 

Eligible termination payments are taxed differently to an employee salary or other components of an employee’s final pay after resignation or termination. It’s essential for employers to understand what is an ETP?, when an ETP is paid, and how to calculate ETP payments.

What is an ETP?

Upon the termination of employment, employers need to pay employees their final pay that consists of a lump sum, or several lump sums. When calculating final pay, employers need to decide if any part of the payment is classified as an ETP. Only certain payments are eligible, and these are taxed at a lower rate than regular payments.

Employment termination payments can include:

  • payment for any unused rostered days off
  • payment for unused sick leave
  • payment in lieu of notice
  • compensation for loss of a job or wrongful dismissal
  • a gratuity or severance package 
  • redundancy payments or early retirement scheme payments which exceed the tax-free threshold
  • invalidity payment, which compensates the employee for early retirement as a result of permanent disability 
  • death benefits that are paid to another person as a result of the death of an employee.

There are some payments that aren’t classified as an ETP even if they’re paid upon termination of employment. This is because they are subject to different tax laws, and include:

  • an employee’s salary, wages or allowances
  • any lump sum payment for unused annual or long service leave
  • compensation for personal injury
  • superannuation benefits
  • any advances or loans given to an employee
  • the tax-free portion of a redundancy payment or early retirement scheme payment
  • payment for restraint of trade, where an employee agrees not to compete with an employer after termination of employment.

What is an ETP payment according to the law?

For a payment to be classified as an ETP, there must be an official ‘termination of employment’. Termination of employment can be as a result of dismissal, redundancy, employee resignation, retirement, or unforeseen circumstances such as illness or disability.

Employment termination can also be by mutual agreement, otherwise known as a life benefit termination payment. In the event of the death of an employee, employers also need to pay a death benefit termination payment to a beneficiary. Both life benefit termination payments and death benefit termination payments are part of ETP but may be taxed differently.

Lastly, upon the termination of employment, employees may also request an employment separation certificate from their employer. This is in case they wish to apply to Centrelink for unemployment benefits. Employers are legally required to issue these upon request.

How is termination pay calculated?

According to the Income Tax Assessment Act 1997, employment termination payments are generally calculated based on an employee’s period of employment. This is known as their ‘service period’ with an employer. 

The service period is the number of calendar days from the date an employee started working for an employer to the date employment was terminated. This includes work done in a part-time, casual or full-time basis. It also includes weekends, public holidays, and any periods of annual or long service leave. Typically, the service period doesn’t factor in any period of leave without pay.

When calculating ETP tax, it can be split into two parts: the taxable component and the tax-free component.

Every ETP has a taxable component. However, there is also a tax-free component for any invalidity payments or payments for employment that took place before 1 July 1983. 

Invalidity payments are made to any employees who cannot work on medical grounds and need to take early retirement. This can include permanent disability or other cases of ill health. Invalidity payments represent the time between when employment was terminated, and the day an employee would have retired. As part of an invalidity payment, employers must fill out an invalidity segment worksheet and submit this to the Australian Taxation Office. 

In addition to invalidity payments which are tax-free, employers should not tax ETP for any days of employment that occurred before 1 July 1983. In both cases, employers also cannot withhold from the tax-free component when paying any ETP. 

Employers should also provide an ETP payment summary as part of an employee’s final payment summary. This indicates how the payments were calculated, as well as any tax on these payments.

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