What is a settlement agreement?
By SuLe · Updated 27 June 2026
A settlement agreement is a legally binding contract under which an employee agrees not to bring specified employment claims, usually in return for a payment — and it is the only safe way to validly settle statutory claims. It must be in writing, cover particular complaints, and the employee must take independent legal advice for it to be valid.
Key facts
- A settlement agreement is the only safe way to settle statutory employment claims (Employment Rights Act 1996, s.203).
- It must be in writing, relate to particular complaints, and the employee must have independent legal advice from an insured adviser.
- Up to £30,000 of a genuine ex-gratia termination payment can be tax-free.
- Any payment in lieu of notice (PENP) is always taxed as earnings, whatever the headline figure.
- Employers usually contribute to the cost of the employee's independent advice.
What is a settlement agreement and when is it used?
It is a formal contract that draws a line under an employment issue: the employee waives specified claims — typically including unfair dismissal and discrimination — in exchange for agreed terms, usually a payment and an agreed reference.
Startups use them at the end of an employment relationship where certainty matters: an exit that could otherwise lead to a tribunal claim, a negotiated departure, or a redundancy the parties want to finalise cleanly. It converts legal risk into a known cost.
The legal reason it exists is that most statutory employment rights cannot simply be contracted away. Under the Employment Rights Act 1996 (s.203), an attempt to exclude a statutory claim is void — unless it is done through a valid settlement agreement or an Acas-brokered COT3.
What makes a settlement agreement legally valid?
Strict conditions, because the law is protecting the employee's statutory rights. The agreement must be in writing and must relate to the particular complaints being settled — a vague "waives all claims" without specifics does not work.
Crucially, the employee must receive independent legal advice on the terms and effect of the agreement, from a qualified adviser who holds professional indemnity insurance. The adviser must be named in the agreement. Employers almost always contribute to the cost of that advice.
The employee also needs a reasonable period to consider the terms — the Acas guidance points to a minimum window. Rushing or pressuring someone to sign on the spot can invalidate the agreement and undermines any protection it was meant to give.
How are settlement payments taxed?
The tax treatment is where founders most often trip up, because not all of the payment is tax-free. The headline rule is that up to £30,000 of a genuine ex-gratia termination payment — money paid for the loss of the job, not for work done or owed — can be paid free of tax.
The important exception is notice. Any payment in lieu of notice is treated as post-employment notice pay (PENP) and is always taxed as earnings, regardless of the £30,000 figure. Contractual payments like accrued salary, bonus and holiday are also taxed as normal.
So a settlement figure is not a single tax-free lump. The agreement should break the payment down and state the tax treatment of each element, and both sides should take advice — getting the PENP calculation wrong creates a tax liability that someone has to meet.
| Element | Tax treatment |
|---|---|
| Genuine ex-gratia termination payment | Tax-free up to £30,000 |
| Payment in lieu of notice (PENP) | Always taxed as earnings |
| Accrued salary, bonus, holiday | Taxed as normal earnings |
| Employee's legal advice contribution | Usually paid by employer, not taxed as the employee's income |
Worked example
Sophie runs a martech startup and agrees a negotiated exit with a senior manager, Raheem, to avoid a contested dismissal. They agree a package: his contractual notice paid in lieu, accrued holiday, and a £20,000 ex-gratia payment for loss of office, plus an agreed reference.
The settlement agreement lists the specific claims Raheem waives, names his independent solicitor, and sets out the tax treatment. The £20,000 ex-gratia sum falls within the £30,000 tax-free band, but Raheem's payment in lieu of notice is taxed as earnings as PENP. Sophie contributes to Raheem's legal advice, gives him a reasonable period to consider it, and both sides sign — closing off the tribunal risk cleanly.
Where founders go wrong
Trying to waive claims in a plain letter or contract
— statutory claims can only be settled via a valid settlement agreement or Acas COT3.Assuming the whole payment is tax-free
— only genuine ex-gratia sums up to £30,000 are; PENP is always taxed.Skipping the independent-advice requirement
— without it, the agreement does not validly waive statutory claims.Pressuring a fast signature
— the employee needs reasonable time to consider, or the agreement can be undermined.
Related questions
Why do I need a settlement agreement rather than a simple deal?
Because most statutory employment claims can only be validly waived through a settlement agreement (or an Acas COT3). A handshake or a plain contract won't stop the employee later bringing a tribunal claim. The settlement agreement is the mechanism the law recognises for a clean break. [More: How do I legally dismiss an employee in a UK startup?]
Does the employee need their own lawyer?
Yes. For a settlement agreement to be valid, the employee must receive independent legal advice from a qualified adviser with insurance, on the terms and effect of the agreement. Employers usually contribute to the cost of that advice as part of the deal.
Is a settlement payment tax-free?
Partly. Up to £30,000 of a genuine ex-gratia termination payment can be paid tax-free, but any payment in lieu of notice (PENP) is always taxed as earnings. The split matters, so the agreement should set out the tax treatment clearly and take advice on it.
Can I make someone sign on the spot?
No. The employee must have a reasonable time to consider the terms and take independent advice — the Acas Code suggests a minimum period. Pressuring someone to sign immediately can invalidate the agreement and looks bad if the matter is later scrutinised.
A settlement agreement only protects you if it is valid — specific claims, independent advice, the right tax split — and a defective one leaves the tribunal door open after you have paid. A SuLe solicitor can draft an enforceable agreement and get the tax treatment right. Book a free consultation about your contracts before you offer terms.
Keep reading: How do I legally dismiss an employee in a UK startup? · When do employees get unfair dismissal rights in the UK? · What notice period should startup employment contracts use? · Can I fire a co-founder who is also an employee? · How do I remove a co-founder or director legally?
Primary sources: GOV.UK — Dismissing staff · Acas — advice and codes of practice
