A settlement agreement is a legally binding contract between an employer and an employee under which the employee agrees to waive some or all of their employment law claims — usually in exchange for a financial payment. They used to be called compromise agreements, and you may still hear that term from time to time, but the name changed in 2013 when the Enterprise and Regulatory Reform Act came into force.
The key thing to understand is this: without a valid settlement agreement, an employee can bring a claim in the employment tribunal regardless of what they've signed or agreed verbally. The statutory right to bring a claim cannot be waived by a simple contractual term in an employment contract or a resignation letter. Settlement agreements exist precisely because they are the one mechanism that the law recognises as a proper waiver — provided certain conditions are met.
Settlement agreements come up in a wide range of situations. The most common are:
• Ending employment by mutual agreement - where you and the employee both accept the
relationship has run its course but you want a clean break without going through a formal process.
• Redundancy - particularly where the redundancy process has been imperfect or you want to offer more than the statutory minimum in exchange for a broader waiver.
• Performance or conduct situations — where a dismissal is defensible but the tribunal risk isn't zero, or where the cost of managing the process properly outweighs the cost of settlement.
• Active disputes - once a grievance has been raised or a tribunal claim is threatened, a settlement agreement can resolve matters quickly and confidentially without the distraction and cost of litigation.
• Senior executive exits - where the financial stakes are high and both parties want certainty.
Settlement agreements are not admissions of liability. Using one doesn't mean you've done
something wrong. It means you've made a commercial decision that certainty is worth more than the
time, cost, and distraction of a tribunal claim — even one you'd likely win.
Before you can have a meaningful conversation about settlement, you need to understand the protection available. The without prejudice rule is a common law rule of evidence that prevents communications made in a genuine attempt to settle a dispute from being produced as evidence in legal proceedings. Put simply: what's said in a without prejudice meeting generally stays there.
The practical effect is significant. You can have a frank conversation with an employee about departing on agreed terms, make an offer, even discuss the weaknesses in their position — and none of that can ordinarily be put before a tribunal if the talks break down. That gives both sides room to be realistic.
The without prejudice rule only applies where there is already a genuine dispute between the parties. You can't use it pre-emptively. If there's no dispute in existence — if, for example, you're approaching an employee out of the blue to suggest they leave before there's any issue — labelling your letter 'without prejudice' provides no protection at all.
This is where many employers come unstuck. They assume the magic words create protection. They don't. The courts look at the substance, not the label. Unilever plc v Procter & Gamble Co [2000] 1 WLR 2436 remains the leading case, and the Court of Appeal was clear: without prejudice protection depends on there being a genuine dispute, not merely on one party's unilateral decision to use the phrase.
Even where the without prejudice rule applies, it isn't absolute. There are recognised exceptions — most notably, the protection falls away if one party behaves improperly during the without prejudice negotiations. What counts as improper? Threats, undue pressure, misrepresentation. Telling an employee they'll be dismissed and receive nothing if they don't sign is likely to be treated as a threat. Don't go there.
• Marking communications 'without prejudice' without an existing dispute gives you no protection.
• If the employee complains of discrimination, some of the without prejudice protection may be lost.
• The rule doesn't stop a court seeing the communications for other limited purposes (e.g. costs).
• Always take advice before initiating settlement discussions if there's any doubt about whether a live dispute exists.
Section 111A of the Employment Rights Act 1996, introduced in 2013, created a separate statutory route for protected conversations. It's sometimes called the 'protected conversation' provision, and it was designed to address the gap left by the without prejudice rule — specifically, the problem of approaching an employee about leaving before any dispute has arisen.
Under s.111A, any offer or discussion made with a view to terminating employment on agreed terms is inadmissible in an ordinary unfair dismissal claim — even if there's no pre-existing dispute at all. That's the critical distinction from the without prejudice rule.
The protection under s.111A covers conversations, offers, and written communications that take place 'with a view to the employment being terminated by agreement.' This means the discussion has to be about ending the employment — it doesn't protect general performance management conversations where settlement isn't on the table.
ACAS has published a Code of Practice on Settlement Agreements which, whilst not legally binding, provides helpful guidance on how to conduct these conversations. Following the Code won't make or break a s.111A argument, but departing from it without good reason is the kind of thing that attracts scrutiny.
The protection is not blanket. There are three main situations where s.111A will not protect you:
• Improper behaviour — The ACAS Code makes clear that certain conduct during negotiations is improper: harassment, discrimination, putting undue pressure on the employee, threatening to impose worse terms if they don't agree, or giving them an unreasonably short time to consider the offer. Any of these can strip away the s.111A protection.
• Discrimination claims — Section 111A only protects against unfair dismissal claims. If the employee brings a claim under the Equality Act 2010 alleging discrimination, harassment, or victimisation, the s.111A protection doesn't apply. A tribunal can hear evidence of the conversation in the context of a discrimination case.
• Automatically unfair dismissal — Claims involving whistleblowing, working time, TUPE, or other categories of automatically unfair dismissal are outside s.111A's scope. The protection is for ordinary unfair dismissal only.
ACAS recommends giving an employee at least 10 calendar days to consider a settlement offer before asking for a response. This doesn't have to be a hard-and-fast rule, but rushing someone into signing is precisely the kind of conduct that can undermine both s.111A protection and the validity of the agreement itself.
These two routes to protection overlap, but they're not the same thing. Understanding which applies in your situation matters — get it wrong and the conversation you thought was protected could end up before a tribunal. The table below sets out the key differences.
| Feature | Without Prejudice | Section 111A ERA 1996 |
| Legal basis | Common law rule of evidence | Statutory — s.111A Employment Rights Act 1996 |
| Pre-existing dispute required? |
Yes — must be a genuine dispute already in existence | No — can be used before any dispute arises |
| Claims protected against |
All civil claims (broad scope) | Ordinary unfair dismissal only |
| Discrimination claims | Protected (subject to exceptions) | Not protected — tribunal can see evidence |
| Automatically unfair dismissal |
Protected (subject to exceptions) | Not protected |
| Improper behaviour exception |
Yes — protection lost if improper conduct | Yes — protection lost if improper conduct |
| ACAS Code applies? | No — common law only | Yes — Code of Practice on Settlement Agreements |
| Best used when... | Active grievance, disciplinary, or claim is threatened | Approaching an employee about leaving before any formal process |
In practice, the two protections often overlap. Where there's already a live dispute, you'll usually be relying on without prejudice. Where you're initiating the conversation with an employee who has no idea what's coming, s.111A is likely the better shield. Many employers use both and label their letters accordingly. There's nothing wrong with saying 'This communication is made without prejudice and pursuant to s.111A ERA 1996.' It doesn't give you double protection for claims that fall outside s.111A, but it does ensure you've covered both bases where both apply.
Where you have any doubt about which route applies - particularly if the employee is in a protected category or has previously raised a grievance - take legal advice before opening the conversation. A misstep here is hard to undo.
Settlement agreements vary enormously in their complexity and value, but there are a number of standard terms that appear in almost every one. Knowing what each does — and what can go wrong will help you negotiate a better deal and avoid costly mistakes.
This is the headline figure — the amount you're paying the employee in exchange for the waiver. It's worth separating the ex gratia element from any contractual sums the employee is owed anyway (notice pay, accrued holiday, unpaid wages). Those contractual payments are taxable in the normal way. The ex gratia payment — sometimes called a compensation payment — is the part that benefits from the £30,000 tax-free treatment under s.401 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). More on tax treatment below.
Under s.401 ITEPA, the first £30,000 of a termination payment that is not otherwise taxable as earnings can be paid free of income tax and (since April 2018) also free of employee's National Insurance. Employer's NICs do apply above £30,000 from April 2018, so be mindful of the full cost.
What counts towards the £30,000 cap? Statutory redundancy pay, ex gratia payments, and other compensation payments caught by s.401. What doesn't count? Payments in lieu of notice (PILONs) that are contractual (these are fully taxable as earnings following the post-2018 rules). Holiday pay, bonuses, and commission accrued but unpaid are always taxable regardless.
The £30,000 tax-free threshold (s.401 ITEPA 2003)
The first £30,000 of a genuine termination payment can be paid without deduction of income tax or employee's NICs. Payments above £30,000 are subject to income tax and employer's NICs. PILONs whether contractual or not are taxable as earnings in full since April 2018. Always draft the payment schedule carefully and include a tax indemnity clause requiring the employee to bear any tax liability the authority later determines.
Employees often push hard for an agreed reference. If you're prepared to offer one, it makes sense to attach the wording as a schedule to the agreement rather than simply promising to provide a 'reasonable' reference — that's too vague and will cause arguments later. An agreed reference should be accurate. Agreeing to say something you know to be false exposes you to a claim for misrepresentation from a future employer who relies on it.
Most settlement agreements contain a confidentiality clause preventing the employee from disclosing the existence, terms, or circumstances of the agreement to anyone other than their immediate family and professional advisers. There are limits. An employee cannot be contractually prevented from making a protected disclosure under the whistleblowing provisions in the Employment Rights Act. Clauses that attempt to do so are void.
These are mutual undertakings — usually symmetrical — that neither party will say anything derogatory about the other. They're useful but only as enforceable as your willingness to pursue a breach. Consider whether an injunction is realistic if the employee posts critical comments on social media after leaving. In many cases, the practical answer is: probably not.
The employee will typically be asked to warrant that they have not accepted other employment (relevant to re-employment provisions), that they are not aware of any claims they haven't disclosed, and that they haven't committed acts of gross misconduct that would have entitled you to dismiss without notice.
These warranties give you a degree of protection if something comes to light after the agreement is signed. Include them as a matter of course.
A settlement agreement is only effective as a waiver of statutory employment claims if it satisfies the conditions set out in section 203 of the Employment Rights Act 1996 (and equivalent provisions in other statutes, such as s.147 of the Equality Act 2010 for discrimination claims). Get these wrong and the agreement may still be valid as a contract, but it won't prevent the employee bringing a tribunal claim.
The s.203 ERA 1996 conditions — all must be satisfied
• The agreement must be in writing.
• It must relate to the particular complaint or proceedings — you cannot use a settlement agreement
to waive unspecified future claims.
• The employee must have received advice from a relevant independent adviser on the terms and
effect of the agreement.
• The adviser must be identified in the agreement by name (or in sufficient detail to identify them).
• The adviser must be covered by a relevant indemnity or professional insurance (usually their
practising certificate as a solicitor).
• The agreement must state that the conditions in s.203(3) have been satisfied.
This condition trips up many employers. You cannot include a clause saying 'the employee waives all claims of whatever nature.' Well, you can draft it that way, but the courts have been clear that the agreement must identify the specific statutory complaints being waived — unfair dismissal under s.94 ERA 1996, wrongful dismissal, direct discrimination under s.13 Equality Act 2010, and so on. The drafter should list every claim that could plausibly arise from the employment and its termination. A belt-and-braces list is standard.
The independent legal advice requirement is non-negotiable. It exists to protect employees from signing away rights they don't understand, and it cannot be waived. The following can act as relevant independent advisers:
• A qualified solicitor or barrister (the most common)
• A person certified as competent to give advice and authorised to do so by a trade union
• A person certified as competent and authorised by an advice centre (e.g., Citizens Advice)
The adviser must be independent — they cannot be someone employed by, or acting for, you as the employer. It's common practice to pay a contribution towards the employee's legal costs: typically £250 to £500 plus VAT. This is not legally required but refusing to contribute looks bad and may cause delays.
The first conversation is the hardest. Most employees don't see it coming, and even where they do, being formally invited to discuss leaving is unsettling. Keep the meeting short and don't over-explain.
Tell the employee that you've been considering their position and that you'd like to explore whether there's a mutually agreeable way forward. Give them time — don't push for an answer in the meeting. Provide the headline terms in writing promptly afterwards.
ACAS guidance recommends that the employee should be allowed to be accompanied to settlement discussions by a colleague or trade union representative if they wish, though this is not a legal right (as it is with a disciplinary or grievance hearing). Allowing it is good practice and rarely causes problems.
Refusing it can generate unnecessary hostility.
There's no formula, but commercial common sense and a realistic assessment of tribunal risk should drive the number. The key benchmarks are:
• Notice pay (or PILON) — always included; this is owed contractually regardless.
• Accrued but untaken holiday — must be paid; not negotiable.
• Statutory redundancy pay — if the situation is a genuine redundancy, this is the starting point. For 2026: based on a week's pay capped at £700.
• Enhanced ex gratia — the premium you're paying for certainty. In straightforward cases with low tribunal risk, this might be one or two months' salary. Where the facts are messy or the employee has protected characteristics, it may need to be considerably more.
• Legal contribution — typically £250 to £500 plus VAT to cover the employee's adviser's fees. Set the figure generously: an employee who can't afford the excess above your contribution may drag the process out.
Start with a fair but not extravagant offer. Leaving room to move is useful — most employees expect to negotiate. But don't open with a derisory figure: it damages trust and makes the subsequent process difficult. If the employee has a solicitor advising them, expect a counter-proposal and a more structured negotiation. Their solicitor may also raise issues you haven't considered — holiday pay going back several years, for example, or an argument that the redundancy is sham. Better to have those conversations resolved in the agreement than litigated in the tribunal.
Tribunal Risk as Your Guide
Think about what a tribunal claim would cost you in management time, legal fees, and potential
award. Even a basic award on an unfair dismissal claim can be up to £21,000 (2026 cap). The
compensatory award is capped at £115,115. Add legal fees, witness time, and reputational exposure
— and a settlement at a fraction of that figure starts to look like a sensible commercial decision.
Settlement agreements are powerful tools when used properly. When they're used badly, they can make a difficult situation considerably worse. These are the mistakes we see most often.
The most damaging error is offering a settlement in circumstances where neither without prejudice protection nor s.111A applies. If you approach an employee with no existing dispute and no protected conversation framework in place, and they reject the offer, they can produce your correspondence in the tribunal as evidence that you wanted to get rid of them. That 'pre-determination' evidence can be devastating in an unfair dismissal case.
Always establish the protection before opening the conversation. If you're not sure which applies, take advice first. The few hundred pounds spent on a thirty-minute call with an employment solicitor before the meeting is vastly cheaper than explaining the conversation in a tribunal witness box.
Misallocating payments between taxable and non-taxable elements is a common and expensive mistake. If you characterise a PILON as an ex gratia payment to push it under the £30,000 threshold, HMRC may reclassify it. If the employee then has an unexpected tax bill, they may come back to you — and the agreement should contain a tax indemnity clause, but that doesn't make the problem disappear. Get the allocation right at the drafting stage.
Every settlement agreement should require the employee to indemnify you against any tax or NIC liability that HMRC determines to be payable on amounts you've treated as tax-free. This doesn't remove your PAYE obligations — you're still obliged to operate PAYE correctly — but it ensures the employee bears the economic cost if HMRC disagrees with your characterisation.
A settlement agreement cannot make a discrimination claim go away if the employee isn't properly advised about it. More fundamentally, if the reason you're trying to exit an employee is connected to a protected characteristic — their age, disability, pregnancy, religion, or any other protected characteristic under the Equality Act — any without prejudice conversation could end up being produced in evidence, and a tribunal may take a very dim view of it.
Settlements don't clean up bad decisions; they resolve disputes arising from them. If an employee has a strong discrimination claim, a settlement may still be the right outcome — but the price will reflect the strength of their case, not just their notice pay. And you won't be able to use s.111A to keep the conversation confidential if the discrimination claim is what the tribunal needs to examine.
Some employers use template agreements that list a handful of claims but miss others. A tribunal can still hear a claim that isn't listed in the waiver — even if the employee has signed the agreement. If a pension-related claim or an equal pay claim isn't included, it may survive the agreement. Have the agreement drafted or reviewed by an employment solicitor every time — templates are a starting point, not a finished product.
Critical risk: signing without complying with s.203 conditions
• If the employee has not received independent legal advice from a qualified and identified adviser,
the agreement will not validly waive their statutory claims.
• They can still bring an unfair dismissal or discrimination claim in the tribunal, even having accepted
and spent the payment.
• Do not cut corners on the advice requirement — it is the single condition most likely to invalidate an
agreement.
Settlement agreements are rarely about weakness. They're about commercial judgement — recognising that a certain outcome at a manageable cost is often preferable to an uncertain one at a much higher price. Consider the situation of a long-serving manager whose performance has declined but whose issues
have never been formally managed — no appraisals, no PIPs, no written warnings. A fair dismissal is possible with the right process, but it will take months. A settlement agreement, offered under s.111A at the right moment, could deliver a clean outcome in days. The cost? Perhaps two or three months' additional salary, treated largely as tax-free. The benefit? No tribunal risk, no prolonged management distraction, and no adverse effect on the remaining team who might otherwise watch a drawn-out exit process undermine morale.
Or consider the opposite scenario: an employee who has raised a grievance alleging serious
discrimination. The investigation is complex, the facts are disputed, and even if you win, the legal costs will be substantial. A without prejudice settlement — structured carefully, with comprehensive claims listed in the waiver — resolves the matter confidentially and allows both parties to move on. That is exactly the kind of commercial decision that settlement agreements are designed to facilitate.