Labor & Employment丨Pay to leave: severance in China

With many employers in China now laying off employees, this article provides a quick recap of the rules of severance compensation.

Severance must be paid in most situations except when an employee is terminated on grounds considered to be for cause or when the employee resigns. This means employers generally have to pay severance when:

a.  a fixed-term contract is not renewed;

b.    employees are terminated for redundancy;

c.    a contract automatically ends due to the employer deciding to shut down and liquidate; or

d.    the employer and employee agree to a termination.

The general rule on severance is that employees are entitled to one month of their average monthly compensation for each year of service. Partial years of service over six months are rounded up to one year, while partial years less than six months are counted as half a year.

I. How is the average monthly compensation calculated?

An employee's average monthly compensation is calculated by adding all cash income earned in the 12 months up to the date of termination, and then dividing that total by 12. That income would include base salary, bonuses and allowances paid in cash (but not reimbursements). The value of an employee equity compensation plan would not be included. Some jurisdictions (e.g., Guangdong and Beijing) require that overtime pay be included. Notably, Shanghai and Chengdu do not.

While the calculation of severance for most employees is simply a matter of multiplying their years of service by their average monthly compensation, a cap exists for employees with relatively high incomes. This cap is based on three times the local average salary. These numbers are announced by local authorities and are usually increased on an annual basis.

Here are examples of the current figures:

Determining the cap can be complicated because some cities will announce more than one figure for the average monthly local compensation. Thus, when calculating severance costs, it's often advisable to either contact the local authorities to determine which figure to use or to take a conversative approach and use the highest announced figure.

In situations where an employer can unilaterally decide to end employment (e.g., by not renewing a fixed-term contract), they could simply apply the cap to employees whose compensation is above the cap, thereby limiting the amount of severance to be paid.

Another wrinkle in the severance rules is that if an employee's average monthly compensation exceeds the local cap, then the employee's service years can be capped at 12 years when calculating severance. It's therefore possible that a highly paid employee with years of service could get less in severance than a lower paid employee who also has many years of service.

As a practical matter, these caps are usually ignored when the agreement of the employee is necessary to terminate their employment. Highly compensated employees will expect not only that severance payments are calculated based on their actual compensation, but also that they will be paid several months of additional compensation.

II. Severance for employees employed before 2008

Calculation methods can be even more complicated and may vary from city to city for employees who started work before the Labor Contract Law came into effect on January 1, 2008. For example, in Beijing and Shanghai, severance for years of service before 2008 must be calculated separately from severance for service after January 1, 2008, with the sum of the two figures being the total severance due.

In some jurisdictions, different rules applicable for service before and after January 1, 2008, may result in substantial severance amounts for highly compensated employees with years of service before January 1, 2008. For example, in Beijing and Shanghai, while the general rule of one month of severance for each year of service applies for both periods of service, the cap on three times the local average salary will not apply for service before 2008. In addition, the cap on severance for service exceeding 12 years applies only for service after January 1, 2008.

In Guangzhou, however, the cap of three times the local average salary also applies to any years of service before 2008. If an employee's average monthly compensation exceeds the cap in Guangzhou, the total length of service will be capped at 12 years, regardless of any service years before 2008. As a result, severance costs for long-term employees can be much lower in Guangzhou than in cities such as Shanghai and Beijing.

III. Special rules on working past statutory retirement ages

The Labor Contract Law does not require severance to be paid when an employee reaches a statutory retirement age and ends their employment. For some long-term employees approaching retirement age, it may be less costly for employers to keep them on the payroll until retirement, rather than terminating them early and paying severance.

China implemented rules on January 1, 2025, that allow employers and employees to agree to extend employment up to three years after the employees reach the applicable statutory retirement age. (The retirement ages are being gradually extended from 60 to 63 for men, 55 to 58 for women holding managerial or technical positions, and from 50 to 55 for women holding non-managerial or technical positions.)

Subsequent measures have clarified that the extended period should be treated as a continuation of the “employment relationship”. As a result, employer obligations under labor laws should continue to apply. For example, an employee terminated on certain grounds during such an extended period would be entitled to severance. These measures, however, also state that if an extended employment is terminated due to an agreement between the employer and the employee, then retirement procedures should be initiated. This would indicate that an employer would not be required to pay severance if an employee agreed to end an extended employment period before the original contract expiration date. 

IV. Statutory damages for unlawful termination

Statutory damages for unfair termination claims are generally calculated at 200% of an employee’s statutory severance entitlement. Local practice, however, may lead to widely varying amounts. For example, in Shanghai, statutory damages are capped at 12 years of service. Highly compensated employees with service before January 1, 2008, could not use the full amount of their statutory severance entitlement as a basis to calculate statutory damages. In some cases, the amount of statutory damages actually ends up being less than the amount of the statutory severance.

V. Important tax breaks

An incentive available to employees who agree to terminate their employment is that a relatively large amount of money can be received free of individual income tax. The tax-free amount is three times the local annual salary, which is currently RMB 443,052 in Shanghai and RMB 565,239 in Beijing. Thus, there's a benefit to employees (and no extra cost to employers) to characterize all compensation that an employee may receive upon termination as severance. Any amounts over this limit are subject to tax.

This tax break, however, doesn't apply to severance that employees receive upon the expiration and non-renewal of their employment contracts. Instead, a lump sum severance is subject to full tax, at a rate as high as 45%. Thus, some employees who hold out during termination negotiations may find they end up owing a larger amount of tax and have less money in their pockets than if they had agreed to terminate their contracts earlier.

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