News

Introduction
How is the average monthly compensation calculated?
Severance for employees employed before 2008
Special rules on work past statutory retirement ages

Statutory damages for unlawful termination
Important tax breaks

Introduction

With many employers in China now engaging in layoffs, this article provides a quick recap of some of the rules on severance that must be paid to terminated employees.

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

• a fixed-term contract is not renewed;
• employees are terminated for redundancy;
• a contract automatically ends due to the employer deciding to shut down and liquidate; or
• 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.

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 employee equity compensation plans would not be included. Some jurisdictions (eg, Guangdong and Beijing) require that overtime pay be included. Notably, Shanghai and Chengdu do not.

While 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's a few examples of 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 best to either contact the local authorities to determine which figure to use or be conversative and use the highest announced figure.

In situations where an employer can unilaterally decide to end employment (eg, not renewing a fixed-term contract) an employer could simply apply the cap for employees whose compensation is above the cap and, therefore, limit the amount of severance 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. Thus, it's possible that a highly paid employee with a long service period could get less in severance than a lower paid employee who also has a long service period.

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

Severance for employees employed before 2008

Calculation methods can be even more complicated and vary by cities for employees who started work before January 1, 2008, which is the date the Labor Contract Law became effective. For example, in Beijing and Shanghai, severance for service years before 2008 must be calculated separately from the service after January 1, 2008 and added to the entitlement for service accrued after January 1, 2008.

Different rules in some jurisdiction for service before and after January 1, 2008 can make severance amounts rather large for highly compensated employees with service before January 1, 2008. For example, in Beijing and Shanghai, while the general rule of one month 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. Moreover, the cap on service years of 12 applies only for service after January 1, 2008.

In Guangzhou, however, the cap of three times the local average salary will also apply to any service years before 2008. Moreover, if the 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.

Special rules on work past statutory retirement ages

The Labor Contract Law does not require severance to be paid when an employee reaches a statutory retirement age and thus ends employment. For some employees with long service periods nearing retirement age, it can be less costly for employers to keep employees on payroll until retirement instead of terminating them early and paying severance.

China issued rules effective January 1, 2025, that permit employers and employees to agree to extend employment up to three years after the employee has reached the applicable statutory retirement age. (The ages are being gradually extended from age 60 to 63 for men, from 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 extended employment is terminated due to an agreement between the employer and employee, then retirement procedures should be initiated. This would indicate that an employer would not be liable to pay severance if an employee agreed to end an extended employment period before the original contract expiration date.  

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, can lead to widely different amounts. For example, in Shanghai, statutory damages are capped at 12 years of service. Thus, 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 fact, in some cases, the amount of statutory damages actually ends up being less than the amount of statutory severance.

Important tax breaks

An incentive available to employees who agree to terminate their employment is that a relatively large amount can be received free of individual income tax. The tax-free amount is three times the local annual salary, which currently works out to 443,052 yuan in Shanghai and 565,239 yuan in Beijing. Thus, there's a benefit to employees (and no extra cost to employers) of characterizing all compensation that an employee may receive upon termination as severance. Amounts received 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, the lump sum severance is subject to full tax, at rates as high as 45%. Thus, some employees who hold out in termination negotiations may find they end up owing a larger tax bill and have less money in their pockets than if they had agreed to terminate their contracts earlier.