The article below was provided by a friend of schoolofbookkeeping.com. Kemberli M. Stephenson, MBA who is a controller and payroll expert. You can learn more about her here.
I’m often asked if a company is required to pay a terminated (whether voluntarily or involuntarily) employee unused vacation time on their final paycheck and if so, how it should be calculated. The answer to the first part of the question is not as straightforward as one would hope. The answer is “It depends.” It actually depends on a number of factors, but two of the most important factors are 1). The state law in the state where you do business; and 2). Your company policy.
Obviously, your company policy should follow the HR & Labor Laws that govern your particular state, but each state has its own requirements on paying vacation pay upon termination. Some states require it, but many do not. Here’s a great article that gives guidance on each state’s requirements. However, just as important to note, in most cases, your company policy should be adhered to in order to avoid any perceived or potential discriminatory action. This means that you shouldn’t pick and choose when to pay out unused vacation time based on circumstances surrounding the termination. The policy is there for a reason; so when you create it, be sure that you’ll be comfortable enforcing it.
To calculate earned (accrued) but unused vacation, divide the total amount of vacation hours awarded annually by the number of pay periods in a year. Multiply the result by the number of pay periods the employee has worked this year. This is the total amount of vacation hours earned this year. From this number, subtract the total vacation time used since the beginning of the year. The end result is the Number of vacation hours that should be paid out on the final paycheck.
Example: (Employee terminated after working 18 pay periods this year and has used 8 hours of vacation).
Total Eligible Vacation Hours per Year: 80 Hours
Pay Periods in the Year: 26 (This assumes you run a bi-weekly payroll)
Divide: 80hrs/26 pay periods = 3.08hrs earned each pay period
Multiply: 3.08hrs x 18 pp = 55.44hrs vacation hours earned this year
Subtract: 55.44hrs (earned) – 8hrs (used) = 47.44hrs unused hours to be paid on final paycheck.
If the employee starts working for you mid-year, the number of hours earned per pay period would be the same, but you would begin counting the pay periods worked starting the day the employee becomes eligible to earn (accrue) vacation hours. If your company policy allows employees to carry forward unused vacation from year to year, perform the calculation above as demonstrated and add the hours carried forward from previous years to the 47.44 hours to get to the final number of unused hours to be paid out.
Finally, depending on the situation, the IRS may consider the final vacation payout supplemental wages. If the wages are deemed supplemental, the income tax withholding rate calculation changes. Visit the blog next week to learn more on how to ensure you’re withholding the correct amount of taxes from the final paycheck.
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