Is an employment settlement taxable? How each part is taxed

The short answer: most of it is taxed, at different rates

When an employment dispute settles, the employer usually pays one figure. For tax purposes that figure is often several payments: wages that were owed, leave that was never taken, pay instead of notice, compensation for losing the job, and sometimes an amount for legal costs or for hurt and humiliation. Each is taxed under its own rule.

The tax rules look at what each part of the payment is really for, not at the label the parties give it. Where part of a lump sum can be identified as, for example, back pay, the Australian Taxation Office (ATO) taxes that part as income (TD 93/58). Where a settlement of a dismissal claim pays one undivided sum, the whole of it is usually taxed as an employment termination payment (ETP): a lump sum paid because your job ended, which has its own tax rates and caps, explained below (TR 2003/13). That is why the way the settlement deed (the signed settlement agreement) describes each amount matters, and why each description has to match what actually happened.

Unpaid wages, leave and notice

Wages, overtime, commission or bonuses owed for work you already did are ordinary income. They are taxed at your marginal rate, and the employer must withhold tax from them as it would from any pay (Taxation Administration Act 1953 (Cth) Sch 1 s 12-35). If some of the back pay relates to a period more than 12 months before it is paid, you may be entitled to a tax offset for lump sums in arrears, provided the arrears are at least 10% of your other taxable income for the year (Income Tax Assessment Act 1936 (Cth) s 159ZRA).

A payment for unused annual leave on termination is taxable, but it is not an ETP (Income Tax Assessment Act 1997 (Cth) s 82-135 and s 83-10). It is generally taxed at your marginal rate. The rate is capped at 30% (plus the Medicare levy) where the leave payment is made with a genuine redundancy, early retirement or invalidity payment, or is for leave accrued before 18 August 1993 (s 83-15). Unused long service leave is not an ETP either, but its rate depends on when the leave accrued, so ask your accountant.

A payment in lieu of notice (pay instead of working out your notice period) is different. The ATO treats it as an ETP, as it does unused sick leave, unused rostered days off, a gratuity or golden handshake (an ex gratia payment, meaning one the employer did not have to make) and a non-genuine redundancy payment (ATO: payments that are ETPs).

Settlement payments are usually employment termination payments

A payment is an ETP if (s 82-130 and s 82-135):

(a) you receive it because your employment ended;

(b) you receive it no later than 12 months after it ended; and

(c) it is not one of the payments the law leaves out, such as unused leave or the tax-free part of a genuine redundancy payment.

A payment to settle an unfair or wrongful dismissal claim meets the first condition, because it would not have been paid if you had not been dismissed: Le Grand v Commissioner of Taxation [2002] FCA 1258. A payment made more than 12 months later can still be an ETP where the delay is due to legal action about the entitlement, or its amount, that began within the 12 months. Otherwise it is taxed at your marginal rate. The 12-month limit does not apply to genuine redundancy payments (ATO: the 12-month rule).

The taxable part of an ETP is taxed at no more than 15% if you are 60 or older by 30 June of the year you are paid (the law calls this reaching your preservation age, which is now 60), or 30% if you are younger, plus the 2% Medicare levy: 17% or 32% in practice (s 82-10). Anything above the cap that applies to your payment is taxed at 45% plus the Medicare levy, which is 47% (ATO: how ETP components are taxed).

Which cap applies depends on what the payment is for (ATO: applying the ETP caps). Compensation is subject only to the ETP cap, which is $270,000 for payments received in 2026–27 (ATO: ETP cap for 2026–27), if three things are true (s 82-10(6)):

(a) it is paid in connection with a genuine dispute (the dispute does not have to reach a court, but keep evidence that it was a real one);

(b) it is mainly compensation for unfair dismissal, harassment, discrimination or personal injury; and

(c) it is more than you could reasonably have expected to receive had you resigned.

Every other ETP (apart from the redundancy payments explained below), including pay in lieu of notice, a golden handshake, and any part of a settlement that is really notice or another amount owed under your contract, gets the concessional rate only up to the lower of the ETP cap and the whole-of-income cap. That cap is $180,000, reduced by your other taxable income for the year. For example, if your other taxable income for the year is $120,000, only the first $60,000 of a golden handshake is taxed at the concessional rate. Both caps are also reduced by any ETPs you have already received earlier in the year, and the ETP cap by any earlier ETP for the same termination, even one paid in an earlier year. Where one settlement includes both kinds of payment, the compensation part counts as other income when the whole-of-income cap is worked out.

Redundancy: the tax-free amount

If your position was genuinely made redundant, part of your redundancy payment is tax free. Only the extra counts: the amount you are paid beyond what you would have received anyway had you resigned, such as wages owed and accrued leave (s 83-170 and s 83-175). For 2026–27 the tax-free amount is $13,598 plus $6,801 for each complete year of service (ATO: tax-free redundancy amounts). After 10 years, that is $81,608. Any part of the genuine redundancy payment above it is an ETP subject only to the ETP cap. A payment in lieu of notice can form part of a genuine redundancy payment if it would not have been paid on a resignation (TR 2009/2).

The concession has three conditions (ATO: redundancy and early retirement):

(a) you must be dismissed before you reach age-pension age (67 for anyone born on or after 1 January 1957), or any earlier age or period of service at which your employment would have ended anyway;

(b) if you and your employer were not dealing at arm's length (for example, because of a family relationship), the payment must be no more than an unrelated employer would have paid; and

(c) there must be no arrangement, with your employer or anyone else, to employ you after the dismissal.

Calling an unfair dismissal settlement a "redundancy payment" does not make it one if the job was not genuinely redundant.

Hurt and humiliation, legal costs and super

Compensation for injury to feelings, humiliation or distress suffered during your employment is generally treated as a capital receipt (a one-off amount for a loss, rather than income), and the capital gains tax rules ignore compensation for a wrong or injury you suffer personally or in your work (IT 2424; s 118-37). A capital payment for personal injury, so far as it is reasonable given the injury and its effect on your capacity to earn, is not an ETP at all (s 82-135(i)).

But if the compensation is paid in consequence of your dismissal, the ATO treats it as part of an ETP. That covers most deeds settling a dismissal claim, including a discrimination or harassment claim about the dismissal (IT 2424 para 24; ATO: applying the ETP caps, Example 2). In a 2026 class ruling about the Qantas ground-handling outsourcing, the ATO accepted that damages for hurt and humiliation were not taxed, because they compensated the unlawful outsourcing decision rather than the terminations that followed (CR 2026/1). That ruling binds only that group. Take advice before you rely on any part of a dismissal settlement being tax free.

In an unfair dismissal claim, the Fair Work Commission cannot include compensation for shock, distress or humiliation caused by the manner of the dismissal (Fair Work Act 2009 (Cth) s 392(4)). A large "hurt and humiliation" figure in a deed settling only an unfair dismissal claim is therefore unlikely to survive scrutiny.

An amount that can be identified as reimbursing your legal costs is not part of the ETP (TR 2012/8). Where the claim was for compensation for losing your job, the costs are not deductible and the reimbursement is not taxed as income. Where the claim was to recover income you were owed under your contract, the costs may be deductible and the reimbursement is then taxable. If the deed pays one undivided sum and the costs part cannot be identified, the ATO treats the whole sum as paid because of the termination, so separate the costs in the deed.

Since 1 July 2026, employers must pay the compulsory super contribution, the super guarantee (12%), each payday on an employee's qualifying earnings (ATO: super guarantee). The ATO's ruling on which payments count was released in draft (LCR 2026/D1; see the withdrawal notice for SGR 2009/2). The deed should say whether each amount includes or excludes super. If part of the settlement is paid into your super fund as an employer contribution, it counts towards your concessional contributions cap, which is $32,500 for 2026–27 (ATO: contributions caps).

Getting the deed right

An employer must withhold tax from an ETP and from an unused leave payment, as well as from wages (Taxation Administration Act 1953 (Cth) Sch 1 ss 12-85 and 12-90), and report the payments to the ATO through Single Touch Payroll, the system employers use to report pay. A clause saying the money is paid "in full and final settlement" does not change that. Employees should check whether a settlement figure is gross or net of tax before agreeing to it, and employers should not agree to pay a figure "tax free" unless the law allows it.

A well-drafted deed separates each amount and says what it is for: unpaid wages, leave, notice, compensation, legal costs, super. Each description has to be true. A deed can make the treatment clearer, but the ATO looks at what each payment really was. Where a large sum turns on how a payment is treated, you can ask the ATO for a private ruling before you sign. It binds the ATO if you carry out the arrangement as you described it (Taxation Administration Act 1953 (Cth) Sch 1 ss 357-60 and 359-5; ATO: applying for a private ruling).

Employment lawyers are not tax advisers. If you are negotiating a settlement, it is worth having your accountant look at the deed before you sign. MKI Legal's employment lawyers can work with your accountant on the deed when asked, so that each payment is described accurately.