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Vacation payout: State laws, taxes & management tips

6 min read

While defining your company’s paid time off policy, there’s much to consider. You’ve got to decide whether PTO accrues from year to year and think about what happens when employees don’t use their days off. If your company has a paid time off policy, your company will also need to have a vacation payout policy.

As with paid time off laws, and paid sick leave laws, the laws governing vacation payout vary from state to state. And for employers working with global teams in various corners of the US, this can be somewhat difficult to manage, let alone navigate tax-related issues that accompany the payout of vacation to terminated employees.

In this guide, we’ll provide all that you need to know about vacation payout laws, requirements for employers, and tax compliance laws to be aware of. Then, we’ll discuss the best practices for things like tracking accrued vacation. Finally, we’ll go over practices to pay employees efficiently and accurately.


What is vacation payout?

Vacation payout or “PTO payout” is a payment that employees receive for unused vacation time. Employees might receive vacation payouts for unused days after the end of a calendar year or upon the termination of their contract. Like paid time off policies and severance pay policies, employers define vacation payout policies in an employee’s compensation agreement.

Not all companies in the United States provide vacation payouts to their employees. And it’s important to realize that individual practices and legal obligations might differ depending on where the company and team members are located.

Are employers required to payout vacation time?

The requirements for employers vary on a state-by-state basis. While there are no federal laws that require employers to offer paid time off to employees, or vacation payout to their employees, some states, like California or Massachusetts, require that employers offer paid leave and payout for unused vacation days.

Because paid time off payout is not a legal requirement for many employers, many choose to adopt a “use it or lose it” policy, in which employees forfeit any accumulated days off at the time of their termination. Note here, that this practice is prohibited in certain states with mandatory vacation payout laws.

Other teams choose to adopt vacation payout policies, in addition to other PTO benefits for employees. In these cases, the amount of vacation payout accrual that an employee is eligible for might differ depending on their employment status and length of tenure. In a similar fashion to other employee compensation and benefits practices, full-time employees and employees who have been at the company for more extended periods might be entitled to more vacation payout at termination.

PTO calculator

Which states require payout of vacation?

Currently, fifteen states in the United States require PTO payout of some form. They go as follows:

  • Alaska
  • Arizona
  • California
  • Colorado
  • Illinois
  • Indiana
  • Louisiana
  • Maine
  • Maryland
  • Massachusetts
  • Minnesota
  • Nebraska
  • North Dakota
  • Ohio
  • Rhode Island
  • West Virginia

In addition to mandatory vacation payout, certain states also prohibit employers from implementing a policy in which employees either use or lose paid time off. The following states prohibit “use-it-or-lose-it” practices:

  • California
  • Colorado
  • Montana
  • Nebraska
  • West Virginia
  • Wyoming

In addition to the states that have an outright ban on use-it-or-lose-it policies, several states have laws that regulate this practice. Here are some special regulations that employers might need to be aware of:

  • In Illinois, employers can give employees a time frame to use paid time off. While use-it-or-lose-it policies aren’t banned, employers must give employees an adequate timeframe to use their vacation or holiday pay. Under Illinois law, employers must provide vacation payouts to terminated employees.
  • In Massachusetts, it’s a similar situation. Employers can have use-it-or-lose-it policies, but they must give employees enough time to actually take off. If they so choose, employers can also place a limit on the amount of PTO that employees can accrue. Once again, in the case of termination, employers must provide PTO payout.
  • New York’s law does not mandate employers to pay employees for unused time off. However, employers must give employees advance notice of any use-it-or-lose-it company policies.
  • There are specific circumstances in North Dakota in which employers don’t have to pay employees vacation payout. Employers are not required to provide vacation payout if the employee receives notice of the company’s payout policy, if employees have worked for less than a year, or if they gave employers less than five days of notice.

How is vacation payout taxed?

If your company offers employees PTO payout for their unused holiday hours, it’s important to understand tax obligations and requirements. Luckily, the Internal Revenue Service provides clear guidelines for employers regarding this issue. Here, we’ll take a closer look at how to handle vacation payout taxes.

Technically speaking, the IRS considers vacation payout to be a form of supplemental wage. Other types of supplemental pay include overtime pay, bonuses, commissions, severance pay, and reported tips.

However, while taxing payout, employers should withhold the same taxes as they would for normal wages. Specifically, you should withhold federal, state, and local income taxes, social security, and Medicare from the amount.

Because vacation payout is a form of supplemental pay, there are some discrepancies to keep in mind while withholding taxes. While social security and Medicare are taxed at the same rate as normal wages (6.2% and 1.45% retrospectively), employers have the option to tax federal income tax slightly differently. Rather than applying the same income taxes, employers can take out a flat tax of 22% of the lump sum amount.

Is vacation payout taxed at a higher rate?

The way that you take out federal income taxes depends on whether or not you’ve already withheld taxes from the employee’s normal wages over the past year. 

If you have withheld taxes in the current or prior year, can choose to take out federal income taxes from vacation payouts in one of the following ways:

  • Take out a flat tax of 22% from the payout amount
  • If you are paying the vacation payout at the same time as the employee’s regular wages, you can combine the two and take out federal income taxes from the total amount.
  • If you are paying the employee’s PTO payout and normal wages separately, you can get the correct tax liability by adding the employee’s normal wages to the supplemental amount and calculating the federal tax withholding from both. Then, you would calculate employees’ federal income tax withholdings from their normal wages. Finally, you would subtract the normal tax withholding from the total tax withholding to get the correct amount to be withheld from the PTO payout.

Conversely, if you haven’t withheld federal income taxes in the past or current year, you would determine federal vacation payout tax by:

  • Adding the vacation payout amount to the employee’s normal wages. Then, while calculating the employee’s payroll taxes at the end of a pay period, you would calculate and take out federal income taxes based on the entire amount.

How to keep track of accrued time off

In order to comply with individual state laws and to adhere to the company’s policy, it’s critical to have a solid method of tracking paid time off accrual for employees in your team. There are many ways to do this.

Firstly, you can keep track of everything in an Excel spreadsheet or use a PTO accrual calculator template to help you calculate the right amount. This method requires diligence, constant updating, and back-and-forth communication with your entire staff, which can be highly time-consuming.

A more efficient and hassle-free solution would be using paid time off tracking software to automate the entire process. In other words, you wouldn’t need to manually update time off allowances, or even handle individual PTO requests for that matter. With the right PTO tracking software, employees can request time off directly from their managers within seconds. Additionally, you’ll be able to monitor how your team uses time off from year to year and make adjustments to your company policies based on your records.

Paying out vacation time accurately

When it comes to calculating vacation payout and employee compensation, small errors can create significant compliance issues and generate major problems. And while calculating time off accrual and payroll, you need to have the right tools to make sure that your processes are transparent and accurate. For that, It is important that you choose the best PTO Tracking Software.

From payroll to employee absences, you can have everything all in one with Factorial. Essentially, it is the one-stop solution for companies looking to streamline their people processes. In addition to our time off management software, Factorial allows you to:

  • Generate payslips and avoid payroll-related errors by automating the entire process.
  • Organize important employee and company documents like tax forms in one centralized location.
  • Request employee signatures and send updates and notifications to your team automatically.
  • Generate custom reports based on employee data and stay on top of key HR metrics, like employee turnover and attrition.
  • Automate time tracking, shift scheduling, talent acquisition, onboarding, performance reviews, and more.

Take the hassle out of your administrative processes and get started with Factorial today.

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