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Severance Pay in an Optimal Contract

Author

Listed:
  • Borys Grochulski
  • Russell Wong
  • Yuzhe Zhang

Abstract

We study the incentive role of severance compensation. In a canonical principal-agent model, we introduce exogenous job destruction risk and show that compensation following job destruction can reduce overall incentive costs. To mitigate the risk of inefficient endogenous termination, agents with low continuation value receive no severance and lose value at job destruction, while agents with high continuation value receive high severance and gain value at job destruction. Comparative statics offer a novel explanation for the positive wage-tenure profile observed in the data: Average tenure and compensation should both be higher in jobs less exposed to job destruction risk.

Suggested Citation

  • Borys Grochulski & Russell Wong & Yuzhe Zhang, 2025. "Severance Pay in an Optimal Contract," American Economic Journal: Microeconomics, American Economic Association, vol. 17(2), pages 241-291, May.
    • Handle: RePEc:aea:aejmic:v:17:y:2025:i:2:p:241-91
    DOI: 10.1257/mic.20220267
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    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search
    • J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings

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