Employee Benefits eLine
Thursday, September 14, 2006—Vol. 5, No. 9

All or nothing-Unused vacation time at termination

“Do I have to pay employees for their unused vacation time at termination?” We are asked that question almost daily on the HR Hotline. Given how often this situation arises, you would think there would be a clear, straightforward answer to that question. Surprisingly, that’s often not the case.

To start with, the law on vacation time varies from state to state, so the answer will depend on where the employee works. In many states, there is no statute addressing pay out of unused vacation at termination, or the statute is frustratingly vague. And just when you think you’ve figured out the answer in a particular state, some court revisits the issue and changes the landscape. That’s what happened recently in Minnesota. (Keep reading even if you’re not a Minnesota employer. This court case will force employers to think about many aspects of their vacation policy that all employers would benefit from reviewing periodically.)

Minnesota: Earned vacation time can’t be forfeited

In Minnesota, as in most states, employers have no obligation to offer employees paid vacation time at all. Consequently, Minnesota courts have consistently held that the obligation to pay vacation time is determined by the agreement between the employer and the employee. As a practical matter, that generally means that vacation time is governed by the terms and conditions of the vacation policy in the employee handbook.

Based on that understanding, the conventional wisdom was that Minnesota employers could refuse to pay out unused vacation time at termination, or attach conditions to such pay outs, as long as the vacation policy clearly stated that is what would happen. But in the case of Lee v. Fresenius Medical Care, Inc., the Minnesota Court of Appeals severely restricted a Minnesota employer’s ability to forfeit unused vacation time at termination.

The employer’s vacation policy in that case specifically stated that unused vacation time would be forfeited if the employee was terminated for misconduct. But the Court of Appeals concluded that earned but unused vacation time was “wages” within the meaning of the Minnesota termination pay statutes. Because the termination pay statutes forbid the forfeiture of earned wages, the court ordered the employer to pay the employee her unused vacation time notwithstanding the language in the handbook.

Now what?

So what should Minnesota employers do now? If you always pay out unused vacation time at termination then this case will have no direct impact on you.

If your vacation policy states that unused vacation time is forfeited at termination or is forfeited under certain circumstances (e.g. if the employee is fired for misconduct or fails to give two weeks notice), you will need to make some changes.

Vacation policy changes

Certainly the most obvious and conservative choice is to change the policy to remove the forfeiture language and pay out all unused vacation time at termination.

If you want to continue to forfeit unused vacation time at termination, the case left open a possible loophole. While earned vacation time can’t be forfeited at termination, neither the Lee case nor the statutes address when vacation time is actually earned. That leaves open the possibility that an employer can insert language in the policy specifying when vacation time is earned. Then, until those conditions are met the vacation time is not earned and so does not have to be paid out at termination.

For example, one course of action might be to make sure the vacation policy only talks about vacation time being “accrued” (rather than “earned”). The policy would then specify that vacation time is not earned until it is both accrued and used. Finally, the policy would state that accrued but unused time will not be paid at termination; because the time was not used, it was never earned and therefore arguably can be forfeited.

Will this tactic work? It’s hard to say. There is certainly precedent in other areas of employment law for distinguishing between benefits that have been merely accrued vs. actually earned (for example, in retirement plans). So there is a valid argument that the employer can do the same with vacation time.

But there is also a distinct possibility that a court would dismiss this as word games and hold that the vacation time is earned as soon as it has been accrued. Also, keep in mind that you’re going to have to explain your clever new wording to employees, who might also accuse you of playing games, raising some sticky employee relations issues. Employers who choose to follow this approach need to recognize that it involves some risk.

(If you need assistance reviewing or rewriting your existing vacation policy, see the end of the article for resources available through HR Solutions and contact information.)

Accumulation of unused vacation time

Employers may also wish to revisit how much vacation time employees can accumulate to reduce the risk of significant vacation pay outs at termination. It would be perfectly legal, for example, to add an accumulation cap to the policy that says that an employee who has accumulated some specified amount of unused vacation time will not accrue any additional vacation until their balance of unused time falls below the cap.

Note that an accumulation cap is fundamentally different from forfeiting time that has already been earned. With an accumulation cap, employees simply stop earning any more time once the cap is reached so there is nothing to forfeit. (The State of California specifically allows this type of cap despite having one of the strictest “no vacation forfeiture” laws in the country.)

Procedure and practice changes

Make sure that you have a good mechanism in place for tracking how much vacation time employees have accumulated and how much has been used. Vacation claims often arise because of sloppy recordkeeping or arguments over how much vacation time the employee has actually taken.

If you have historically been lax about charging employees for vacation time when they take time off, you may wish to rethink that practice. Every time an employee takes time off that you don’t count as vacation time, it increases the amount you may have to pay out at termination. Except in a few cases where the law imposes restrictions (e.g. employees on military leave) you can generally require an employee to use available vacation time to cover an absence.

We’re not suggesting that you charge an employee vacation time for every minute they are away from work or that it’s never appropriate to allow an employee to take paid or unpaid time without charging vacation time. And, as with any benefit, you should always carefully consider the employee relations impact of any changes to the vacation policy and whether such changes fit with your corporate culture and the purpose behind the benefit. Nevertheless it is a good idea to have a clear policy on when employees will be charged vacation time and consider the financial implications of your policy choices.

What about PTO?

How does this ruling affect employers who have Paid Time Off (PTO) policies that combine vacation and sick time into a single bank of time? Almost certainly employers must pay out unused but earned PTO at termination just the same as vacation. One possible way to minimize this liability is to specify that only a fraction of the unused PTO representing the “vacation” portion of the PTO (say 60-75%) will be paid out at termination. This approach has been endorsed by the Attorney General of Massachusetts but has not been tested in Minnesota or any other state that we are aware of, so proceed with caution.

Wisconsin and other states

For now, Wisconsin employers are OK (unless they have employees working in Minnesota, of course). Wisconsin law takes the position that unused vacation and PTO time is presumptively vested and must be paid out at termination, unless the vacation/PTO policy says otherwise. So as long as your written policy clearly provides for forfeiture at termination, it should be enforceable in Wisconsin.

Employers with employees in other states should also be familiar with the vacation pay out requirements in those states. While most states will permit forfeiture of vacation at termination of employment, a few notable exceptions include California, Illinois, and North Dakota.

More help

HR Hotline subscribes can contact the HR Hotline at 800.258.3190 or hotline@associatedfinancialgroup.com for more information on vacation and PTO policies. HR Solutions will be contacting employers currently participating in our Handbook Maintenance program regarding necessary changes to their handbooks, but Handbook Maintenance clients should feel free to contact one of the HR Consultants if they have any questions before then. Employers who don’t currently participate in the Handbook Maintenance program but would like assistance drafting or editing their vacation, PTO, or other policies (or an entire handbook) can contact the HR Solutions group at 800.258.3190 or info@associatedfinancialgroup.com.