Why severance pay?

In many countries, it is customary or even mandated that firms should pay employees they let go a severance package. While that may make sense as compensation for a labor contract that is getting broken, mandating it under all circumstances may make little sense on a first glance. It adds to firing costs and may lead firms to retain less productive workers too much. And from having witnessed that first hand, this can induce an employee to become a poison for everyone else to tease out severance pay after getting fired.

Donald Parsons goes through the rationale of mandating severance pay and compares it to a labor market where no such pay is mandated. It turns out there would be not much difference, as firms do voluntarily offer severance pay, as mentioned to break a contract, but also to avoid having an employee move to the competition. On a aggregate level, such pay does slow down worker movement a little bit, but it also has its advantages. For example, it can substitute for unemployment insurance for some time and it can insure against wage loss in reemployment. This is good, especially if moral hazard or administrative costs in these programs are high.