Severance Pay in an Optimal Contract

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. (JEL D82, D86, J31, J41, J64, J65)