Who Pays Separation Pay When a Labor Contractor Closes in the Philippines?

Updated for the current Labor Code (as amended) and prevailing DOLE rules. This is an educational overview, not legal advice.

Short answer

In a legitimate contracting setup, the contractor (the service provider) is the direct employer and is primarily liable to pay separation pay when it closes. However, the principal (client) may still end up paying in two key situations:

Solidary (joint) liability kicks in if the contractor fails to pay statutory monetary claims owed to its employees—including separation pay due under the Labor Code.
Labor-only contracting is found: the arrangement is illegal and the principal is deemed the employer, making the principal directly liable for all employer obligations (including separation pay, if an authorized cause applies).

The legal scaffolding—why the contractor pays

1) Who is the employer?

In legitimate job contracting, the contractor has substantial capital or investment, exercises control over its personnel, and bears the risk of profit or loss. The contractor is the employer of the deployed workers.
In labor-only contracting, the contractor is a mere manpower supplier without the requisites above; the principal becomes the employer by legal fiction.

2) Separation pay for company closure

Under Article 298 (formerly 283) of the Labor Code, closure or cessation of business is an authorized cause for termination. The rule on separation pay is:

Closure not due to serious business losses: Separation pay of one (1) month pay or one-half (1/2) month pay per year of service, whichever is higher. A fraction of at least six (6) months counts as one whole year.
Closure due to serious business losses or financial reverses: No separation pay is required—but the employer must be able to prove the losses with sufficient, credible evidence.

Because the contractor is the employer in a legitimate setup, the contractor bears this obligation when it ceases operations.

3) Solidary liability of the principal

Articles 106–109 of the Labor Code create solidary liability for the principal and the contractor for monetary claims of the latter’s employees arising from violations of labor standards. Courts and DOLE treat separation pay due under Article 298 as a statutory monetary benefit. Practical effect: if the contractor closes and does not or cannot pay separation pay, employees can legally claim from the principal. The principal may later pursue reimbursement from the contractor or its surety, if any.

Notice and procedure (due process)

To validly terminate for closure, the employer (i.e., the contractor, or the principal if deemed the employer) must:

Serve written notice to each affected employee and to the DOLE Regional Office at least 30 days before the intended effectivity date.
Pay separation pay (if required) on or before the effectivity of termination (and in practice, together with final pay).
Submit the Establishment Termination Report (commonly via RKS Form 5 / latest DOLE template) reflecting the authorized cause and affected employees.
Observe non-discriminatory selection and compliance with any applicable CBA or company policy.

Failure to observe the 30-day dual notice can render the termination ineffectual or expose the employer to nominal damages and administrative sanctions.

When the principal ends the service contract

Ending a service agreement between principal and contractor does not by itself create an employment relationship with the principal. The contractor is expected to re-assign employees to other clients/projects. If there is no available reassignment and the contractor decides to retrench or close, the contractor must then comply with Article 298 (notices + separation pay, if applicable).

Caveat: If the “contractor” is a mere manpower supplier (labor-only), the principal is the employer. If the principal’s business continues but only the headcount is reduced, the appropriate authorized cause would likely be redundancy or retrenchment, not “closure,” with the corresponding higher or lower separation pay formulas under Article 298.

Special scenarios and how liability shifts

Legitimate contractor closes, no serious losses proven
- Primary payer: Contractor
- Backstop payer: Principal (solidary liability) if contractor defaults
Legitimate contractor closes with serious business losses (properly proven)
- No separation pay due from contractor
- Principal’s solidary liability does not arise for separation pay (nothing is due), though other final pay items may still be owed
Labor-only contracting is established
- Principal is the employer
- If the principal is not closing, separation pay for “closure” doesn’t apply; other authorized causes (e.g., redundancy) govern.
- If the principal itself closes operations, apply Article 298 directly to the principal.
Project completion (true project employment in legitimate contracting, e.g., construction)
- Completion of a bona fide project is a valid ground for termination; separation pay is generally not required unless provided by CBA, employment contract, or company policy.
- Closure rules (and separation pay for closure) are different from project completion.
Contractual or CBA enhancements
- Service agreements sometimes require the principal to shoulder or advance separation pay if the contractor fails, or to absorb affected workers. These contractual clauses can override the default risk allocation between principal and contractor.

Computing separation pay (closure scenario)

Baseline:
- No serious losses: pay the higher of (a) 1 month pay, or (b) 1/2 month pay × years of service (≥6 months rounds up).
- With serious losses (adequately proven): none.
“One month pay” means the latest salary rate (basic pay). If CBAs or policy define “pay” to include certain fixed allowances, follow that definition.
Other terminal pay items (always separate from separation pay):
- Pro-rated 13th-month pay (Pres. Decree 851)
- Unused Service Incentive Leave (if any, 5 days/year minimum, commutable if company policy allows or if separation prevents use)
- Any earned but unpaid wages, overtime/holiday differentials, etc.
- Government-mandated certificates and clearances for benefits claims

Tax note: Separation pay due to closure/retrenchment or other causes beyond the employee’s control is tax-exempt under the NIRC (Sec. 32[B][6][b]) as implemented by BIR rules.

Evidence of serious losses (to lawfully skip separation pay)

To validly withhold separation pay based on serious business losses, employers must show objective, independently verifiable proof, typically:

Audited financial statements showing substantial and actual losses
Comparative financial data demonstrating continuing or imminent reverses
Board resolutions and supporting business records
Good-faith business judgment (not a convenient pretext)

The burden of proof rests on the employer invoking the exemption.

Documentation checklist (for contractors)

Board/Owner resolution approving closure and authorizing signatories
30-day notices to employees and to the DOLE Regional Office (retain registry receipts or acknowledgments)
Establishment Termination Report (current DOLE form)
Separation pay computations per employee; payroll proofs of settlement
Audited FS and supporting papers (if invoking serious losses)
Service agreement and any clauses on separation/assumption by principal
Proof of attempts to reassign (if applicable), especially in multi-client contractors
Certificates of employment and quitclaims (observe fairness; avoid overbroad waivers; pay first before asking to sign)

What principals should do (risk management)

Pre-qualify contractors for legitimacy (capitalization, tools, control, compliance history).
Contract for a performance bond or escrow to cover final pay and separation pay exposure.
Insert a step-in clause allowing the principal to advance payments to workers and charge back the contractor if needed.
Require proof of compliance (SSS, PhilHealth, Pag-IBIG remittances; payroll summaries) monthly.
Provide transition plans for end-of-contract—e.g., preferential hiring by the incoming contractor (with continuity of tenure not guaranteed unless agreed).

Workers’ remedies

File a money claim for unpaid separation pay and terminal benefits with the DOLE Single-Entry Approach (SEnA), then to the NLRC if unresolved.
Implead both the contractor and the principal under solidary liability.
SSS unemployment insurance (RA 11199): eligible workers involuntarily separated for authorized causes (including closure) may claim unemployment benefits (subject to contribution conditions and limits).
Tax exemption: request a BIR ruling/certification only if the employer cannot issue adequate tax-exempt characterization; often the employer’s proper payroll treatment suffices.

Frequently asked edge cases

Contractor “hibernates” but does not legally close: If operations cease indefinitely and employees are let go, this still fits closure/cessation under Article 298; separation pay rules apply.
Contractor pays partial, then dissolves: Employees may pursue the principal under solidary liability and, if available, call on the bond.
Incoming replacement contractor refuses to absorb workers: No legal compulsion to absorb unless CBA, law, or contract says so.
End of project vs. closure: Do not conflate. Project completion generally does not require separation pay; closure does (absent serious losses).
Labor-only finding later: If a court or DOLE finds labor-only contracting, the principal becomes the employer, and the analysis resets under Article 298 against the principal.

Practical templates (plain-language)

Employee notice (30 days before effectivity)

We regret to inform you that [Contractor Name] will cease operations effective [Date] due to [reason]. In compliance with Article 298 of the Labor Code, this serves as 30-day prior notice. Your separation pay has been computed at [amount/formula] and will be released on [date], together with your final pay and certificates.

DOLE notice (regional office)

Pursuant to Article 298, [Contractor Name], with principal office at [address], will close operations effective [Date], affecting [number] employees listed in the attached roster. Reason: [closure reason]. We undertake to pay separation pay in accordance with law (or: we are invoking serious business losses and attach supporting documents).

Key takeaways

Default rule: In a legitimate setup, the contractor pays separation pay upon its own closure, following Article 298.
Exception #1: If the contractor fails to pay, the principal can be made to pay under solidary liability for statutory monetary benefits.
Exception #2: If the arrangement is labor-only, the principal is the employer and bears direct liability (subject to the correct authorized cause).
No pay only if serious losses are proven.
30-day dual notice (employees + DOLE) is mandatory.

If you want, I can adapt this into a check-off compliance packet (letters, RKS filing guide, and a calculator you can drop into your payroll sheet).