Employee incentives: optimizing structures for changes in UK employment law

Any business operating with employees in the UK will likely be aware of the many changes that have been introduced, and are still to be introduced, under the Employment Rights Act 2025.

Two of the potentially most significant changes, taking effect on 1 January 2027, are the reduction in the qualifying period for unfair dismissal claims from two years to six months and the abolition of the cap on compensation for unfair dismissal claims (this is currently capped at the lower of 52 weeks' pay and £123,543). A third, which will take effect on 1 October 2026, is the increase from three to six months in the limitation period in which an employee can bring an unfair dismissal claim. As a result of these changes, we anticipate a sharp increase in the number of unfair dismissal claims threatened and presented at an employment tribunal, and in the amounts of money claimed. The removal of the cap on the total value of the claim is also likely to make settling claims more challenging and expensive.

All businesses will feel the impact of employees gaining unfair dismissal rights after six months of employment, and there will be clear challenges in managing and assessing employees' performance and suitability in the first few months of the job.

Businesses with well remunerated employees, and employees with significant incentives, such as equity or bonuses, are likely to be most affected by removal of the compensation cap, but it may also have an impact on employers who wish to dismiss employees who are likely to find it difficult to mitigate their losses, such as older or disabled employees. Historically, the compensation cap has made it relatively straightforward to settle unfair dismissal claims unless there is a claim of discrimination or whistleblowing involved (where the cap does not apply), or a contractual claim (which in any event would be more likely to be pursued in the civil courts). After 1 January 2027, this will change as employees realize that there is, in theory, at least no limit on the amount of compensation they can ask a Tribunal to award. 

Employers with employees in the UK should consider now what steps they can take to mitigate the possibility of claims or improve the chances of settling them. We set out some broad points to consider below. 

• Ensure recruitment processes are robust. Consider additional interviews or tests, as well as background checking and detailed references. Identifying issues that mean an employee is not suitable (or not preferred) or which can be actively addressed from day one of employment will reduce the chance of a dismissal on performance grounds.

• Use probationary periods to actively assess performance and suitability. With only six months until the employee attains the right not to be unfairly dismissed, make sure they are accurately assessed in detail within the first 3-4 months so that a fully informed decision can be made. Keep detailed records of issues to potentially use if a dismissal is necessary on performance grounds after the six-month point has passed.

• Consider how to structure incentives. The clearer the likely award the more likely an employee will seek this in any claim or settlement discussion. Mechanisms such as genuinely stretch targets that are not always achieved, longer vesting periods for awards and appropriate use of discretion can all give rise to uncertainty over what the employee might ultimately have received had they remained employed. This could be useful in negotiations. This is an area in which employers should seek advice about the best approach in the context of their business.

• Improve the likelihood of a fair dismissal. Performance dismissals for senior individuals are rare because the process for making a fair dismissal on performance grounds requires the employer to give the employee an opportunity to improve their performance, typically over a period of a few months. This may not be commercially viable. It is possible for employers to argue that there is 'some other substantial reason' (in addition to or instead of performance concerns) that justifies a fair dismissal with a shorter process. It may help to address these points in employment contracts. Either way, good employee relations practices such as detailed records of performance concerns or complaints against an employee, and ensuring that these are raised and addressed in good time, will all potentially help support a decision to dismiss. 

• Encourage settlement on departure. Signing a valid settlement agreement on the departure of an employee is the only way to prevent a claim at a later stage. The longer limitation period for claims increases the chance that subsequent decisions by the business, or a liquidity event, may make a claim more attractive or more valuable. There are various mechanisms that could make it attractive for outgoing employees to sign settlement agreements, but these need careful thought and advice on the pros and cons and detailed drafting.

To hear more about the Employment Rights Act 2025 and potential implications for share incentives, please speak to our UK Corporate and Employment teams.