Work documents explaining third-party sick pay

What Is Third-Party Sick Pay?

The end of the year brings company parties, holiday parties, and family parties. For those of us in payroll, there’s also third-party sick pay. Put the ugly sweater away—you won’t need it for this kind of party. Understanding third-party sick pay is essential for businesses to ensure accurate payroll compliance and proper handling of sick pay taxation.

Sick Pay 101

To understand third-party sick pay, let’s take a step back and understand what “sick pay” really is. Sick pay’s purpose is to replace the wages of an employee who cannot perform work due to illness or a non-job related injury. Most companies offer a sick pay policy or an allotted, set amount of days. Standard taxes and deductions are deducted from these wages.

Have the flu? If you take the day off and are still paid for it, that’s considered “sick pay.”

When an illness lasts longer than expected and an employee ends up using up their sick time, companies may force them to take unpaid leave. These are all examples of brief absences from work. But what happens when that absence is a result of an injury or illness that is more prolonged? That’s where we might encounter a Third Party.

Third-Party Sick Pay

Employees on extended leave that are expected to return are often paid through an employer’s sick plan. This wage replacement will come in the form of short-term or long-term disability, commonly abbreviated as STD and LTD, respectively. These payments are made by either the employer, an employer-selected third party administrator (TPA), an insurance company, or in some cases, a state disability program.

Come year-end, third-party sick payments need to be reported by the employer on behalf of the employee for Form W-2 reporting. The amount paid will vary by the income of the employee, so let’s focus on how these payments are taxed.

Navigating the tax implications of sick pay and adhering to employer sick pay policies are crucial aspects of payroll reporting requirements. In the realm of disability benefits management, it's important for employers to be aware of employee sick pay rights and payroll tax deductions.

Stay ahead of critical year-end, year-start deadlines with our 2022 HR Calendar.

Sick Pay Taxation

Depending on the exact circumstances and the TPA used, the employee’s tax liability varies in the following ways:

Employer Paid: If the policy is 100% funded by the employer, then the payments are 100% taxable to the employee.

Employer and Employee Paid: If there is a shared policy in place and the employee pays for a portion of the plan with after-tax dollars, he or she is entitled to the equivalent percentage of their payment to be non-taxed. In other words, if the employee pays 30% and the employer pays for 70%, a $1000 payout would mean $700 is taxable to the employee.

In the next two scenarios, the employer does not pay into the sick policy at all. In that case, the employee is subject to the following taxability:

Employee Paid (Pre-Tax): The entire portion of the sick pay would be taxable to the employee.

Employee Paid (Post-Tax): None of the sick pay is considered taxable.

Note that in any of the scenarios where the employee is taxable, the employer is still responsible for matching Social Security and Medicare and withholding any Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA) amounts.


Third-party sick pay providers will directly issue payments to the employees. Subsequently, they also remit notices of these payments to the employer to record. It’s best to record these notices as they arrive to ensure they are captured before the new year. As employers, it is critical to know what plan you offer employees to ensure that you’re keeping tabs on these payments accurately and in accordance with the provider.

Thankfully you’re never alone this time of year when you use a payroll provider. Payroll specialists are well versed in the year-end rush and know how to handle questions that inevitably occur around third-party sick pay.

Efficient management of sick leave payroll, meticulous sick pay recordkeeping, and staying informed about employee compensation law are key to maintaining compliant payroll practices.

There you have it—all you need to know about third-party sick pay. Turns out that the only thing that needs to be ugly at year-end are those holiday sweaters after all.

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