On April 1, 2020, a California Court of Appeal issued a long-awaited decision relating to the use of so-called “unlimited” vacation plans. In McPherson v. EF Intercultural Foundation, Inc., the court ultimately did not decide the viability of such plans under California law, but instead held California law requires payout of vacation to certain employees under the fact-specific issues in this case.¹ With respect to the ability of California employers to offer “unlimited” vacation plans to employees without the potential need to pay out this time when an employee separates from employment, the court stated, "[w]e by no means hold that all unlimited paid time off policies give rise to an obligation to pay 'unused' vacation when an employee leaves."

The court explained why the employees in this case were entitled to a vacation payout, but how other employees subject to a different policy and practice might not be so entitled, providing a non-exhaustive list of policy and practice examples that might not trigger a payout obligation. Because the court did not provide a black-and-white rule concerning when, under California law, an "unlimited" policy does and does not require payout when employment ends, employers using, or considering adopting, an "unlimited" vacation policy should tread lightly.

General Rule for Vacation Vesting & Payout in California

Per the California Supreme Court, vacation pay is deferred wages that vest as employees perform work to earn it. Unless a collective bargaining agreement provides otherwise, California Labor Code section 227.3 requires employers to cash out unused vacation or paid leave with vacation characteristics, e.g., combined paid time off benefits not limited to specific purposes, more commonly known as PTO, or other time off policies that are similarly structured to vacation.

The Trial Court Decision

Applying Labor Code section 227.3 and case law, a Los Angeles County Superior Court judge held the non-accrued vacation at issue in this case was a vested right subject to California payout requirements. The judge explained, “offering vacation time in an undefined amount simply presents a problem of proof as to what the employer’s policy was.” The court held that “[s]ince twenty days' annual vacation was approved at least once, it is sufficiently clear that at least that much vacation was actually available to plaintiffs under the [] policy applied to them.” Per the court, “the question then is whether more than twenty days' annual vacation vested.” The judge observed “trial testimony made clear that plaintiffs never considered that they could be approved for some large amount of vacation” and “concluded that the evidence establishes that twenty days, and no more, vested.” While the court noted “that in some cases where an amount of vacation is undefined as to a particular employee, an employee handbook might provide the best guidance as to what vacation time was actually available under the employer's policy,” it held “this is not the best course in this case.” Instead, the judge “determined that the best approach is a more straightforward one: 20 days of vacation vested annually for each plaintiff, and any unused portion is payable at termination.”

The Appellate Court Decision

The appellate court largely adopted the trial court's logic for why – in this case with these facts – Labor Code section 227.3 requires a vacation payout. Notably, the company did not have a written policy for these employees. It did not promise these employees a specific amount of vacation or tell them they could use a specific amount of vacation in a year. The company did not even formally tell these employees it had a vacation policy for them. Rather, a vacation benefit came up either during side conversations supervisors had with a new employee or in an email. Additionally, the company did not notify these employees what would happen if they did not take a sufficient amount of vacation.

The company, however, allowed these employees to take vacation and paid them their full wages during vacations. Moreover, it did not tell these employees that vacation was not part of their compensation. The company's practice was to give these employees some fixed amount of vacation, and the company expected them to take an amount of vacation with an implied limit that was in a range typically available to other employees who, conversely, were subject to a written vacation policy with defined parameters. Accordingly, the unwritten vacation policy for these employees included an implied cap. Additionally, the unwritten policy had three express parameters, i.e., these employees: 1) must notify their supervisor before taking vacation; 2) must ensure they could complete their work notwithstanding the vacation; and 3) did not need to input vacation days taken into an online timekeeping system.

The employees did not believe they had "unlimited" vacation. The court noted that the practical realities of employment prevented these employees from taking a large amount of vacation in a year or any vacation during a specific period of time, e.g., "[d]uring the peak season plaintiffs worked more than 100 hours a week, seven days a week, up to 18 hours per day."

Combining all these specific facts, and applying them to specific employees, the appellate court held the trial court correctly found these employees were entitled to some certain amount of vacation when employment ended, offset against vacation they took.

Unlimited Policies that Might Not Require Payout

The court limits its decision to the specific policies and employees in the case. However, in noting that it appreciates the benefit and understands the appeal of unlimited time off policies, the court provides the following guiding principles of a written policy that might, depending on the facts of the particular case, constitute an unlimited time off policy:

(1) clearly provides that employees’ ability to take paid time off is not a form of additional wages for services performed, but perhaps part of the employer’s promise to provide a flexible work schedule—including employees’ ability to decide when and how much time to take off;

(2) spells out the rights and obligations of both employee and employer and the consequences of failing to schedule time off;

(3) in practice allows sufficient opportunity for employees to take time off, or work fewer hours in lieu of taking time off; and

(4) is administered fairly so that it neither becomes a de facto “use it or lose it policy” nor results in inequities, such as where one employee works many hours, taking minimal time off, and another works fewer hours and takes more time off.

For companies waiting on this decision to receive a clear road map on how, if at all, they can structure an “unlimited” vacation policy, these guiding principles do not provide a bright-line rule employers can apply to determine whether or not they must pay out vacation when employment ends. These principles appear to constitute factors courts should consider (among others) when concluding whether the vacation policy under review requires payout.

Of the four examples, half concern what a policy says, whereas the other half concern how, in practice, the employer applies the policy. Accordingly, employers cannot simply point to language in their policies to avoid a payout requirement if how they administer the policy differs from how the policy reads. Importantly, ongoing administrative oversight and review of how policies work in practice may neutralize a primary reason an employer adopts an unlimited policy: administrative ease. For this reason, some employers might find operating in limbo concerning whether they are holding future financial liability has less appeal than the certainty a definite amount of vacation provides.

Debunking the Myth that Everyone Offers Unlimited Paid Leave

According to MetLife’s 17th Annual U.S. Employee Benefit Trends Study 2019, unlimited paid time off is the emerging benefit that most interests employees. Yet, per Arthur J. Gallagher & Company's 2019 Organization Wellbeing & Talent Insights, only 3% of surveyed employers offer this benefit, with 5% of companies noting they previously considered offering it, and another 5% saying they are considering offering it in the future. Similarly, in its 2018 Employee Benefits Survey, the Society for Human Resource Management (SHRM) notes few respondents provide unlimited paid leave benefits.

More recently, in its 2019 Employee Benefits Survey, SHRM notes "Open or unlimited leave, though the topic of much discussion for several years now, has not changed very much since 2016." Therefore, it is not common for employers to offer unlimited paid leave.

Because there are limits to a company's benefits package – even when generous – companies should consult with knowledgeable counsel to define those parameters and involve necessary company stakeholders – e.g., legal, human resources, and managers – to discuss whether and how a paid leave program and operational needs can harmoniously exist simultaneously.