Mandatory Arbitration: Should Your Small Business Use It

A lawyer once sent me a two-page arbitration clause to drop into our offer letters, with a note saying that every client of his used one. I approved it in about four minutes. When I finally read it properly, a good part of it would not have survived a serious challenge, and I could not have told you what it was supposed to save us.

That is the pattern with mandatory arbitration. It gets adopted as a default, copied out of a template, without anybody pricing what it buys or what it costs. Then something happens, and the employer discovers that the clause either does not reach the claim, or reaches it at a price nobody had budgeted.

I build the people and records tooling for businesses without an HR department at FirstHR, so this is the analysis I wish I had done before signing off. What the agreement actually does, what the federal framework allows, what Congress took off the table, what the states have tried, and whether the math works for a small employer. General information, not legal advice.

What a Mandatory Arbitration Agreement Is

A mandatory arbitration agreement is a contract, signed before any dispute exists, in which an employee agrees to resolve legal claims against the employer through private arbitration rather than in court. It is mandatory because signing is a condition of getting or keeping the job, not a choice made once the argument has already started.

Three distinctions get blurred constantly. Predispute is not the same as post-dispute: an agreement to arbitrate a live dispute is a different legal animal and faces almost none of the same objections. Mandatory is not the same as binding: an agreement can be voluntary and still binding once accepted. And an arbitration clause is not a confidentiality clause, though the two travel together often enough that people assume one implies the other.

Scale first, because it explains why this feels like a settled default. Research from a national survey of private-sector employers conducted through Cornell University in 2017 found that 53.9 percent of establishments had adopted mandatory arbitration, covering 56.2 percent of nonunion private-sector employees, or 60.1 million American workers. Whatever you decide, you are not deciding it in a vacuum.

The Federal Arbitration Act Framework

The Federal Arbitration Act is the whole reason these agreements work. Section 2 makes a written arbitration provision in a contract involving commerce valid, irrevocable and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract. That saving clause is not decoration. It is the opening through which every unconscionability argument arrives.

The transportation exemption deserves more attention than small employers usually give it. Section 1 of the statute excludes contracts of employment of seamen, railroad employees, or any other class of workers engaged in foreign or interstate commerce, and the Supreme Court has read that phrase narrowly to mean transportation workers rather than everyone in commerce.

What changed is who counts. In Southwest Airlines Co. v. Saxon the Court looked at what the individual actually does, holding that a class of workers directly involved in transporting goods across state or international borders falls inside the exclusion. Then in Bissonnette v. LePage Bakeries Park St., LLC, decided unanimously on April 12, 2024, the Court held that a transportation worker need not work in the transportation industry at all. The case involved bakery distributors who delivered products to stores, and the Court sent it back for the lower court to apply the corrected test.

The practical consequence for a small business is narrow but real. If part of your workforce moves goods across state lines, a federal court may refuse to compel arbitration for those people even though the identical clause binds everybody else. State arbitration statutes can sometimes fill the gap, but you should know before you rely on the clause, not after.

What These Agreements Can No Longer Cover

Sexual assault and sexual harassment claims are outside the reach of any predispute arbitration agreement, at the claimant’s option. The Ending Forced Arbitration of Sexual Assault and Sexual Harassment Act, signed March 3, 2022, amended the federal arbitration statute so that no predispute arbitration agreement or predispute joint-action waiver is valid or enforceable in a case relating to a sexual assault or sexual harassment dispute, if the person alleging the conduct so elects.

Read the mechanics carefully, because the drafting is broader than the headline. The election belongs to the claimant, so the employee may still choose arbitration. The waiver of joint or class proceedings falls with the arbitration clause. And federal courts have generally held that a viable harassment allegation exempts the entire case rather than a single count, which means a hostile work environment claim can drag retaliation, discrimination and wage counts into court with it.

Timing is the live battleground. The statute applies to disputes that arise, or claims that accrue, on or after the enactment date, regardless of when the agreement was signed. The Sixth Circuit addressed this in Memmer v. United Wholesale Mortgage, LLC in 2025, and the Ninth Circuit reached its first interpretation in Combs v. Netflix, Inc. on July 8, 2026, holding that conduct and a termination predating March 3, 2022 left the employee inside her arbitration agreement.

Two more carve-outs belong in every draft. Administrative charges survive the agreement: the Equal Employment Opportunity Commission has stated that an arbitration agreement does not preclude an individual’s right to file a charge and have the case investigated, and that it remains fully available to employees regardless. Understanding how an agency charge actually proceeds is worth more here than any clause.

The labor board reaches the same result from a different direction. Following the Supreme Court’s decision on class waivers, the Board has still held that an agreement broad enough that an employee could reasonably read it as barring a charge with the Board is unlawful on that ground alone. Language, not intent, is what gets judged.

Class and Collective Action Waivers

Class and collective action waivers inside arbitration agreements are enforceable, and for most small employers they are the strongest argument in favor of having one. In Epic Systems Corp. v. Lewis, decided in 2018, the Supreme Court held that agreements requiring individualized arbitration must be enforced as written and that federal labor law does not displace that command.

That matters because of which claim is most likely to end a small business. A single discrimination suit is expensive. A wage and hour collective action covering every hourly employee for three years is a different order of magnitude, and misclassification cases in particular expand from one person to a whole job title without any new facts.

The board’s treatment of work rules has swung with its composition more than once, so treat the outer edges as unsettled rather than resolved. What has stayed constant since the Epic decision is narrower and easier to comply with: keep the waiver individual, keep the agency carve-out explicit, and do not word the clause so broadly that it reads as a gag on employees talking to each other or to a government agency.

State Laws That Limit What You Can Require

Several states passed outright bans on requiring arbitration as a condition of employment, and federal courts have mostly held those bans preempted. California is the case to know. Assembly Bill 51 made it unlawful, with criminal exposure attached, to condition employment on an arbitration agreement.

On February 15, 2023 the Ninth Circuit held in Chamber of Commerce v. Bonta that the Federal Arbitration Act preempts it. The reasoning is straightforward once you see it: a state may not place a special burden on the formation of arbitration agreements specifically, because that treats arbitration worse than other contracts. New York’s civil practice rule barring arbitration of discrimination claims and New Jersey’s comparable provision have met the same fate in most federal decisions.

Where states have real power is at the back end, policing how the arbitration runs. That is where a California employer feels the difference most.

The fee deadline rule is the one that surprises people. Under the California statutes, an employer that fails to pay arbitration fees within thirty days of the due date is in material breach, waives the right to compel arbitration, and can be liable for the employee’s fees. In Hohenshelt v. Superior Court, decided August 11, 2025, the California Supreme Court held the statute survives federal preemption when read to allow relief for lateness that is not willful, fraudulent or grossly negligent. Missing an invoice is a genuine way to lose the forum you paid to build.

If you employ people in more than one state, this is another reason to check the rules where each employee actually sits rather than where the company is registered. The same logic applies to every other policy in a distributed team, which is the point of the guide to employment laws for remote workers.

Who Pays, and Why It Is Not Automatically Cheaper

When you impose arbitration as a condition of employment, you pay for the forum. That single rule undoes most of the cost argument people make for these agreements, and it is not optional: it comes from the case law on unenforceable cost shifting and from the administrators’ own rules.

The California Supreme Court set the marker in Armendariz v. Foundation Health Psychcare Services, holding that an employer imposing mandatory arbitration must bear the costs unique to arbitration, because an employee cannot be required to pay expenses they would never have faced in court. Other states get to comparable places through ordinary unconscionability analysis.

The administrators built the same principle into their fee schedules. Under the American Arbitration Association’s employment rules, the employee’s exposure is limited to a capped administrative filing fee while the company pays the arbitrator’s compensation, travel, the hearing facility and a case management fee. Under the JAMS minimum standards of procedural fairness for employment cases, an employee subject to a required arbitration clause pays a single $400 filing fee and the company covers every other fee and expense.

Be honest about the trade. Arbitration can shorten the schedule, compress discovery, keep the dispute out of public filings, and remove the tail risk of a jury award nobody can predict. A Cornell study of employer-promulgated arbitrations, published in the Journal of Empirical Legal Studies in 2011, found employees prevailed in 21.4 percent of decided cases with a median award of $36,500. The federal court comparison set beside it, from Eisenberg and Hill, shows a 36.4 percent win rate and a $176,426 median. Both medians are stated in 2005 dollars.

Those numbers are the reason employers like arbitration and the reason critics call it forced. Read them carefully, though: they compare decided cases, and most disputes in either forum settle long before anyone reaches an award.

What arbitration does not do is remove the cost of defending a case. Your counsel still prepares, still takes depositions, still argues. The arbitrator’s bill is added on top of that, at professional rates, for time a judge would have provided for free. For a business with one dispute every few years, the forum bill can exceed anything the compressed schedule saved.

What Makes an Agreement Unenforceable

Agreements almost never fail on the core promise to arbitrate. They fail on the extras somebody added to gain an edge: a damage cap, a shortened deadline, a discovery limit, a one-way obligation, a fee-splitting clause. Courts apply ordinary contract defenses through the saving clause in the federal statute, and unconscionability is the one that does the work.

Unconscionability generally has two halves. Procedural unconscionability looks at how the agreement was formed: a take-it-or-leave-it document handed to an applicant with no chance to negotiate supplies some of it almost by definition. Substantive unconscionability looks at whether the terms themselves are unreasonably one-sided. Most courts require both, on a sliding scale, so a fair set of terms usually survives even a rushed signing.

One drafting point does more than the rest. Include a real severability clause and think about what you want to happen if a term is struck. Some courts sever the offending provision and enforce the rest. Others hold that a document permeated with unconscionable terms cannot be saved by editing, and refuse to enforce any of it. Piling on aggressive terms increases the chance you lose the entire agreement rather than the term.

Rolling One Out Without Breaking It

How you present the agreement matters as much as what it says, because the second half of the unconscionability test looks at formation. Bury it inside the handbook as one clause among fifty and you invite an argument that nobody knew they were waiving a jury trial.

Practically, the agreement should ride in the same packet as the rest of the signed paperwork. The offer letter and the confidentiality agreement go out together, and if you do not already have the latter, an NDA template is the fastest way to get a defensible one in place.

Storage is the unglamorous half of the work. A signed arbitration agreement you cannot produce is not an agreement, and countersigned records scattered across email are how employers lose motions they should have won. Keeping the whole signed file in one system, with dates and versions, is what HR document management is for.

When a Small Employer Should Skip It

Skip it when the exposure you actually face is a handful of individual disputes with salaried staff. In that shape, arbitration buys privacy and speed while adding a per-case forum bill and an outcome you cannot appeal, and the trade rarely comes out ahead.

Consider it seriously when you employ a large hourly workforce, when overtime and meal-break exposure is genuine, or when a single misclassification theory could apply to an entire job title at once. That is the scenario the waiver was built for, and no other tool addresses it as directly.

Whatever you decide, it is worth remembering what actually reduces claims. Clear workplace policies, documented performance conversations, and a termination process somebody thought about beforehand prevent more disputes than any clause resolves.

And when a separation is contested, a properly drafted severance agreement with a valid release closes the matter far more cheaply than either forum.

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