Nothing can damage a company like a lawsuit. For employers, litigation spells steep legal bills and sleepless nights. For staff members, drawn-out disputes can be distracting and divisive. And when a lawsuit stems from inflammatory claims, such as sexual harassment, the publicity can ruin a company's reputation.

Lawsuit nightmares are becoming a reality for more business owners these days. Employment disputes represent one of the fastest-growing segments of cases in the U.S. court system, according to Samuel Estreicher, a professor of labor and employment law at New York University's School of Law. Meanwhile, legal fees are skyrocketing. It costs $100,000, on average, to defend a case in court, according to some estimates.

In an effort to avoid the courtroom -- and stay off the local news -- some companies are requiring their employees to arbitrate disputes with a neutral third party. Corporations like Hallmark and Anheuser-Busch have been arbitrating disputes with employees for years. Now, some small and medium-size businesses have begun to follow suit, says David Gibbs, an employment lawyer at Boston law firm Bowditch & Dewey. In some ways, he says, they have even more at stake than their corporate counterparts. "Lawsuits can wreak more havoc on a smaller company," he says.

Dan Henderson, founder and CEO of Summit Products, a toy company based in Trussville, Ala., asked his employees to sign an arbitration agreement last year after hearing a lawsuit horror story from a fellow business owner. Back in 1997, Summit Products almost folded after the company's first offering -- an educational toy called the Allowance Kit -- struck out with consumers, forcing Henderson to suspend payroll for eight months. Last year, the toy maker was on a roll, with more than $8 million in sales, and the last thing Henderson needed was a costly lawsuit. Saving money wasn't Henderson's only motivation. He had a good relationship with his 21 employees, and he planned to keep it that way. By eliminating the possibility of lawsuits, Henderson hoped to encourage amicable resolutions to problems that could arise as his company expanded. "We're growing so fast," he says. "Arbitration might be necessary at some point."

To be sure, arbitration can be just as pricey as a lawsuit, depending on how long it takes and how much, if anything, employees are awarded. Arbitrators -- usually retired judges or lawyers -- charge between $800 and $1,000 a day, on average. Many employers pick up the bulk of the tab -- which could total as much as $20,000 -- to avoid seeming unfair in the eyes of workers and the law. Employees, on the other hand, typically pay a nominal filing fee of about $150; in most cases, both sides pay for their own legal representation.

Communication is key to a successful arbitration policy. If you're clear about the agreement with your employees, they're more likely to accept it willingly and less likely to dispute it later on. Henderson, for instance, held a meeting with his staff to explain how arbitration could help them resolve problems quickly and amicably. Then he explained how the process would work: If a dispute arose, an employee would first try to resolve it with a manager. If they couldn't reach a resolution, the employee could then request a meeting overseen by a mediator and attended by both parties and their lawyers. The last resort would be an arbitration by a lawyer or judge, whose decision would be binding. To keep the process moving, many companies establish reasonable time limits for each step; for example, a policy might stipulate that the arbitration hearing occur within 90 days of the selection of an arbitrator.

A multistep approach like Henderson's is a smart move, according to Gibbs, because it encourages regular communication. "In many instances, all an employee needs is to be heard and to discuss a problem constructively," he says. Lawsuits, on the other hand, tend to do just the opposite: Once a claim is filed, both sides are encouraged by their lawyers to clam up until the case is settled.

Keep in mind that a poorly designed arbitration policy may not hold up in court. Case in point: In 2002, 21 former employees of Ryan's Family Steak Houses -- a restaurant chain based in Greer, S.C., with more than 300 locations nationwide -- filed a class-action lawsuit against the company, claiming it had failed to pay them overtime. Ryan's tried to enforce its arbitration agreement, but the U.S. Sixth District Court barred them, claiming that the policy was unfair to employees. The court ruled that the company, which required job applicants to sign the agreement to be considered for a position, failed to give them enough time -- sometimes less than 20 minutes -- to read and consider the policy. In some cases, managers gave out wrong information about the contract, which, the court added, was too complex for many workers to understand. This past March, the court reaffirmed its decision on appeal. The plaintiffs are now proceeding with their original class-action lawsuit, which could eventually involve hundreds of former Ryan's employees. The case serves as a cautionary tale for other business owners considering arbitration.

Some business owners worry that arbitration will prompt frivolous claims by employees.

Dan Henderson, for his part, covered his bases by explaining his arbitration policy to his employees before asking them to sign the agreement. He included the policy, which was drafted by his lawyer, in Summit's employee handbook, but most lawyers recommend keeping arbitration agreements separate from other documents to avoid confusion. When drafting your company's policy, use simple language and specify which claims are covered. An exhaustive list isn't necessary; simply mention that the agreement applies to statutory claims, such as those covered by the federal Civil Rights Act, and nonstatutory claims, such as disputes involving promotions, raises, and vacation time.

If you don't have an in-house human resources director to help implement an arbitration program and educate your staff, consider hiring a consultant. If a dispute arises, matchmaking services such as New York City's CPR Institute for Dispute Resolution can help you find professional mediators and arbitrators in your region. For $750, CPR will assess your company's needs in a conference call with a dispute resolution expert. If you decide to proceed, the company will charge another $2,750 to help you find a mediator, and $3,750 to match you with an arbitrator. You may get a better deal if you ask local employment lawyers for referrals and do some comparison shopping.

Since the onus usually falls on businesses to pay for arbitration, some entrepreneurs might worry that it could prompt employees to file frivolous complaints instead of resolving them with their co-workers and managers during the normal course of business. So far there's no statistical evidence to support that concern. Henderson, for his part, hasn't had a single request for mediation or arbitration since he implemented Summit Products' alternative dispute-resolution program last year, a fact he attributes to the company's solid track record with its staff members. "We already have the trust of our people," he says. "It's in our best interests to maintain good relationships with them so they don't leave." For Henderson, an arbitration agreement is an insurance policy -- treat your employees respectfully, and you'll never have to use it.

Why arbitration is a good deal for employees -- and employers

One study found that employees who arbitrated disputes prevailed 62% of the time, compared with a 43% win rate in court, according to a recent study by the National Workrights Institute, a Princeton, N.J., research organization.

Arbitration generated about the same median monetary awards for successful claimants -- $63,000 for arbitration, compared with $68,000 in court.

The good news for employers is that arbitrations were resolved in eight months, on average, but court cases dragged on for two years.