Social and occupational functioning difficulties are a characteristic feature of schizophrenia, and a growing body of evidence suggests that deficits in social cognition contribute significantly to these functional impairments. The present study sought to investigate whether the association between social cognition and social functioning in schizophrenia would be mediated by self-reported levels of empathy. Thirty outpatients with a diagnosis of schizophrenia or schizoaffective disorder, and twenty-five healthy controls completed a well-validated facial affect processing task (Ekman 60-faces facial task from the Facial Expressions of Emotion — Stimuli and Tests; FEEST), The Awareness of Social Inference Test (TASIT; to assess emotion perception and complex social cognitive skills such as the detection of sarcasm and deceit, from realistic social exchanges), and measures of self-reported empathy and social functioning. Participants with schizophrenia performed more poorly than controls in identifying emotional states from both FEEST and TASIT stimuli, and were impaired in their ability to comprehend counterfactual information in social exchanges, including sarcasm and lies, on the TASIT. Impairment in the comprehension of sarcasm was associated with higher empathic personal distress, and lower recreational functioning. Impairment in the identification of the emotions of others was found to be associated with lower satisfaction and lower empathic fantasy. However, empathy could not be explored as a mediator of associations between social cognition and functional outcome, due to lack of common associations with functional outcome measures. These findings have implications for the remediation of specific social cognitive deficits with respect to improving functional outcomes in schizophrenia.