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UK Payroll and Tax explained
UK Payroll and Tax: The Complete Guide for Employers
If you're employing someone in the UK for the first time, payroll is probably the thing that keeps you up at night. And honestly? That's reasonable. The UK payroll system is detailed, heavily regulated, and the penalties for getting it wrong are not trivial.
But here's the thing: once you understand the building blocks, UK payroll is actually quite logical. It follows a clear structure. There are defined rates, set deadlines, and established processes. It's not a mystery. It's just detailed.
This guide walks you through the entire UK payroll and tax system, from the basics of PAYE to the specifics of Real Time Information reporting, pension auto-enrolment, and HMRC penalties. Whether you're setting up your own UK payroll or using an Employer of Record to handle it for you, understanding these fundamentals will help you make better decisions and avoid costly mistakes.
What Does UK Payroll Involve for Employers?
UK payroll is the process of calculating and distributing pay to your employees while meeting all your legal obligations to HMRC and The Pensions Regulator. It involves several interconnected responsibilities.
At its core, UK payroll requires you to:
- Calculate gross pay for each employee based on their salary or hourly rate
- Deduct income tax through the PAYE system
- Deduct employee National Insurance contributions (NICs)
- Calculate and make employer NIC payments (these are an additional cost to you)
- Enrol eligible workers in a workplace pension and make contributions
- Report pay and deductions to HMRC in real time
- Provide payslips to employees every pay period
- Submit year-end returns and issue P60s
Every single one of these is a legal requirement, not an optional extra.
Miss a deadline or miscalculate a deduction, and HMRC will come knocking.
The UK tax year runs from 6 April to 5 April. Most payroll processes align to this cycle, with key deadlines at the end of each tax year and throughout.
How Does the PAYE System Work?
PAYE stands for Pay As You Earn, and it's the system HMRC uses to collect income tax and National Insurance contributions directly from employment.
Rather than employees paying their tax in a lump sum at the end of the year, PAYE spreads it across every pay packet.
Here's how it works in practice.
The PAYE Process
- You register as an employer with HMRC. This gives you a PAYE reference number and an Accounts Office reference.
- HMRC issues tax codes for each employee. The tax code tells you how much tax-free pay the employee is entitled to. The most common code for 2025/26 is 1257L, which means £12,570 of tax-free pay per year.
- You calculate deductions each pay period. Using the tax code, you work out how much income tax and employee NIC to deduct from each pay packet.
- You report to HMRC in real time. Every time you pay employees, you submit a Full Payment Submission (FPS) through payroll software.
- You pay HMRC. By the 22nd of the following month (or the19th if paying by cheque), you send the total of income tax, employee NICs, and employer NICs to HMRC.
Our PAYE explained guide walks through each step with examples and calculations.
Tax Codes
Tax codes are how HMRC communicates to you how much tax to deduct. The code is made up of numbers and letters:
- 1257L means the employee has the standard Personal Allowance of £12,570
- BR means all earnings are taxed at the basic rate (20%) - used for second jobs
- D0 means all earnings are taxed at the higher rate (40%)
- NT means no tax is to be deducted
- K codes mean the employee has benefits that exceed their Personal Allowance
If an employee's tax code changes mid-year, HMRC will send you a notification. You apply the new code from the next pay period.
What Are the UK Income Tax Rates and Bands?
The UK operates a progressive income tax system. The more you earn, the higher the rate of tax on your earnings above each threshold. For 2025/26, the bands for England, Wales, and Northern Ireland are:
A few important points to note.
The Personal Allowance tapers. If an employee earns over £100,000, their Personal Allowance reduces by £1 for every £2 earned above £100,000. By the time they earn £125,140, they have no Personal Allowance at all. This creates an effective marginal tax rate of60% on income between £100,000 and £125,140.
Scotland has different rates. If your employee is a Scottish taxpayer (determined by where they live, not where they work), the bands are different:
Getting the right tax rate for the right employee is your responsibility as the employer. This is one reason payroll software is essential.
How Do National Insurance Contributions Work?
National Insurance contributions (NICs) fund the UK's social security system, including the State Pension and certain benefits. Both the employer and the employee pay NICs, and they're calculated separately.
For 2025/26, employees pay:
- 8% on earnings between £12,570 and £50,270 per year2%
- 2% on earnings above £50,270 per year
Employee NICs are deducted from the employee's pay, just like income tax.
Employers pay:
- 15% on all earnings above £5,000 per year (the Secondary Threshold)
This is an additional cost to the business, on top of the employee's salary. It's one of the most common things that surprises international employers. When you budget for a UK hire, you need to account for this 15% (on earnings above £5,000) on top of their gross salary.
Our National Insurance guide has detailed calculations and examples.
If your total employer NIC liability is under £100,000 per year, you may qualify for the Employment Allowance, which reduces your employer NIC bill by up to £10,500 per year. However, if you're the only employee and also the sole director of a limited company, you don't qualify.
If your employee has a student loan, you're responsible for deducting repayments through payroll. HMRC will notify you which plan type applies (Plan 1, Plan 2, Plan 4, Plan 5, or Postgraduate), and you deduct the appropriate percentage from earnings above the relevant threshold. For 2025/26, the main thresholds and rates are:
- Plan 1: 9% on earnings above £26,900
- Plan 2: 9% on earnings above £29,385
- Plan 4: 9% on earnings above £33,795
- Plan 5: 9% on earnings above £25,000
- Postgraduate: 6% on earnings above £21,000
These deductions sit alongside PAYE and NICs, and you report them through the FPS. The money goes to HMRC, which passes it to the Student Loans Company.
If you provide employees with non-cash benefits, these are known as "benefits in kind" and have tax implications. Common examples include:
- Company cars and fuel
- Private medical insurance
- Life insurance (except for registered group life schemes)
- Gym memberships
- Interest-free or low-interest loans
Benefits in kind are reported to HMRC on form P11D by 6 July after the end of the tax year. You also pay Class 1A employer NICs at 15% on the value of most benefits.
Some benefits are tax-exempt, including employer pension contributions, workplace parking, and certain cycling equipment under the Cycle to Work scheme. Getting the classification right is important, as errors can lead to unexpected tax bills for your employees and penalties for you.
Salary sacrifice arrangements allow employees to exchange part of their salary for a non-cash benefit. Common uses include pension contributions, cycle-to-work schemes, and electric vehicle leasing. The advantage is that both income tax and NICs are calculated on the reduced salary, saving money for both the employee and the employer.
However, HMRC has specific rules about what qualifies. The arrangement must be properly documented, the salary reduction must be real and effective, and the employee must agree to the change. Not all benefits qualify for tax-efficient treatment through salary sacrifice.
What Is Pension Auto-Enrolment?
Since the Pensions Act 2008, every employer in the UK must automatically enrol eligible workers into a qualifying workplace pension scheme. This is not optional, and The Pensions Regulator takes enforcement seriously.
Who Is Eligible?
A worker must be automatically enrolled if they:
- Are aged between 22 and State Pension age
- Earn more than £10,000 per year
- Work in the UK
Workers who don't meet these criteria (for example, those earning between £6,240 and £10,000) have the right to opt in. Those earning below £6,240 can join voluntarily.
Under the ERA 2025 changes, pension enrolment is now a day-one right. Previously, employers could defer enrolment for up to three months.
Minimum Contributions
The minimum total contribution is 8% of qualifying earnings:
- Employer minimum: 3%
- Employee minimum: 5% (including tax relief)
You can contribute more than the minimum, but never less. Qualifying earnings are the employee's gross pay between £6,240 and £50,270 per year.
Our UK workplace pension guide covers scheme selection, contribution calculations, and ongoing compliance.
What Is Real Time Information (RTI) Reporting?
RTI is how HMRC keeps track of employer payroll obligations in real time. Instead of submitting a single annual return, you report every time you pay employees.
Full Payment Submission (FPS)
Every time you run payroll (weekly, fortnightly, or monthly), you must submit an FPS to HMRC. This must be sent on or before the day you pay your employees. The FPS includes:
- Employee details (name, NI number, tax code)
- Gross pay to date in the tax year
- Tax and NIC deductions in this period
- Employer NIC due
- Student loan deductions (if applicable)
- Pension contributions
Employer Payment Summary (EPS)
If you need to report adjustments (for example, reclaiming statutory payments like SMP or SSP, or if no employees were paid in a month), you submit an EPS by the 19th of the following month.
Payment to HMRC
By the 22nd of the month following pay day (or the 19th if paying by cheque), you must pay HMRC the total of:
- Income tax deducted
- Employee NICs
- Employer NICs
- Less any recoverable amounts (like statutory payments)
If you miss the payment deadline, HMRC applies interest and may issue penalties.
What Annual Reports and Forms Are Required?
The UK payroll year-end involves several key documents and deadlines.
By 31 May after the end of the tax year, you must give every employee who was working for you on 5 April a P60. This summarises their total pay and deductions for the year.
When an employee leaves, you must issue a P45 showing their pay and tax deductions to date. The new employer needs this to apply the correct tax code.
If you provide benefits in kind to employees (company cars, private medical insurance, etc.), you must report these on a P11D by 6 July after the end of the tax year.
You submit a final EPS to reconcile your account with HMRC for the year.
What Penalties Does HMRC Impose for Payroll Errors?
HMRC takes payroll compliance seriously, and the penalty regime reflects that. The most common triggers for penalties are late submissions, late payments, incorrect deductions, and minimum wage violations.
Common Payroll Mistakes
Before we get to the specific penalties, here are the mistakes that trip up international employers most often:
- Using the wrong tax code. If you apply an incorrect tax code, you'll deduct the wrong amount of tax. HMRC will eventually correct this, but the employee may face an unexpected tax bill, and you may need to make adjustments.
- Missing the FPS deadline. The FPS must be submitted on or before pay day. Many employers assume it can go in afterwards. It can't.
- Forgetting employer NICs. Some employers focus on the employee's deductions and forget that employer NICs are an additional cost they need to pay.
- Not enrolling workers in a pension from day one. Under the ERA 2025 changes, pension enrolment is a day-one right. Deferring it is no longer an option.
- Miscalculating holiday pay. The rules around holiday pay have tightened. Using rolled-up holiday pay for irregular-hours workers is no longer permitted.
Getting these right from the start saves you headaches down the line. If you're not confident, an EOR or managed payroll service can take this off your plate entirely.
Late FPS Submissions
If you submit your FPS late (after the payment date), HMRC may issue a penalty based on the number of employees:
Late Payment
If you pay HMRC late, interest accrues from the due date. HMRC can also charge penalties of up to 5% of the amount owed for persistent late payment.
Incorrect Deductions
If you fail to deduct the correct amount of tax or NICs, you may be liable for the underpaid amount plus interest and penalties. HMRC can go back up to six years for careless errors and up to 20 years for deliberate errors.
National Minimum Wage Violations
If payroll errors result in workers being paid below the National Minimum Wage or National Living Wage, HMRC can issue penalties of up to 200% of the underpayment (capped at £20,000 per worker) and publicly name the employer.
What Payroll Software Options Are Available?
Running UK payroll manually is technically possible but practically inadvisable. The complexity of tax codes, NIC calculations, RTI reporting, and pension contributions makes software essential.
Payslips Are a Legal Requirement
Before we get to software options, one thing worth highlighting: you must provide every employee with a payslip every pay period. This is a legal requirement under the Employment Rights Act 1996. The payslip must show:
- Gross pay
- Variable and fixed deductions (tax, NICs, pension, student loans, etc.)
- Net pay
Since April 2019, this requirement extends to workers as well as employees, including those on zero-hours contracts. If you're providing payslips digitally, the worker must be able to access them easily. Most payroll software handles this automatically, but if you're running payroll manually, it's another thing you need to get right.
Main Options
HMRC's Basic PAYE Tools. Free software for employers with fewer than ten employees. It handles basic payroll calculations and RTI submissions, but it's limited in functionality.
Commercial payroll software. Options include Sage, Xero, QuickBooks, BrightPay, and Staffology. These handle calculations, RTI submissions, payslips, pension integration, and year-end reporting.
Managed payroll services. Outsourcing your payroll to a specialist provider who handles everything for you. This is common for businesses without in-house payroll expertise.
Employer of Record. If you're using an EOR, the EOR handles all payroll obligations on your behalf. You don't need UK payroll software or expertise; it's all managed for you.
Choosing the Right Option
The right choice depends on your situation:
- Fewer than ten employees and simple payroll? HMRC's Basic PAYE Tools may suffice.
- Growing team with complex needs? Commercial software like Xero or BrightPay.
- No UK presence and want zero payroll hassle? An EOR or managed payroll service.
Our UK payroll for foreign companies guide has specific advice for employers without a UK entity.
How Does an Employer of Record Handle UK Payroll?
If you're employing UK workers through an Employer of Record, the EOR takes on all payroll obligations. Here's what that means in practice.
The EOR:
- Registers as the employer with HMRC
- Operates PAYE and calculates all deductions correctly
- Submits FPS and EPS returns on time, every time
- Pays HMRC the correct amounts by the deadlines
- Enrols workers in a qualifying pension scheme from day one
- Issues payslips every pay period
- Handles statutory payments (SSP, SMP, SPP)
- Issues P60s and P45s at the appropriate times
- Manages P11Ds for any benefits in kind
You pay the EOR a monthly fee per employee, and they handle the rest. Your involvement is limited to approving timesheets or confirming salary details.
This is particularly valuable if you don't have a UK entity and don't want to set one up. Running UK payroll from overseas is complex; an EOR eliminates that complexity entirely.
Our EOR cost guide breaks down the typical fees involved.
Agility EOR is far more than just a service provider. We’re flexible, innovative and focused on outstanding client service. Supporting you every step of the way – and valuing your people as the cornerstone of success.
Frequently Asked Questions
Most employers pay monthly, but you can pay weekly, fortnightly, or monthly. The key requirement is that you submit an FPS to HMRC on or before each payment date.
Technically yes, but it's complex. You need to register as an employer with HMRC, use approved software for RTI submissions, and meet all payment deadlines. Most foreign companies either set up a UK entity or use an Employer of Record to handle this.
Gross pay is the employee's total earnings before deductions. Net pay is what they actually receive after income tax, NICs, pension contributions, student loan deductions, and any other deductions have been subtracted.
Employer NICs are 15% of earnings above £5,000 per year. For an employee earning £50,000, that's approximately £6,750 per year in employer NICs on top of their salary.
HMRC can issue financial penalties of up to 200% of the underpayment, publicly name you as a non-compliant employer, and require you to repay the difference to the worker. It's a serious offence.
Yes. Every employer must automatically enrol eligible workers into a qualifying pension scheme from day one of employment. The minimum employer contribution is 3% of qualifying earnings.
Want UK Payroll Without the Complexity?
Agility EOR handles all UK payroll obligations for you: PAYE, tax, NICs, pensions, RTI reporting, and statutory payments. No UK entity needed, no payroll software to set up, no HMRC deadlines to worry about.
See how Agility EOR handles your UK payroll