What is PAYE? Explained for Employers

Pay As You Earn (PAYE) is HMRC’s system for collecting Income Tax and National Insurance contributions from employment income. Employers must operate PAYE on most payments made to employees, directors and certain workers, making it one of the core payroll and HR compliance functions within any UK organisation. A properly managed PAYE process ensures employees pay the correct tax, statutory deductions are accurate and the business avoids HMRC penalties.

What this article is about:
This guide explains how PAYE works from an employer’s perspective. It covers the legal duties placed on employers, how Income Tax and National Insurance are calculated, what deductions must be processed through payroll, how HMRC real-time information submissions work and the risks for employers if PAYE is not operated correctly. The aim is to give HR professionals and business owners a clear and authoritative understanding of PAYE so they can run payroll accurately and remain compliant.

Payroll oversight is increasingly scrutinised by HMRC, especially in relation to incorrect tax codes, missing RTI submissions and errors in statutory payments such as Statutory Maternity Pay and Statutory Sick Pay. Ensuring PAYE is handled properly from onboarding to offboarding reduces compliance exposure and builds confidence that employees are being paid correctly. With this backdrop, the article moves through the core elements of PAYE: understanding the framework, calculating deductions, meeting employer obligations and addressing practical issues that HR teams encounter.

Section A: Understanding PAYE

PAYE is the mechanism HMRC uses to collect Income Tax and National Insurance from employment income before it reaches the employee. For employers, understanding when PAYE applies, how it interacts with employment status and what components drive the calculation is fundamental to running compliant payroll. This section provides a structured overview of the PAYE framework so HR teams and business owners can anchor their decision-making in clear legal requirements.

1. What PAYE means and when employers must operate it

PAYE applies to most payments made to employees, including wages, salaries, bonuses, overtime, commission and certain benefits. HMRC requires PAYE to be operated from the first payment made to a worker who is treated as an employee for tax purposes where:

• the employee earns at or above the National Insurance Lower Earnings Limit, or
• the employee earns at or above the PAYE tax threshold, or
• the employee has another job or receives a workplace or personal pension, or
• the employee receives taxable benefits or other payments on which tax or NIC must be deducted.

Employers must register with HMRC as soon as they know they will pay someone and any of these triggers will apply. This avoids the misconception that the Lower Earnings Limit alone governs whether PAYE must be operated.

Some categories of worker fall into grey areas, especially casual staff, zero-hours workers and irregular contractors. The obligation is not determined by the label given to the working arrangement but by whether the individual meets HMRC’s definition of an employee for tax purposes. If the business controls how the work is done, supplies tools and equipment and integrates the person into the workforce, PAYE is usually required and HMRC may seek unpaid tax and NIC from the employer if PAYE has not been operated correctly.

2. How PAYE links to employment status and taxable earnings

PAYE calculations start with identifying what counts as taxable earnings. This includes basic pay and most forms of remuneration, but employers must understand exceptions relating to expenses, benefits and reimbursements. Misclassifying an employee as self-employed can result in unpaid PAYE, interest and penalties. HMRC will look at the reality of the working arrangement, not the contractual wording, so HR teams should ensure employment status assessments are consistent, documented and, where appropriate, supported by tools such as the Check Employment Status for Tax (CEST) service.

Where employment status is clear, taxable earnings drive the tax and NIC calculation. Employers must include all taxable additions, as omissions such as bonuses or allowances create underpayments that HMRC can recover from the business. Accurate data capture and clear payroll processes are central to ensuring that earnings are allocated correctly and that taxable and non-taxable elements are distinguished in line with HMRC guidance.

3. Key components of PAYE: tax codes, NI categories and RTI

Several components influence the PAYE calculation and must be kept up to date:

• Tax codes determine how much tax-free pay the employee is entitled to. HMRC issues tax codes to employers, and payroll must implement them from the stated date on the notice. Using an incorrect code is a common cause of under- or over-deductions and may trigger HMRC reconciliations.

• National Insurance categories determine which NIC rates apply. These depend on age, employment type and eligibility for reduced rates, for example for apprentices, employees under 21 and qualifying veterans. Directors are subject to an annual earnings period for NICs, with the option of using the alternative method during the tax year, which requires careful configuration in payroll software.

• Thresholds and rates for Income Tax and NIC can be changed or frozen by fiscal events and budgets. Employers must update payroll systems in line with the start of each tax year and be aware that NIC changes, including reductions to primary Class 1 NIC, directly affect employee deductions and employer cost planning.

• Real Time Information (RTI) reporting requires employers to submit details of payments and deductions to HMRC on or before each payday. This gives HMRC up-to-date information on tax and NIC, reducing the scope for discrepancies and informing employee tax code changes.

Proper operation of these components ensures PAYE is accurate, recoverable and legally compliant. Employers should review tax codes, NI categories and threshold updates at each tax year end and whenever HMRC issues new instructions to reduce the risk of systemic errors.

Section Summary

PAYE is triggered when a business employs someone and makes taxable payments that meet HMRC’s thresholds or involve other risk factors such as additional jobs, pensions or taxable benefits. Employers must correctly determine employment status, identify taxable earnings, apply HMRC tax codes, select the correct NI category, calculate tax and NIC based on current thresholds and report payroll data through RTI. Understanding and keeping these foundations up to date avoids most PAYE errors encountered by HR teams and business owners and strengthens the organisation’s overall compliance position.

Section B: PAYE Deductions and How They Work

Employers are responsible for ensuring that all statutory deductions are calculated and processed correctly through payroll. PAYE is not limited to Income Tax and National Insurance; it is also the mechanism through which statutory payments, court orders and other mandatory deductions are applied. This section sets out how each category of deduction works and the compliance implications for employers and HR teams.

1. Income Tax calculations under PAYE

Income Tax is calculated by applying the employee’s tax code to their taxable earnings for the period. Payroll systems convert the tax code into a personal allowance, which is spread across the tax year. Earnings above this allowance are taxed at the relevant rate: basic, higher or additional rate. Employers must also adjust for irregular payments, such as bonuses or back pay, which can change the cumulative calculation.

HMRC expects employers to implement updated tax codes immediately. Any delay risks underpayments or overpayments that may fall back on the employer if HMRC determines payroll processes were insufficient or if systemic errors recur.

2. National Insurance contributions (NICs)

NICS are calculated based on NI category and earnings thresholds. Employees pay primary Class 1 NIC while employers pay secondary Class 1 NIC. Key compliance points include:

• NICs apply per earnings period, not cumulatively.
• Certain groups, including apprentices, employees under 21 and veterans, qualify for specific NI categories.
• Directors have an annual earnings period and special NIC rules that require accurate configuration in payroll software. The alternative method may be applied during the year with a final annual adjustment at year end.
• Changes to NIC thresholds or reductions in rates announced through fiscal events must be applied promptly by employers to avoid incorrect deductions.

3. Statutory payments processed through PAYE

PAYE is the mechanism for administering statutory payments, including:

• Statutory Sick Pay (SSP)
• Statutory Maternity Pay (SMP)
• Statutory Paternity Pay (SPP)
• Statutory Adoption Pay (SAP)
• Statutory Shared Parental Pay (ShPP)

These payments have strict eligibility rules and must be calculated using the Average Weekly Earnings (AWE) test. Employers must:

• use the correct relevant period when calculating AWE
• retain evidence and calculations for audit and HMRC review
• apply statutory rates published each year

Incorrect AWE calculations can result in HMRC requiring the employer to fund any shortfall, even if the original error arose from employee-supplied data. Small employers may reclaim some SMP, SAP and ShPP through the Small Employers’ Relief scheme, which must be reported correctly via the EPS.

4. Other payroll deductions

Several additional deductions must be processed through PAYE, including:

• Student loan and postgraduate loan repayments
• Pension contributions under auto-enrolment
• Attachment of Earnings Orders (AEOs)
• Child maintenance deductions
• Salary sacrifice arrangements

Employers must ensure:

• student loan plan types are accurately applied to prevent misallocated repayments
• pension schemes use the correct qualifying earnings definition and thresholds
• AEO priority rules are followed when multiple orders exist

Incorrect processing exposes the employer to arrears, penalties or employee disputes. HR teams must ensure payroll systems reflect current thresholds, repayment rates and statutory order requirements issued by HMRC, the Student Loans Company and The Pensions Regulator.

Section Summary

PAYE handles multiple categories of deduction beyond Income Tax and NICs. Employers must ensure all deductions are calculated accurately, statutory payments are processed correctly using the correct relevant period and documented AWE calculations, and payroll systems reflect current legislative requirements. Clear payroll controls and documentation reduce exposure to HMRC intervention and employee disputes.

Section C: Employer PAYE Compliance Duties

PAYE compliance is an ongoing legal responsibility for every employer. It starts with registering the business with HMRC and continues throughout the employment relationship, from onboarding to issuing final payslips and P45s. This section explains the operational and legal duties that employers must meet to remain compliant and avoid penalties.

1. Registering as an employer with HMRC

A business must register as an employer before issuing its first payday where PAYE is required. HMRC generally recommends registering at least four weeks before the first payroll run to allow time for PAYE references and online account access to be issued.

Registration is mandatory where any of the following apply:

• the employee earns at or above the PAYE tax threshold
• the employee earns at or above the Lower Earnings Limit for National Insurance
• the employee has another job or pension
• the employer provides taxable benefits or makes payments on which tax or NIC must be deducted

Once registered, HMRC provides the employer PAYE reference and the Accounts Office reference. Both must be used on RTI submissions and when sending PAYE and NIC payments to HMRC.

2. Running payroll and submitting RTI returns

Real Time Information (RTI) is HMRC’s digital reporting framework that requires employers to submit payroll data on or before every payday. The two primary RTI submissions are:

• Full Payment Submission (FPS): details of every payment and deduction for each employee.
• Employer Payment Summary (EPS): used for adjustments such as reclaiming statutory payments or indicating no payments have been made for a period.

HMRC generally does not charge a penalty for the first late return in a tax year, but repeated failures trigger automatic penalties. Employers must still file an FPS even if the payment is made late. RTI data must also match the actual payments made to employees and the amounts paid to HMRC; inconsistencies increase the likelihood of compliance checks.

3. Record-keeping duties and payslip accuracy

Employers must keep detailed payroll records for at least three years to meet HMRC requirements, although best practice is to retain payroll data for six years to align with limitation periods for employment tribunal and audit risks. These records must show gross pay, deductions, tax codes, NI categories, statutory payment calculations, student loan deductions and RTI submissions.

Accurate payslips are a legal requirement under the Employment Rights Act 1996. Employees and workers are entitled to itemised payslips that show:

• gross pay
• variable and fixed deductions
• net pay
• hours worked where pay varies by time worked

Inaccurate or incomplete payslips expose employers to tribunal claims and undermine PAYE and RTI compliance.

4. Errors, corrections and HMRC compliance checks

PAYE errors are common and include missing tax codes, incorrect NI categories, late RTI submissions, duplicate employee records and misreported hours or payments. Employers must correct errors promptly using:

• FPS amendments for in-year corrections
• Year-to-Date (YTD) corrections where supported by the software
• corrected P60s where a year-end error affects statutory reporting

HMRC may conduct PAYE compliance checks to review payroll processes, statutory payment calculations, employment status assessments and RTI accuracy. Poor systems, undocumented procedures or repeat mistakes increase the risk of penalties and backdated liabilities. HR leaders should ensure payroll is audited regularly and that issues are addressed proactively.

Section Summary

PAYE compliance requires employers to register with HMRC, run payroll accurately, submit timely RTI returns and maintain comprehensive payroll records. Errors must be corrected promptly using the appropriate HMRC mechanisms. Strong payroll governance and documented processes reduce the risk of penalties, reconciliations and HMRC compliance checks.

Section D: PAYE Issues for HR and Business Owners

PAYE responsibilities extend beyond the technical payroll calculation. HR teams and business owners must manage onboarding, employment status, tax code changes and off-payroll working to reduce compliance risk. This section focuses on the real-world issues employers encounter and the steps needed to prevent operational errors that lead to HMRC enquiries.

1. Onboarding employees and right to work considerations

Effective PAYE management begins with onboarding. Employers must collect accurate starter information, including personal details, payment preferences and the HMRC starter checklist, which replaced the former P46. Errors at this stage commonly lead to incorrect tax codes being applied, especially where employees do not provide a P45.

Right to work checks must be completed before employment begins. These checks do not replace PAYE obligations but sit alongside them. Where an employer fails to complete a compliant right to work check, they face civil penalties and increased scrutiny of their PAYE and wider employment practices.

2. Handling tax code changes and irregular payments

Tax codes change for several reasons, including new employment, taxable benefits, underpayments and HMRC coding reconciliations. Employers must operate new codes from the first payday after receiving a P6 or P9 notice from HMRC. Failure to implement changes leads to cumulative inaccuracies, most of which HMRC expects employers to correct through in-year adjustments.

Irregular payments such as bonuses, commission, holiday pay arrears and termination payments can alter the PAYE calculation. Employers must ensure payroll understands how to process irregular payments under cumulative or non-cumulative coding, depending on the circumstances and HMRC instructions.

3. Off-payroll working (IR35) and PAYE implications

For medium and large businesses engaging contractors through personal service companies, the off-payroll working rules (IR35) may require the business to operate PAYE on contractor payments. HR and payroll teams must ensure that:

• Status Determination Statements (SDS) are issued to contractors and agencies
• Contractor roles are reassessed when working practices change
• Ponderation processes are documented to mitigate dispute risk
• PAYE is operated on deemed employment income where IR35 applies

If a contractor disagrees with the SDS, the responsibility for operating PAYE remains with the client unless the engager is a small company meeting the Companies Act thresholds. The small companies exemption applies only to the private sector, and public sector bodies must apply off-payroll rules in all circumstances.

Incorrect application of IR35 rules leads to significant liabilities, including unpaid PAYE and NIC, interest and penalties. HMRC increasingly scrutinises IR35 compliance in sectors with large contractor populations.

4. Risks: underpayments, late filing and penalty exposure

PAYE carries significant compliance risk. Common problems include:

• underpayments due to incorrect tax codes or missing earnings
• late RTI filings
• duplicate payroll records
• incorrect NI categories
• errors in statutory payment calculations

HMRC expects employers to have controls in place to prevent repeated mistakes. Poor payroll governance leads to penalties, reputational harm and costly backdated liabilities. HR professionals should ensure internal processes are reviewed regularly and any issues are addressed before payroll deadlines.

Section Summary

Employers face a range of operational PAYE challenges during onboarding, tax code management, contractor engagement and payroll changes. Addressing these risks through effective HR processes and accurate payroll administration reduces exposure to HMRC action and strengthens overall compliance.

FAQs

Is PAYE mandatory for all employers?
PAYE is mandatory if any employee meets a PAYE trigger, including earning at or above the tax threshold or Lower Earnings Limit, receiving taxable benefits, receiving a pension or having another job. Most employers operating payroll will need to run PAYE.

Which earnings are subject to PAYE?
Most employment income is taxable, including wages, bonuses, overtime, commission, allowances and certain benefits. Some reimbursed expenses and approved mileage payments may fall outside PAYE if processed correctly in line with HMRC rules.

What happens if HMRC issues the wrong tax code?
Employers must apply the code provided by HMRC even if it appears incorrect. Employees must contact HMRC to correct any issues. Employers should ensure the code is implemented immediately to avoid cumulative inaccuracies and under- or overpayments.

Do directors have different PAYE rules?
Yes. Directors are subject to an annual earnings period for NIC calculations, which affects how NIC is calculated on irregular or large payments. Directors are still subject to PAYE for Income Tax.

How do student loan and postgraduate loan deductions fit into PAYE?
These deductions must be applied when HMRC notifies the employer or when the employee’s starter checklist indicates repayments are required. Employers must apply the correct plan type to avoid incorrect deductions.

What if payroll misses an RTI deadline?
HMRC may charge late filing penalties, especially for repeated failures after the first late submission in a tax year. Employers should submit corrections promptly and ensure payroll cycles are well controlled.

Does PAYE apply to contractors?
Generally, contractors paid through their own company fall outside PAYE. However, where IR35 applies under off-payroll working rules, the business may need to operate PAYE on deemed employment income.

Glossary

Useful Links