What is PAYE?

PAYE Explained

PAYE stands for Pay As You Earn. It is the system through which HMRC collects income tax and National Insurance contributions from employees’ earnings before they receive their pay. Employers act as tax collectors on behalf of HMRC, deducting the correct amounts and sending them to the government.

The system ensures tax is collected throughout the year rather than in a single annual payment, making it manageable for both employees and HMRC.

Who Needs to Operate PAYE?

An employer must register for and operate PAYE if any of the following apply:

• Any employee earns at or above the Lower Earnings Limit (£123 per week for 2024/25)
• Any employee has another job
• Any employee receives a pension
• Any employee receives expenses or benefits in kind

This includes limited companies paying directors, even if the director is the sole employee.

How PAYE Works

For Employees

Each employee is assigned a tax code by HMRC. The tax code tells the employer how much tax-free income the employee is entitled to. The employer uses this code alongside HMRC’s tax tables to calculate the correct deduction each pay period.

The standard process for each pay run:

1. Calculate the employee’s gross pay (salary, overtime, bonuses, commission)
2. Apply the tax code to determine tax-free pay for the period
3. Calculate income tax on the taxable portion using the relevant rates
4. Calculate employee National Insurance contributions
5. Calculate employer National Insurance contributions
6. Make any other deductions (student loan, pension, attachment of earnings)
7. Pay the employee the net amount

The Cumulative Basis

PAYE operates on a cumulative basis within each tax year. This means the calculation considers total pay and tax from the start of the tax year (6 April), not just the current pay period. If an employee has been overtaxed in earlier months, the system automatically corrects this through reduced deductions in later months.

Some employees are taxed on a non-cumulative (Week 1/Month 1) basis, where each pay period is treated independently. HMRC may instruct this when issuing a tax code, typically as a temporary measure.

Tax Codes

Tax codes are central to PAYE. The most common code is 1257L, which gives a tax-free personal allowance of £12,570. The number in a tax code is multiplied by 10 to give the annual tax-free amount.

Common code suffixes:

For a detailed breakdown, see the full guide on tax codes .

Real Time Information (RTI)

Since 2013, employers must report payroll information to HMRC in real time using the RTI system. This involves submitting two main reports:

Full Payment Submission (FPS)

An FPS must be sent to HMRC on or before each payday. It contains details of every employee paid, including:

• Gross pay
• Tax deducted
• National Insurance contributions (both employee and employer)
• Student loan deductions
• Hours worked (for certain employees)
• Starter and leaver information

Employer Payment Summary (EPS)

An EPS is submitted when the employer needs to report items that reduce their HMRC liability, such as:

• Statutory maternity, paternity, or sick pay recovered
• Employment Allowance claims
• Periods with no employees paid (nil returns)

The EPS must be submitted by the 19th of the following month.

Employer Obligations

Employers operating PAYE must:

• Register as an employer with HMRC before the first payday
• Calculate and deduct the correct tax and NICs each pay period
• Submit RTI reports on or before each payday
• Pay HMRC by the 22nd of each month (electronic) or 19th (postal)
• Provide P60s to all employees by 31 May after the tax year
• Report benefits in kind on P11D forms by 6 July
• Keep payroll records for at least 3 years after the end of the tax year

Payment to HMRC

The total amount due to HMRC each month includes:

Small employers (quarterly PAYE schemes with average monthly payments under £1,500) can pay quarterly instead of monthly.

Employment Allowance

Eligible employers can claim the Employment Allowance of up to £5,000 per year against their employer NIC liability. This is claimed through the EPS. To qualify, the employer must have had employer NIC liability below £100,000 in the previous tax year.

The allowance is not available to companies where the sole employee is also a director.

Statutory Payments

Employers must administer statutory payments through the payroll, including:

• Statutory Sick Pay (SSP): £116.75 per week (2024/25), paid from the 4th qualifying day of sickness
• Statutory Maternity Pay (SMP): 90% of average weekly earnings for 6 weeks, then £184.03 per week for up to 33 weeks
• Statutory Paternity Pay (SPP): £184.03 per week for up to 2 weeks
• Statutory Shared Parental Pay (ShPP): £184.03 per week

PAYE and Other Tax Obligations

PAYE handles income tax and NICs for employees, but it does not cover all tax obligations. Self-employed individuals pay their tax through self-assessment instead. Employers with employees working through intermediaries must consider IR35 rules.

Companies themselves pay corporation tax on their profits, which is a separate obligation from PAYE.

Penalties

HMRC imposes penalties for PAYE failures:

• Late FPS filing: Penalties range from £100 to £400 per month depending on the number of employees
• Late payment: Penalties start at 1% of the amount unpaid, escalating with repeated lateness to up to 4%
• Inaccurate returns: Penalties based on the behaviour that led to the error, from 0% (careless with unprompted disclosure) to 100% (deliberate and concealed)
• Late P11D or P11D(b): £300 per form, plus £60 per day

Payroll Software

Operating PAYE manually is impractical for most employers. HMRC provides Basic PAYE Tools free of charge for employers with fewer than 10 employees. Larger employers typically use commercial payroll software or outsource payroll to an accountant or payroll bureau.

Compatible software must be able to submit RTI reports directly to HMRC and support Making Tax Digital requirements.