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, which is set for each tax year
- 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:
- Calculate the employee’s gross pay (salary, overtime, bonuses, commission)
- Apply the tax code to determine tax-free pay for the period
- Calculate income tax on the taxable portion using the relevant rates
- Calculate employee National Insurance contributions
- Calculate employer National Insurance contributions
- Make any other deductions (student loan, pension, attachment of earnings)
- 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 the standard personal allowance divided by 10 followed by L. The number in a tax code is multiplied by 10 to give the annual tax-free amount, so the standard code changes whenever the personal allowance changes.
Common code suffixes:
| Suffix | Meaning |
|---|---|
| L | Standard personal allowance |
| M | Marriage Allowance recipient |
| N | Marriage Allowance transferor |
| T | HMRC needs to review items |
| 0T | No personal allowance |
| BR | All income taxed at basic rate (20%) |
| D0 | All income taxed at higher rate (40%) |
| D1 | All income taxed at additional rate (45%) |
| NT | No tax deducted |
| K | Deductions exceed allowances (tax code adds to taxable pay) |
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:
| Component | Description |
|---|---|
| Employee income tax | Deducted from employee pay |
| Employee NICs | Deducted from employee pay |
| Employer NICs | Paid by the employer on top of salary |
| Student loan deductions | Deducted from employee pay |
| Apprenticeship Levy | For employers with pay bills over £3 million |
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, a fixed annual amount set by the government, against their employer NIC liability. This is claimed through the EPS. Since April 2025, there is no longer a requirement for the previous year’s employer NICs to be below £100,000.
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): since April 2026, the lower of the weekly flat rate and 80% of average weekly earnings, paid from the first qualifying day of sickness
- Statutory Maternity Pay (SMP): 90% of average weekly earnings for 6 weeks, then the weekly flat rate (or 90% of earnings if lower) for up to 33 weeks
- Statutory Paternity Pay (SPP): the weekly flat rate (or 90% of earnings if lower) for up to 2 weeks
- Statutory Shared Parental Pay (ShPP): the weekly flat rate (or 90% of earnings if lower)
The flat rates are uprated each April and published in HMRC’s employer rates and thresholds.
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.