How the Pay As You Earn system works – an employer's perspective
Pay As You Earn (PAYE) is HMRC’s system to collect income tax (which helps pay for services like education and healthcare), and National Insurance (which helps pay for some benefits and the State Pension) from employees.
On this page we tell you more about how PAYE tax and National Insurance deductions work. For most employers, their PAYE deductions will be handled by their payroll software. Even those who are running their payroll manually can access help in the form of PAYE tax and National Insurance calculators.
Nevertheless, if you want to run your own payroll, it will certainly help to have a basic understanding of the PAYE system – so that you can spot errors or so that you can check your employees’ payslips.
‘Pay’ for tax and National Insurance purposes
The PAYE regime requires tax and National Insurance to be deducted from most payments made by employers to employees.
To be able to operate PAYE correctly, you must therefore understand the main things that count as ‘pay’ for tax and National Insurance contributions (NIC) purposes (pay for the purpose of NIC is broadly the same as pay for tax although there are some differences). See our guidance on pay and deductions for more information.
Tax under the PAYE system
Where a person is employed, the employer will deduct income tax from their wages and pay it to HMRC under the PAYE system. A tax code is used by an employer to calculate the amount of tax to deduct from an employee’s pay. A tax code is normally made up of numbers and letters for example 1257L or K396.
Under the PAYE system, an employee’s personal allowance (the amount they are allowed to earn before they pay tax – £12,570 in 2023/24) is allocated evenly throughout the year. HMRC uses a tax code to tell an employer what tax free earnings an employee is entitled to in a particular pay period, so that tax at the appropriate rates may be calculated on the balance. This may be the personal allowance amount of £12,570 or it may be higher or lower, depending on their exact circumstances.
The more a person earns, the higher the amount of income tax they pay. You can see the key rates of income tax and personal allowances on GOV.UK.
PAYE spreads an employee’s income tax bill over the tax year (which starts on 6 April of one year and ends on 5 April in the next) rather than paying tax in one lump sum. It is important to understand that PAYE is not an exact measurement of an employee’s tax liability; rather it is an estimate of the tax that the employee should pay based on HMRC’s understanding of the income that they will receive and their personal circumstances.
How tax codes work
You collect income tax from an employee in accordance with their tax code. We explain about the way tax codes work on our dedicated page.
National Insurance under the PAYE system
If you employ someone, as well as collecting and sending the right amount of tax to HMRC, you will also need to collect and send NIC to HMRC.
NICs are paid to build up entitlement to certain state benefits, including the State Pension.
Contributions are based on a percentage of earnings. Both employees and employers usually make payments. NIC payments made by employees are called primary Class 1 contributions and those made by employers are called secondary Class 1 contributions.
For 2023/24, employees do not pay NIC on pay up to the primary threshold of £242 per week (£1,048 per month). However, between the lower earnings limit (LEL) of £123 per week (£533 per month) and the primary threshold, employees will be treated as if they have paid NIC, which can help protect entitlement to the State Pension and other benefits.
This is one of the reasons why employers are always required to record and report information about employees who earn at least the LEL under the PAYE system, even if no money actually needs to be sent to HMRC – so that HMRC can see that they need to mark NIC as paid on the employee’s record.
For 2023/24, employers are liable to pay NIC on any employee’s pay over £175 per week (£758 per month).
You can see the key rates of employer NIC on GOV.UK. However, because most small employers can get up to £5,000 a year off their National Insurance bill there may not actually be any employer’s NIC to pay. We explain more in our guidance on the Employment Allowance.
It is important to note that unlike tax, which is calculated cumulatively (that is, by looking at what has happened in the tax year so far), National Insurance is calculated by looking at employee’s earnings, whether paid weekly or monthly, in isolation, on each payday.
Jenny lives in England and has two part-time jobs. They both pay her £300 a week. Jenny’s tax-free personal allowance (weekly amount of £242) is allocated against her first job through the payroll in accordance with her PAYE code of 1257L, 20% tax is deducted on every pound from her second job in accordance with code BR. Her weekly tax deductions in 2023/24 are therefore: Job 1: £11.60 (£300 - £242 = £58 x 20%), Job 2: £60.
At the end of the tax year, we can see that Jenny has paid more or less the right amount of tax, taking into account that her tax-free personal allowance for the year is £12,570.
Income from first job
Income from second job
Less personal allowance
Balance subject to 20% tax
The tax collected through the payroll for job 1 is £11.60 x 52 = £603.20
The tax collected through the payroll for job 2 is £60 x 52 = £3,120
Total collected = £3,723.20
For NIC purposes, the fact she is working two jobs is not taken into consideration like it is for tax. Her NIC liabilities for her two jobs are calculated totally independently from each other and are not compared to an overall annual amount, like for tax. So, she will pay £6.96 a week in each of her jobs, a total of £13.92 (each job’s NIC calculated as £300 - £242 = £58 x 12%). (There is an 'annual maximum' of contributions that applies where someone has two or more jobs but this only really affects those on higher incomes.)
National Insurance for those aged under 21 years old and apprentices under 25
Employers with employees under 21 years old do not have to pay Class 1 secondary contributions (that is, the employers’ contribution) in respect of their pay, providing the earnings are less than £50,270 per annum (£967 per week or £4,189 per month).
The employee will continue to pay National Insurance at the usual rates – so this is a benefit only to the employer.
Full details of the scheme can be found on GOV.UK.
There are different National Insurance category letters to support these schemes.
You can claim relief from employer Class 1 National Insurance contributions when you employ someone in a UK Freeport tax site.
As part of the government’s work to ‘level up’ and boost economic activity, they have created a number of Freeports to generate employment opportunities in some of the most deprived communities across the UK.
One of the benefits to employers that operate within a Freeport location is a reduction in the amount of employer NIC payable. There is a new ‘Freeport Upper Secondary Threshold (FUST)’ set at £25,000, below which a zero-rate of employer NIC will be applied. The calculation of employee NIC is unaffected.
Information on GOV.UK gives more details on where these Freeports are located and how to scheme will be operated. Again, there is a different National Insurance category letter to support this.
Employing your spouse or close relative – treatment for National Insurance purposes
It is important that you are aware that there are no special tax rules that apply to employing members of your family. The same tax rules apply to family members as they do to any other employees.
However, for NIC purposes if you employ someone you usually live with in the same ‘dwelling house’ then this will be disregarded and no NIC will be payable. We explain more about this in our employing a family member guidance.
National Insurance Employment Allowance for employers
In 2023/24, you may be able to claim the Employment Allowance of up to £5,000 a year off your National Insurance bill.
Who can claim?
The Employment Allowance is targeted at smaller employers, so your employer's Class 1 NIC liabilities must have been less than £100,000 in the previous tax year.
It includes individuals employing certain care and support workers. However employers of other domestic staff (such as chauffeurs, gardeners, nannies) are excluded from having the allowance. Certain other employers are also not eligible, for example single person limited companies, where the director is also an employee.
Employers whose employees are all either under 21 or apprentices under 25 or veterans, do not need to pay employer’s NIC anyway, so do not need to claim the Employment Allowance.
If an employer is paying all their employees less than £175 per week or £737 per month in 2023/24, they will not be liable for employer's NIC, so do not need to claim the Employment Allowance.
How does it work?
The allowance is given as a credit to reduce the employer’s National Insurance contributions actually payable, up to a maximum of £5,000 over the whole tax year. This means an employer could pay their employee anything up to about £830 per week in total in 2023/24 (around £43,000 per annum) and will have no employers NIC to pay as the liability comes under the £5,000 allowance. (Alternatively, an employer could employ four full-time employees on the NLW without paying employer NICs.)
By comparison an employee paid £850 a week in 2023/24 will generate an employer’s NIC liability of around £5,100. Under the Employment Allowance, the first £5,000 can be deducted, leaving £100 payable for the tax year.
Note that any employer’s NIC above £5,000 will only be paid once the Employment Allowance has been exhausted, so in the example above you would pay over no employer’s NIC for the first 11 ‘payment’ months of the tax year (or first three quarters if you are a quarterly payer) and £100 in total over month 12 (or in the final quarter).
How do employers claim it?
If you file HMRC returns online: the Employment Allowance is usually claimed on an Employer Payment Summary (EPS) which you should submit at the beginning of the tax year, or when you take on your first employee if later (your payroll software might prompt you to do this). You simply tick the box in your payroll software which confirms you are eligible and the Employment Allowance will be applied automatically to reduce your employer's NIC bill.
If you use HMRC’s Basic PAYE Tools (BPT) software, then you will find the box to tick in the Employer details section – select ‘Change employer details’.
You should be aware that you must send in an EPS to tell HMRC that the allowance is being claimed each year. If you simply do things as usual but reduce the amount that you pay to HMRC by the allowance, this will flag as an underpayment on their systems and it is likely you will be contacted by HMRC. Please also note you only need to tick the relevant box once to make HMRC aware you are claiming the Employment Allowance – this will then apply on an ongoing basis throughout the year. You should not untick the box when the Employment Allowance has been fully used.
If you file your HMRC returns on paper: tick the box which asks whether the Employment Allowance is to be claimed on page 2 of the form RT5. You need to remember to subtract the value of the allowance from your employer's NIC liability before you make an actual payment to HMRC.
For more information on claiming the Employment Allowance see booklet RT7 – Guidance for employers exempt from filing Real Time Information online.
Can I claim the £5,000 allowance after the tax year has started?
Yes. If claiming it late means that you will not have used the maximum amount of Employment Allowance allowable, HMRC will offset the balance against another PAYE liability or refund you, so the allowance is not lost.
From April 2023, you pay your employee £275 per week, however you only realise in week 10 that you can claim the Employment Allowance, rather than doing so from week 1. The Employment Allowance will therefore be applied from week 10 – it cannot be backdated to week 1. This means that although you will not pay any Employer’s NIC from week 10 onwards, you will have paid NIC of £15.05 in each of weeks 1 to 9 that strictly you did not need to. At the end of the tax year HMRC will therefore give you a credit for £135.45 (£15.05 x 9) to use against other PAYE liabilities (or will refund you the amount if you have nothing to use it against).
Where can I find more information on the Employment Allowance?
Guidance on the Employment Allowance can be found on GOV.UK.
What else does the PAYE system collect?
The Apprenticeship Levy, which is payable by certain employers from 6 April 2017, is charged at a rate of 0.5% of an employer’s annual pay bill.
A £15,000 annual allowance given to employers means that the levy is only paid by employers whose annual pay bills exceed £3m – so it will not be relevant to small or micro employers.