How is payroll calculated? Everything you need to know

The crux of the payroll function is to pay employee’s wages accurately. Payroll is calculated by working out the individual gross pay for each employee. Tax, National Insurance (NI), and other deductions are subtracted from gross pay at agreed rates, using tax codes issued by HMRC, to show the net pay employees receive.

Payroll calculations also involve calculating employers’ PAYE, and other tax deductions employers must pay to HMRC under the Pay As You Earn (PAYE) scheme.

Below, you will learn how to calculate payroll for employees and employers, how to register and set up payroll, which payroll software options to consider, and what your obligations to HMRC are as an employer under the PAYE scheme.

What needs to be calculated for payroll?

The process of payroll involves calculating an employee’s pay. As well as wages, this includes the bonuses, allowances, and benefits that each individual employee qualifies for.

The other side of the transaction involves calculating deductions. Most employees pay income tax and NI, which is collected by employers and paid to HMRC.

There are other deductions that can apply, most notably pension contributions under auto-enrolment, but also student loan repayments, child support maintenance payments, and more.

An employer must keep accurate and detailed records of pay, tax, and NI rates for all employees to report to HMRC. Payroll numbers can help this administrative process.

How to register as an employer

When a company hires its first employee, they must register as an employer with HMRC if that, or any, employee earns above the existing threshold of £123 per week – even if you’re a startup owner only employing yourself. You must do this no longer than two months in advance of, or four weeks after, hiring your first employee.

You will receive a PAYE reference number and a reference with HMRC’s accounts office to file monthly PAYE records and payments. PAYE payments must be made to HMRC by the 22nd of the next month after a payday. If a payment is late, HMRC may charge a penalty and interest.

Each new employee must be registered with HMRC. Use the employee’s P45 to decide which tax code to use to operate PAYE. If you don’t have a P45, HMRC’s new employee online tool can help.

How to set up payroll

After registering as an employer with HMRC and getting a login to operate PAYE online, to pay an employee for the first time, a company – or a payroll service provider, if you’re outsourcing your payroll processes – should use payroll software to record each employee’s details, calculate pay and tax, and report the details to HMRC.

HMRC needs to know all details and changes for all employees so they can work out how much the business collectively owes.

The main tasks required once a payroll system is set up are to:

• Collect and keep accurate employee records
• Inform HMRC when employees join and leave or change address
• Record pay
• Deduct tax, NI and other applicable deductions
• Report the details to HMRC through a full payment submission (FPS) on or before each payday
• Pay the tax and NI to HMRC

Companies must also keep records so they can complete annual reports and tax returns each tax year.

Employers must collect detailed information about their employees’ previous employment and circumstances to apply the right tax code to pay them correctly and make the right deductions.

Information required includes salary details, NI number, a P45 from their last job, and changes in employee status such as promotions, becoming a director, and when they reach state pension age.

How to calculate pay and deductions

Even when using payroll software, payroll teams should understand how to pay employees and how payroll is calculated, and be able to perform manual payroll calculations. Most accountancy qualifications cover this.

Follow these steps to calculate an employee’s pay and deductions:

1. Collect all relevant employee data – Find out an employee’s gross pay: their total salary before deductions. Find out how many hours they worked and ensure you have their tax code and NI number.
2. Calculate taxable pay – Subtract tax-free allowances from gross pay. For example, if gross pay is £3,500 per month and the employee’s tax code is 1257L, deduct £1,047.50. This gives you £2,452.50 in taxable pay.
3. Calculate the tax and NI due on this amount.

Current income tax for annual earnings between £12,570 to £50,270 is 20%, so 20% of our example £2,452.50 = £490.50 income tax.

The current Class 1A NI rate for employees is charged at 13.8% for earnings between £125 per week and £533 per week. For an employee earning £3,500 per month or £807 per week, Class 1A NI is charged on the full amount between the thresholds, so £533 minus £125 = £408 per week. 13.8% of this = £56.31 NI per week.

In addition to tax and NI deductions, payroll calculations are performed for any other deductions, such as pension contributions or student loan repayments. The relevant deductions are subtracted from gross pay and calculated using the applicable rates and thresholds to determine an employee’s net pay.

The employee’s payslip should provide full details of the tax code used, gross pay, deductions, and net pay.

Read more: If you have employees based overseas, shadow payroll can help you stay compliant with local tax and pay regulations.

Calculating auto-enrolment and other regular deductions

Under auto-enrolment, most employers must offer a workplace pension that they and their employees contribute to. The minimum total amount is 8% of an employee’s salary. This forms an important part of payroll calculations for most companies.

The amount paid by both parties depends on the type of scheme and whether the employee has been automatically enrolled or opted into one, which would usually be a private pension.

An employee’s contribution usually benefits from tax relief of 20%.

An example of the calculation is:

An employee earns £500 per week and opts to pay 4%. The employer pays the minimum amount of 3%, and an additional 1% comes from tax relief on the employee’s contribution. So:

4% of £500 = £20, + 3% of £500 = £15, + 1% of £500 = £5, which totals £40 altogether.

These calculations are part of the payroll calculations that need to be made, but the actual money is paid over to the pension provider.

Other regular deductions under PAYE include:

• The Cycle to Work scheme
• Apprenticeship Levy
• Child maintenance payments
• Benefit debt deductions
• Underpaid tax payments
• Other salary sacrifice schemes

Can payroll software perform payroll calculations?

The best payroll software can automate payroll calculations, including when the national living wage applies, working out employees’ pay and tax and employers’ tax, and generating payslips. It reduces errors and ensures a company’s payroll complies with tax rules.

Without payroll software, payroll calculations can be done on a spreadsheet. Payroll operators can enter, sort, and manipulate payroll data using Excel or Google Sheets, but other options may provide more functionality and be easier to integrate with external systems such as HMRC.

Payroll software can streamline the payroll process and maintain up-to-date employee information. The best software can be customised to create bespoke employee reports and generate salary and tax data for management accounts.

Consider the specific needs of your business, and research different options before deciding which payroll software system to use. Ensure that it is HMRC compliant, and can accurately record employee details, calculate pay and tax, create payslips, and deduct pension contributions.

Reporting deductions to HMRC

Employers must complete an employer payment summary (EPS) that outlines any deductions the company may qualify for that could reduce the total full payment submission (FPS) liable to HMRC for each pay period.

Potential deductions to report through an EPS include:

• Reclaiming statutory maternity, paternity, adoption, parental bereavement, or shared parental payments
• NI contributions holiday for previous tax years
• The Apprenticeship Levy if your company’s annual wage bill is above £3 million a year
• The employment allowance

If a company has not paid any employees during a tax month period, they send an EPS to HMRC instead of an FPS. HMRC can fine you if you need to send an EPS but fail to.

Conclusion

Calculating payroll is a vital employer obligation. It is important because employees need to be paid accurately and on time to cover their outgoings, HMRC requires payment of tax and NI from employees, and the employer’s obligations under the PAYE scheme need to be covered.

Employers must register with HMRC when they employ their first staff member, even if this is the business owner. They register and receive a PAYE reference to use when paying HMRC.

Payroll software is used to perform the calculations and deductions, and record and update employee details.

For more help, see HMRC’s guide to payroll.