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What is PAYE (Pay As You Earn)?

PAYE is the system employers use to deduct Income Tax and National Insurance from employee wages before paying them.

Current Rate (2025/26)

Deductions based on employee's tax code

Example

Your employee earns £3,000/month. PAYE calculates and deducts ~£400 tax and £150 NI before paying them £2,450.

Key Dates

PAYE payments due to HMRC by 22nd of following month (or 19th if paying by post)

How PAYE (Pay As You Earn) Works in Practice

PAYE is the system through which employers collect Income Tax and National Insurance on behalf of HMRC, deducting them directly from employees' wages before payment. As a company director paying yourself a salary or employing staff, you are legally responsible for operating PAYE correctly. Getting it wrong can result in penalties and interest charges from HMRC.

When you hire your first employee (including paying yourself a salary as a director), you must register as an employer with HMRC. This gives you a PAYE reference number. You are then required to run payroll on or before each payday, calculate deductions using each employee's tax code, and report these figures to HMRC in real time through a Full Payment Submission (FPS).

The amount of Income Tax deducted depends on the employee's tax code, which HMRC issues. The most common code is 1257L, meaning the employee gets £12,570 of tax-free income per year. The payroll system divides this across pay periods (usually monthly) and applies the correct tax rate to earnings above the allowance. National Insurance contributions are calculated separately based on earnings thresholds.

Real Time Information (RTI) means you must report payroll information to HMRC on or before each payday, not at the end of the month or year. This is a significant compliance obligation. If you pay employees on the 28th of each month, your FPS must reach HMRC by that date. Late FPS submissions can trigger penalties.

Step by Step

Each pay period, you process payroll by entering each employee's gross pay into your payroll software. The software calculates Income Tax based on their tax code using HMRC's cumulative tax tables. It also calculates employee National Insurance and employer National Insurance separately.

You deduct the employee's tax and NI from their gross pay to arrive at net pay, which is what hits their bank account. The employer's NI is an additional cost to the company on top of the salary. You then submit a Full Payment Submission (FPS) to HMRC reporting all deductions. At the end of each month, you send an Employer Payment Summary (EPS) if you need to report any reductions (like Employment Allowance or statutory payment recoveries).

The total PAYE liability (employee tax + employee NI + employer NI) must be paid to HMRC by the 22nd of the following month if you pay electronically, or by the 19th if you pay by post. Small employers paying less than £1,500 per month can pay quarterly instead.

Practical Tips

  • Set up payroll software before your first payment and run a test submission to ensure everything is configured correctly with HMRC
  • Process payroll on a fixed date each month and never miss an FPS submission deadline to avoid automatic penalties
  • Claim the Employment Allowance at the start of each tax year through your payroll software to reduce your employer NI bill
  • Keep payroll records for at least 3 years as HMRC can request them during a compliance check

Common Mistakes to Avoid

  • Not registering as an employer before the first salary payment, which means PAYE deductions are not being reported and paid to HMRC
  • Submitting the Full Payment Submission late (after payday), which triggers automatic penalties under the RTI regime
  • Forgetting that director salary payments still need PAYE processing even if the salary is below the tax threshold, as NI may still apply
  • Not claiming the Employment Allowance which could save up to £10,500 per year on employer's National Insurance

Frequently Asked Questions

Do I need to run PAYE if I only pay myself a small salary?

Yes. Even if your salary is below the tax and NI thresholds, you should register as an employer and run payroll. This ensures your salary is properly recorded, protects your State Pension entitlement, and keeps you compliant with RTI reporting requirements.

When are PAYE payments due to HMRC?

PAYE payments are due by the 22nd of the month following the pay period if you pay electronically, or by the 19th if paying by post. For example, April payroll deductions must be paid by 22 May. Small employers can pay quarterly if they owe less than £1,500 per month.

What is the PAYE penalty for late filing?

HMRC charges a fixed penalty for each month you fail to submit your FPS on time. The amount depends on the number of employees: £100 for 1-9 employees, £200 for 10-49, £300 for 50-249, and £400 for 250 or more. These penalties can accumulate over multiple months.

Can I run payroll myself or do I need an accountant?

You can run payroll yourself using HMRC's free Basic PAYE Tools for up to 9 employees, or commercial payroll software. Many directors of small companies handle their own payroll, especially if they are the only employee. An accountant or payroll bureau is worth considering once you have multiple employees.

What is the most tax-efficient salary for a director in 2025/26?

Many accountants recommend a salary at the NI Secondary Threshold (£5,000 for 2025/26) to avoid employer NI, or at the Primary Threshold (£12,570) to build full State Pension entitlement without paying employee NI. The optimal level depends on your overall tax position and whether you claim Employment Allowance.

Source: HMRC PAYE Manual - PAYE10000: Introduction to PAYE

Related Terms

National Insurance

National Insurance (NI) is a tax on earnings that funds state benefits like the State Pension and NHS. Both employees and employers pay it.

Tax Code

Your tax code tells your employer how much tax-free income you can have before they start deducting tax from your pay.

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