UK PAYE Guide 2026: How to Set Up and Run Payroll for Small Business

Before PAYE (pre-1944)

• Employees received full gross salary
• Responsible for paying income tax annually via self-assessment
• Most employees spent entire salary, couldn’t pay year-end tax bill
• Tax collection rate: below 70%

PAYE System (1944–present)

• Employer deducts income tax and NIC before paying employee
• Employer remits deducted amounts to HMRC monthly
• Employee receives net salary (after deductions)
• Tax collected throughout year — not in lump sum at year-end
• Collection rate: above 95%

Triggers for PAYE Registration

• Employing anyone — including company directors taking salary
• Paying any employee £123/week (£533/month, £6,396/year) or more
• Employing someone who has another job or receives a pension
• Providing expenses or benefits in kind to employees

Even if paying below thresholds: register anyway to avoid confusion. HMRC expects all employers to be registered.

What HMRC Issues After Registration

• Employer PAYE reference — 13 digits, format 123/AB45678. Use on all HMRC correspondence.
• Accounts Office reference — 13 digits, format 123PA45678901. Use when paying HMRC.
• PAYE Online login — access HMRC portal to check tax code updates, submissions, payments

📤 FPS — Full Payment Submission

Submitted: On or before every payday — no exceptions.

Contains per employee: gross pay this period, tax deducted, employee NIC, employer NIC, student loan deductions, pension contributions, year-to-date totals.

📨 EPS — Employer Payment Summary

Submitted: By 19th of the month following payment — only when needed.

Submit EPS when:

• Claiming SMP, SPP, SAP, or SSP recovery from HMRC
• Claiming Employment Allowance (up to £5,000/year off employer NIC)
• No employees paid in a month (nil EPS — tells HMRC no FPS expected)

What 1257L Means

• 1257 = £12,570 personal allowance (tax-free)
• L = Entitled to standard personal allowance
• First £12,570 of annual earnings: 0% tax
• £12,571–£50,270: 20% (basic rate)
• £50,271–£125,140: 40% (higher rate)
• Above £125,140: 45% (additional rate)

Tax Calculation Example (£30,000/yr)

Employee NIC (Deducted from Salary)

Example — £30K/yr employee: £2,500/month. Below £1,048 = £0. £1,048–£2,500 = £1,452 × 12% = £174.24/month employee NIC.

Employer NIC (Employer Pays — Not Deducted from Salary)

Example — £30K/yr employee: £2,500/month. Below £758 = £0. £758–£2,500 = £1,742 × 13.8% = £240.40/month employer NIC.

What to Pay and When

Deadline: 22nd of the month following payday (electronic payment). 19th if paying by cheque — but electronic is always recommended.

What to include in payment:

• Employee income tax deducted
• Employee NIC deducted
• Employer NIC
• Less: Statutory payment recovery (from EPS)
• Less: Employment Allowance (from EPS)

Payment Calculation Example (£30K employee, Employment Allowance)

Employment Allowance covers £5,000/year of employer NIC — most valuable for businesses with 2–10 employees. Claim via EPS. See Xero Payroll which calculates and claims this automatically.

P60 — Annual Employee Summary

Deadline: 31 May following tax year-end

Required for every employee still employed on 5 April (tax year-end). Shows: gross pay for tax year, total income tax deducted, total employee NIC, employer PAYE reference.

How to provide: PDF via email (acceptable), or paper if employee requests. Xero Payroll, Sage, and BrightPay generate P60s automatically.

Penalty for missing deadline: £300 + £60/day if delay continues.

P11D — Benefits in Kind

Deadline: 6 July following tax year-end (HMRC + employee copy)

What counts as benefits in kind: Company car, private medical insurance, gym membership (employer-provided), employee loans over £10,000 at below-HMRC rate, employer-provided living accommodation, vouchers.

Class 1A NIC: Employer pays 13.8% on total benefits value — due 22 July.

Penalty for missing: £300 + £60/day. Most missed: company car reporting (must report every year, same car).

Phase 1: HMRC Registration (Week 1)

• ☐ Go to gov.uk/register-employer
• ☐ Provide company + first employee details
• ☐ Wait 5–10 days for PAYE reference (call 0300 200 3200 if urgent)
• ☐ Receive: Employer PAYE reference + Accounts Office reference
• ☐ Download HMRC Basic PAYE Tools OR sign up for Xero Payroll

Phase 2: Employee Setup (Week 2)

• ☐ Collect: Full name, address, DOB, NI number
• ☐ Collect: P45 from previous employer (or Starter Checklist if no P45)
• ☐ Collect: Bank details (sort code, account number)
• ☐ Enter into payroll system: salary, pay frequency, start date
• ☐ Enter tax code (from P45, or 1257L if no P45), NIC category (usually A)

Phase 3: First Payroll Run (Week 3–4)

• ☐ Calculate gross pay, income tax, employee NIC, employer NIC
• ☐ Calculate net pay (gross − tax − employee NIC)
• ☐ Generate payslips (gross, deductions, net, year-to-date totals)
• ☐ Submit FPS to HMRC — on or before payday
• ☐ Transfer net pay to employees via Faster Payment or BACS

Phase 4: Monthly HMRC Payment (Following Month)

• ☐ By 22nd of following month — electronic payment
• ☐ Amount: Employee tax + employee NIC + employer NIC
• ☐ Less: EPS recovery (SMP, SPP etc.) + Employment Allowance
• ☐ Reference: Accounts Office Reference (13-digit number)
• ☐ Recommended: Set up HMRC direct debit to never miss deadline

Phase 5: Ongoing Monthly Routine

• ☐ Every payday: Calculate pay, generate payslips, submit FPS, pay employees
• ☐ 22nd following month: Pay HMRC (tax + NIC)
• ☐ If statutory payments: Submit EPS by 19th, claim recovery
• ☐ Monthly: Check HMRC PAYE Online for tax code updates — apply immediately

Phase 6: Year-End (April–July)

• ☐ By 31 May: Generate and send P60 to all employees
• ☐ By 6 July: Submit P11Ds to HMRC + provide copies to employees (if benefits in kind)
• ☐ By 22 July: Pay Class 1A NIC on benefits value (13.8%)
• ☐ 6 April: New tax year begins — confirm new rates/thresholds apply

❌ Mistake 1: Paying Employee Before PAYE Registration

Employee receives gross salary (no deductions). HMRC discovers via employee self-assessment or data sharing. Result: £100/month late registration penalty + all back-tax and NIC owed with interest.

✅ Fix: Register gov.uk/register-employer at least 2–4 weeks before first payday. Never pay gross salary to an employee.

❌ Mistake 2: Missing FPS Submission Deadline

Automatic £100/month penalty even if HMRC payment is made on time. Penalty letter arrives 2–3 months later — many employers assume FPS was submitted correctly. Applies every month of non-compliance.

✅ Fix: Use payroll software that auto-submits FPS (Xero Payroll does this on payroll finalisation). Set calendar reminder: “FPS due on or before payday.”

❌ Mistake 3: Using Wrong Tax Code

Employee pays wrong tax amount (too much or too little). At year-end HMRC issues correction. Employer must recalculate, back-pay or recover from employee. Complex, time-consuming, relationship-damaging.

✅ Fix: Always use P45 code. If no P45, use Starter Checklist. Check HMRC PAYE Online monthly for code changes.

❌ Mistake 4: Missing Statutory Payments (SMP, SSP)

Employee on sick or maternity leave not paid statutory amounts. Employee complains or makes HMRC complaint. Employer must back-pay statutory amounts plus potential penalty. Small employers also miss the 103% recovery opportunity.

✅ Fix: See UK Statutory Leave Guide 2026. Use Xero Payroll which calculates SSP and SMP automatically.

❌ Mistake 5: Forgetting P11D for Company Cars / Medical Insurance

Company car must be reported every year (even same car). Private medical insurance must be reported even if only £500 value. Class 1A NIC of 13.8% due on total benefits value by 22 July.

✅ Fix: Set 6 July reminder. P11D penalty: £300 + £60/day. Many employers use an accountant or payroll bureau for P11D to avoid errors.

❌ Mistake 6: Not Claiming Employment Allowance

Small employers miss up to £5,000/year reduction in employer NIC — just because they don’t know to claim it or forget to submit EPS. This is money left on the table every year.

✅ Fix: Submit EPS claiming Employment Allowance at start of each tax year. Xero Payroll claims this automatically. Eligible if employer NIC <£100,000/year.

Q: Can I pay myself as director without PAYE?

No. If you take any PAYE salary (not dividends only), you must register and operate PAYE even as sole director. Many directors take £12,570/year salary (personal allowance — no income tax) plus dividends for tax efficiency. Still must register, submit RTI each payday, and pay any employer NIC. See IR35 Guide 2026 for director/contractor structures.

Q: What if employee has two jobs?

Second job uses different tax code — usually BR (20% on all earnings, no personal allowance already used at main job). HMRC issues the code. Do NOT apply standard 1257L — this would give the employee personal allowance twice, meaning they’d underpay significant tax and face a correction bill at year-end.

Q: Do I need PAYE for contractors?

No — PAYE applies to employees only. Contractors invoice you and handle their own tax via Self Assessment. However, IR35 rules may apply: if a contractor is a “disguised employee,” medium/large companies must assess their status. If inside IR35, you operate PAYE on their payments. See IR35 Guide 2026.

Q: Can I use Xero accounting without Xero Payroll?

Yes. Xero Payroll is a £6/employee/month add-on. You can use Xero for accounting and a separate payroll system (HMRC Basic PAYE Tools, Sage, BrightPay), then manually enter payroll journals in Xero. But auto-integration is far better — Xero Payroll syncs payroll costs into your accounts automatically. See How to Set Up Xero 2026.

Q: What if I forget to pay HMRC on time?

Interest charged daily (HMRC base rate + 2.5%, currently ~7%/year). After 30 days: 1% penalty on amount. Persistent non-payment: HMRC can seize assets (distraint), prosecute directors personally, or wind up the company. Best prevention: set up HMRC direct debit — auto-collects on 22nd each month.

Q: How do I handle an employee leaving mid-month?

Pay final salary pro-rata (15 days of 30-day month = 50% monthly salary). Submit FPS marking employee as “leaver” with leaving date. Generate P45 — Xero and most payroll software do this automatically. Provide P45 to employee within 24 hours of leaving. Employee needs P45 to give next employer correct tax code.

Register First

gov.uk/register-employer before first payday. 5–10 day processing. Paying gross salary first = £100+/month penalties and back-tax.

FPS Every Payday

On or before payday — not after. Xero Payroll submits automatically. Manual tools require you to click Submit. Calendar reminder essential.

HMRC by 22nd

Tax + NIC by 22nd of following month. Set up direct debit. Employment Allowance (£5,000/yr) claimed via EPS — don’t miss it.