PAYE explained: a plain English guide for employers
PAYE — Pay As You Earn — is the mechanism through which employers collect income tax and National Insurance contributions from employees' wages and pay them to HMRC. It was introduced in 1944 and has been the primary method of income tax collection in the UK ever since. For anyone running payroll for the first time, understanding how PAYE works is the essential foundation.
The principle is simple: employees do not receive their full salary and then pay their own tax at the end of the year. Instead, the employer deducts the correct amount of tax and NI each time wages are paid, and pays those deductions to HMRC — typically on the 22nd of each month (or 19th if paying by post). The employee receives their net pay. The employer accounts for the deductions.
How does the employer know how much to deduct? This is where tax codes come in. HMRC assigns each employee a tax code that tells the employer how much of the employee's income is tax-free (their personal allowance) and at what rate the remainder should be taxed. The most common tax code is 1257L, which reflects the standard personal allowance of £12,570. See our detailed guide on tax codes explained for what each letter suffix means and how to handle emergency or non-standard codes.
National Insurance is calculated separately from income tax. For employees, NI is currently charged at 8% on earnings between the Primary Threshold (£12,570 annualised) and the Upper Earnings Limit (£50,270), and 2% above that. For employers, Class 1 NI is charged at 15% on earnings above the Secondary Threshold (£5,000 from April 2025). Employers must calculate and pay both the employee and employer NI contributions to HMRC. See our guide on National Insurance categories for the different letter categories and when each applies.
PAYE operates in real time via the RTI (Real Time Information) system. Every time you pay an employee, you must send a Full Payment Submission (FPS) to HMRC on or before the payment date. The FPS contains the employee's gross pay, deductions for tax and NI, and any student loan repayments. Submitting late is a compliance failure that HMRC can penalise. See RTI submissions: FPS and EPS explained for the full detail on what each submission contains and when to send it.
Here is the basic payroll calculation sequence for each employee each pay period:
1. Start with gross pay (salary or hours × rate)
2. Apply pension deductions (employee contribution, usually pre-tax under salary sacrifice)
3. Apply any student loan repayments
4. Calculate taxable income using the tax code
5. Apply the correct income tax rate bands
6. Calculate employee NI contributions
7. Net pay = gross pay minus income tax minus employee NI minus pension minus student loan
8. Calculate employer NI contributions (separate — does not reduce net pay)
9. Submit FPS to HMRC on or before payday
10. Pay net pay to employee via BACS
11. Pay HMRC the collected tax + employee NI + employer NI by the 22nd of the following month
For businesses doing payroll for the first time, the most common errors are: using the wrong tax code, failing to register for PAYE before the first pay run, submitting the FPS late, and confusing employee NI with employer NI. See our guide on payroll errors: how to correct them before HMRC notices for what to do when things go wrong.
If your business also uses Accounted for bookkeeping, payroll journal entries can be exported directly from Mellow to your accounting records, keeping PAYE liabilities reconciled month by month. See Accounted for how the integration works.
Mellow runs PAYE calculations automatically, submits FPS to HMRC in real time, and keeps a full payroll history for every employee. [Start a free trial →](https://mellowhr.com/register)