How Does PAYE Work? The PAYE System for Employers

When you onboard a new employee, one of the first things to get right is PAYE. Correctly applying tax codes, National Insurance, and deductions sets the tone for accurate payroll, builds employee trust, and prevents unnecessary questions later. 

PAYE (Pay As You Earn) is the system HMRC uses to collect tax and National Insurance from employees. It’s a crucial element of payroll, but with changing regulations and reporting requirements, mistakes can quickly lead to compliance issues. This guide explains how PAYE works, why getting PAYE right matters for employers, and how to manage it confidently.

PAYE stands for Pay As You Earn. It’s the system that HMRC uses to collect Income tax and National Insurance directly from employee wages. As the employer, you are responsible for operating PAYE through payroll, ensuring that every deduction is correctly made and submitted to HMRC on time.

Employers run PAYE on behalf of HMRC to ensure taxes are collected directly from employee wages accurately each month. This removes the burden from employees to pay lump sums at the end of the year. This system keeps tax collection accurate, timely, and straightforward for both the government and businesses. 

For HR and finance teams, knowing how PAYE works is essential. It ensures compliance with legal requirements, maintains accuracy in payroll, and provides transparency for employees. Mistakes in PAYE can lead to incorrect payments and fines from HMRC. 

PAYE is more of an employer compliance system, rather than just a set of deductions. It’s a compliance framework that determines what you must calculate, report and pay to HMRC every month. Each payslip you issue carries legal responsibilities. Every change in an employee's earnings or benefits can influence how PAYE is applied.

HMRC assigns every employee a tax code based on their individual circumstances, including personal allowance, benefits, multiple jobs, or any unpaid tax from previous years. Each code acts as a set of instructions for payroll, indicating how much Income Tax should be deducted from an employee’s wages. 

These codes directly impact tax calculations because they determine how much of an employee’s earnings are tax-free and their ‘qualifying earnings' to be deducted from. For example, a standard code like 1257L allows an employee to earn £12,570 per year, before paying tax, whereas tax codes like BR (Basic Rate) or NT (No Tax) apply different rules based on the circumstances. Applying the correct code ensures accurate take-home pay and compliance with HMRC requirements. 

Our guide, ‘UK Tax Codes Explained: A HR’s Guide’, provides more information on each tax code and how to apply the correct tax code to your employees' payroll. Tax codes can change frequently, making it essential to always submit the most up-to-date code in payroll. Incorrect codes can result in wrong deductions, ongoing issues and frustrated employees. 

Running PAYE means more than just processing salaries; it’s about making sure every deduction is correct, on time, and fully compliant. As an employer, you are responsible for collecting Income Tax and employee National Insurance contributions from every paycheck. If your employees have student loans, those repayments also need to be deducted automatically once they hit the repayment threshold.  

Workplace pensions are another key component. If an employee is enrolled, their contributions must be calculated and deducted each pay period to comply with auto-enrolment rules. In addition to these core deductions, as an employee, you may need to process other legally required payments, such as an Attachment of Earnings Orders or voluntary charitable contributions made through payroll giving. 

Accurate management of these deductions is crucial for payroll compliance, employee trust, and avoiding penalties from HMRC. For more detailed guidance, HR and payroll teams can refer to our recent blogs, including National Insurance Explained and Employer’s Guide to Workplace Pension Contributions, which provide step-by-step instructions for handling these deductions correctly.

Your PAYE responsibilities don’t end once the deductions have been calculated. As an employer, you’re also required to calculate and pay employer National Insurance contributions, ensuring these amounts are correct and submitted to HMRC by the correct deadlines. These costs form a key part of your payroll budget, so accuracy is essential to avoid errors at a later date. 

Issuing clear, accurate payslips is another legal requirement. Every payslip must show earnings, deductions, National Insurance and pension contributions, giving employees full visibility over how their pay has been calculated. As an employer, you must maintain these records to meet HMRC auditing and compliance standards. Keeping accurate records is essential, not only for regulations but also for quickly resolving any future HMRC compliance checks with confidence.

PAYE thresholds directly affect how much Income Tax and National Insurance an employee pays, and this can vary significantly depending on their earnings. For the 2025/26 tax year, the standard Personal Allowance is £12,570, meaning employees can earn up to this amount before Income Tax is deducted. 

For example, if an employee earns £12,000 per year, their income sits entirely below the Personal Allowance, so no Income Tax is deducted. However, National Insurance (NI) may still be deducted if their earnings exceed the NI threshold, resulting in small deductions through payroll. 

If an employee earns £30,000 per year, only the portion above the personal allowance is taxed. In this case, £30,000 - £12,570 = £17,430 is subject to Income Tax at the basic rate, with National Insurance also deducted on earnings above the NI threshold. PAYE spreads these deductions evenly across the year, keeping take-home pay consistent. 

For a higher earner, on £60,000, PAYE calculations become more complex, and Income Tax is applied across multiple bands. Qualifying earnings above £12,570 are taxed, so £47,430 falls into the higher rate band. National Insurance contributions also change once the upper National Insurance threshold is reached, reducing the National Insurance earnings above that level. Accurate payroll calculations ensure the correct tax and National Insurance are deducted at each stage. 

Full Payment Submission (FPS)

Every time you pay an employee, you must send a FPS (Full Payment Submission) to HMRC on or before payday. This report includes employees' earnings, deductions, tax code and National Insurance information. It is important to note that late submissions of this document may lead to penalties. 

Employer Payment Summary (EPS) 

An Employer Payment Summary (ESP) is submitted to HMRC when you need to report payroll information that isn’t included in a Full Payment Submission. This includes reclaiming statutory payments such as Statutory Maternity, Paternity or Sick Pay, reporting Employment Allowance, or telling HMRC that no employees were paid during a specific tax period. Submitting an ESP on time ensures your PAYE account is accurate and prevents incorrect tax demands from HMRC. 

Paying HMRC 

When it comes to paying HMRC, as an employer, you must ensure that all deductions collected through PAYE are submitted on time. This includes Income Tax, both employee and employer National Insurance contributions, and any student loan repayments. Payments are typically made monthly, but some smaller employers may be eligible to pay quarterly. 

Meeting HMRC reporting deadlines is crucial; late or missed payments can result in penalties and interest charges. Staying organised and scheduling payments in line with HMRC requirements helps keep your payroll compliant and your business running smoothly. 

PAYE is a crucial component of every payroll run. Accurate calculations are essential to reduce the risk of errors, incorrect payments, HMRC penalties and employee dissatisfaction. 

To remain compliant, employers must ensure tax codes are applied accurately, calculations are correct, and all RTI submissions are submitted by the deadline. Payments to HMRC must also be made by the required deadlines, and audit-ready records should be maintained to support transparency and reduce risk. 

The common PAYE challenges for employers often come from the day-to-day challenges that come with running payroll. Unexpected tax code updates, irregular pay patterns, or employees leaving or starting the company can all impact PAYE accuracy. Statutory payments, benefits and one-off adjustments often introduce further complications, especially when payroll is managed manually or across multiple systems. These challenges often increase the risk of errors, making it harder for HR and finance teams to maintain consistency and compliance.

At Payroll Solution Services, our specialists focus on making payroll simple and straightforward. Our expertise enables us to create tailored solutions for your business, protecting you from risks and reducing the hassle associated with PAYE. 

We manage everything from tax code updates and deductions to RTI submissions, employer NIC calculations and HMRC payments, for large enterprises, small-to-medium enterprises, and CIS. 

We also handle all starter and leaver processes, keeping you compliant with changing regulations, and providing transparent reporting through the payroll portal. With our support, your HR and finance teams can focus on strategic work - while we handle the details and compliance regulations. 

Let our payroll specialists take the complexity out of PAYE so you can focus on growing your organisation.

Strong PAYE processes drive accurate payroll, foster employee trust, and ensure compliance with HMRC. With the right expertise from Payroll Solutions, it doesn’t have to be complicated. 

At Payroll Solutions Services, we bring clarity, consistency and full compliance to your payroll processes, so your team can focus on your business, while we handle the numbers. 

Contact us today, to see how we can simplify your PAYE and keep your payroll accurate and fully compliant every single month. 

How is PAYE different from self-assessment?

The main difference is that PAYE is a system where tax is calculated and deducted automatically from an employee’s pay by their employers. Whereas self-assessment requires individuals to declare their income themselves directly to HMRC, normally, they have more complex income, such as self-employment or additional investments. 

What happens if PAYE is calculated incorrectly?

When PAYE is calculated incorrectly, employees can end up paying too much or too little tax and National Insurance, prompting HMRC to step in and correct the balance. For employers, these errors can lead to compliance checks, penalty charges, interest on unpaid amounts and potential enquiries by HMRC. 

Do all employees need to be on PAYE?

If your business has employees or directors who earn above £96 per week for the 2025/26 tax year, you’ll need to set up PAYE. This applies even if you only employ one person. 

How often do tax codes change?

UK tax codes are usually updated at the beginning of each tax year to align with changes to Personal Allowance limits and tax bands set by the government. However, they can also be adjusted on an individual basis during the year, if an employee’s financial or personal circumstances change.