How to calculate UK payroll taxes: A step-by-step guide for small business owners

Payroll tax can be calculated manually, but thankfully we have software to help make it easier.

Payroll tax is a notoriously confusing area for small business owners, especially those new to managing employees. Getting it wrong can lead to penalties, employee dissatisfaction, and a lot of wasted time.

In this comprehensive guide, we break down the process of calculating payroll tax in the UK, and provide clear explanations and practical advice to help you navigate the complexities of the Pay As You Earn (PAYE) system, National Insurance contributions (NICs), and other deductions.

Here’s what we cover:

What are payroll taxes?

In the UK, payroll taxes typically refer to the amounts you deduct from your employees’ wages and pay on their behalf to HMRC.

This includes income tax under the PAYE system, and National Insurance contributions (NICs). Essentially, these taxes fund things like the NHS, state pensions, and other public services.

PAYE is HMRC’s core system for calculating and collecting income tax and NICs directly from anyone formally employed.

As an employer, when managing payroll you’ll be dealing primarily with these two components. But there might be other deductions too, depending on your employee’s circumstances.

Parallel to the payroll tax deducted from employees, you the employer must also pay certain contributions calculated in proportion to the employees’ wages.

This mainly refers to your own employers’ National Insurance contributions, but in some situations includes the Apprenticeship Levy (which will evolve into the Growth and Skills Levy). More on that later.

If you don’t fully understand how these taxes and the PAYE system work you risk incurring penalties.

But don’t worry as further on in this article, we’ll explain how to keep your business compliant.

Manual payroll tax calculation: Step-by-step process

Deducting payroll tax is part of being a responsible employer, and there’s a thriving market in software to help you do it.

But if yours is a very small business or a start-up, you might not have sufficient budget for purpose-built software.

In that case, you’ll want to know how to calculate payroll tax yourself. It’s fairly simple maths: just a matter of following the right sequence, double-checking your figures, and keeping detailed records.

And HMRC offers various free PAYE calculators, which are ideal for individuals or small employers. The basic sequence is:

• Gather each employee’s pay details
• Work out their gross pay for the period
• Calculate the income tax and National Insurance due
• Check for other contributions that have to be deducted
• Register your employee’s net pay figure, including extras such as commissions
• Notify HMRC.

Now, we’ll go through these points one by one:

1. Gather details

The obvious starting point is the amount you paid your employee. But there are other details that you’ll need on hand:

• Gross pay is the total amount your employee earns before any deductions.
• Employee tax code specifies their personal allowance, the amount they can earn before paying income tax. Each employee’s personal allowance depends on whether they have additional sources of income, or whether they’re married, among other factors.
• Tax band, which means the tax calculation category your employee falls into depending on the total amount of taxable income they earn. It determines the percentage of taxable income that will be withheld as tax.
• Payment date and period covered. This is not always a full month. Some contracts may specify alternatives such as weekly or biweekly.
• Taxable income, such as the portion of gross pay that’s subject to income tax, calculated after deducting the personal allowance.

The final point, taxable income, may be further reduced by other tax-free allowances or expenses that can be excluded.

“Tax-excluded expenses” is a bit of a misnomer because it makes it sound like they’re tax-free at the time of spending.

The tax-free part in fact refers to a waiver on the amount you reimburse to the employee after they claim their expenses. That reimbursement is technically part of their pay, but it’s tax-free.

Expenses that fall within this bracket include:

• Travel expenses, including accommodation, fuel or public transport
• Business equipment, such as laptop or phone
• Working from home costs, such as internet access
• Entertainment, such as a formal dinner for meeting clients.

2. Calculate income tax

Here, you’ll refer to the tax band mentioned above—your highest-earning employees will pay tax at a higher rate than those earning basic pay.

HMRC provides tax calculators and tables that tell you the relevant tax rate for each tax band. Alternatively, you can look up the rates on the HMRC website.

These are the figures for the 2025/26 tax year:

Tax band	Taxable income range	Tax rate
Personal allowance	Up to £12,570	0%
Basic rate	£12,571 to £37,700	20%
Higher rate	£37,701 to £125,140	40%
Additional rate	Above £125,140	45%

So both the allowance and the tax band (in effect, the tax rate) determine how much of an employee’s gross pay will be removed for tax.

Applying a percentage to a single figure is easy enough. But when you do this for lots of employees, it’s easy to slip up.

Keep a record of your calculations, as you’ll need to report these figures to HMRC, and if there’s an anomaly they will be able to spot where it occurred.

3. Calculate National Insurance contributions (NICs)

Both you and your employee pay NICs. But, as with income tax bands, the actual amount deducted varies from person to person.

Your employees’ contributions depend on their earnings and National Insurance category. Again, HMRC’s NIC calculator comes in handy for working out the correct amounts.

For the 2025/26 tax year, there are at least 19 categories of employee NIC calculations, reflecting age, skill level, or whether they served in the armed forces, for example. And then for each category there are different tiers of percentage rates reflecting the amount earned.

Confusingly, HMRC refers to these as thresholds, rather than rates or bands.

You’ll calculate NICs based on each employee’s gross earnings above the primary threshold, which is the limit at which pay-based NIC contributions kick in.

For your own NIC calculation (employers’ NIC), in addition to the earnings-based component, you could incur NIC contributions on perks you give to your employees, such as a company car or phone, on the compensation they receive if they’re made redundant, and even on awards they receive for sporting activities.

4. Deduct other contributions

Besides income tax and NICs, you might need to deduct other contributions from your employees’ pay.

These could include:

• Student loan repayments
• Pension contributions
• Holiday pay
• Payments for maternity/paternity leave.

If an employee is repaying a student loan, the instalments due are usually based on their earnings, so it makes sense that the employer has to take care of that.

Pension contributions can be either automatic (auto-enrolment) or voluntary. In the former case, it’s the employer’s responsibility to ensure that payments are made.

In the latter, the employer is under no obligation, but may decide to take care of it since the channels are already in place. They may even decide to match the employee’s voluntary payments.  

An extreme case of an additional deduction is when an employee has defaulted on some debt—such as council tax or child maintenance—and a court rules that payments should come directly out of their pay. This is known as an “attachment of earnings” order.

5. Calculate net pay

Net pay is what your employee takes home after all deductions. It’s what’s left after you’ve subtracted income tax, NICs, and any other contributions from their gross pay.

However, it should also include any overtime, bonuses, commission, and statutory payments on top of the agreed regular wages or salary.

This is the amount you pay into each employee’s bank account.

It’s a legal requirement that the payslips you provide clearly show all deductions. This not only helps employees understand their earnings, but is good practice all round, promoting transparency.

6. Notify HMRC and issue payslip

The PAYE system requires that you report these figures to HMRC on or before the day you pay your employees.

HMRC’s standard document for this is the Full Payment Submission (FPS), which you can submit online or through payroll software. This is a legal requirement, detailing the payments and deductions made.

The law also requires that you provide each employee with a payslip that clearly shows their gross pay, all deductions (income tax, NICs, student loan repayments, pension contributions, and so one), and their net pay.

This helps employees understand how their pay is calculated.

How much is employer tax?

As an employer, you have your own tax obligations. You’ll pay employers’ National Insurance contributions, which are based on your employees’ combined earnings, above a certain threshold.

For the 2025/26 tax year, employers pay NICs at a rate of 15% on employee earnings above £5,000 per year (£96 per week). This is calculated based on gross earnings, before the employees’ NICs are deducted.

The level that employers start paying NICs (the secondary threshold) is £5,000 per year.

You may claim up to £10,500 Employment Allowance.

Note that not all employers are eligible—for example, sole directors of limited companies are usually not eligible.

Also, the calculations for employers’ NICs will vary based on factors such as your employees’ age and employment status. You can find the latest rates and thresholds on the HMRC website.

If your annual payroll bill exceeds £3 million, you’ll also have to pay the Apprenticeship Levy/Growth and Skills Levy, which is charged at 0.5% of your monthly pay bill. The government then puts this money towards apprenticeship training schemes across the UK.

Common payroll tax calculation mistakes

Even with careful attention, mistakes can happen if you manage your payroll documentation manually.

Common errors include:

• Using outdated tax codes or rates: regulations, official guidelines and HMRC methodology are subject to change, so it’s easy to fall behind on the latest updates. You can stay on top of the correct tax codes and rates by subscribing to HMRC email alerts or regularly checking its website for updates. If you use payroll software, make sure it’s up to date.
• Incorrect calculation of NICs: in the above sections, we glossed over the true complexity of the different NIC categories and thresholds—that’s a separate article in itself. It can be a minefield of potential errors due to misinterpreting the rules or using incorrect thresholds. Double-check your calculations against HMRC’s NIC tables, use online calculators, or seek professional advice if you’re unsure about the correct categories and rates.
• Overlooking other deductions: while employees should keep you informed about their circumstances, it’s ultimately your responsibility to ensure you have accurate and up-to-date information. So it’s also down to you to be aware of other deductions such as student loan repayments or pension contributions. Don’t just focus on the main deductions like income tax and NICs. Implement a system for regularly collecting and updating employee data, such as an employee self-service portal or periodic reviews, based on a checklist of all possible deductions. Those details can later be plugged in to payroll software for rapid calculation of the right deduction types.

If you do find a mistake, correct it immediately and inform HMRC so you avoid penalties or employee disputes.

Penalties and fine print to be aware of include:

• Late filing: £100 or more per month, depending on the size of your payroll.
• Late payment: starting at £100 per late submission, but can vary depending on the specific circumstances and the lateness of the payment. They also carry interest, typically at 2.5% above the Bank of England base rate.
• Compliance checks: HMRC can inspect your records and impose further penalties for underpayment or non-compliance.

Tools to simplify payroll tax calculation

Thankfully, there are many tools available to simplify payroll tax calculations. Payroll software can automate calculations, generate payslips, and submit reports to HMRC.

These tools, together with HMRC’s online calculators and resources, can save you time and reduce the risk of errors.

Consider using a cloud-based payroll system for easy access and updates.

If you’re new to payroll, don’t hesitate to seek professional advice. An accountant or payroll specialist can provide valuable support and ensure you’re compliant.

Accurate and fast payroll tax calculation is key

A good understanding of the different components of payroll tax ensures that your employees are paid correctly and that your business remains compliant with HMRC regulations.

Whether you choose to calculate payroll manually or use HMRC-compatible payroll tax software, there’s no escaping the need to stay informed and organised, because accuracy is the key to avoiding unexpected costs.

Don’t be afraid to outsource this task to people in the know or simplify the process by investing in the best tools available.

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