How to Calculate Payroll

You must pay your employees correctly. This means making the appropriate National Insurance and tax deductions, as well as including any overtime pay. But, to do so, you must have your own payroll that runs efficiently.

If you don’t, it can have serious repercussions for your business. For example, you could face fines from HMRC, or risk breaching your employment contracts. As a result, an employee might raise a breach of contract claim against you at an employment tribunal.

And you may be wondering whether your employees can discuss their salary with others - well find out with our expert guide.

In this guide, we'll discuss the payroll process, payroll software, and how to work out employee wages.

What is payroll?

Payroll is the process of a business paying employees over a set period and on a specific date. It can also refer to the list of staff being paid by a company.

Payroll functions include:

• Tracking hours worked by employees, including overtime hours.
• Calculating pre-tax deductions. For example, unpaid sick leave.
• Establishing post-tax deductions, for instance, salary advances.
• Determining what employee benefits they're entitled to, for instance, any bonuses.

Based on this, you can begin calculating wages. But, you must ensure it's compliant with payroll legislation to avoid action from HMRC. For example, you could receive a late payment penalty if you don’t pay tax contributions on time.

What is a payroll number?

A payroll number is what businesses assign to employees when they join their company. It's a key part of the payroll service, as all information relevant to each employee will be linked to their payroll number. This might include their:

• Name and contact details.
• Title.
• Working hours.
• Salary and benefits.
• National Insurance number.

Payroll numbers help businesses track employee payments, as well as calculate non-voluntary and voluntary deductions, to ensure staff are paid correctly.

Remember, if you pay employees monthly, there will be 12 pay periods each year. But, you can decide to pay staff weekly, fortnightly, or every four weeks.

What are the mandatory deductions of an employee's income?

There are several deductions that can be taken from an employee's total gross pay. Ensure you're aware of them so you know how to calculate each employee's gross pay correctly.

Deductions include:

Payroll tax

You must ensure you deduct payroll taxes (also known as PAYE) from each of your employee's net pay. It’s your legal duty to deduct these, if you don’t, the HMRC can hold you liable for your negligence. For example, they could investigate you for tax evasion.

PAYE is the system by which an employer reports and pays tax and National Insurance contributions on behalf of their staff to HMRC. You will need to operate PAYE if:

• You pay any of your employees over £123 per week.
• Pay a major expense or expenses.
• Offer benefits.
• You pay pension contributions.
• Employ someone with a second job.

Remember, your staff's wages may differ from one pay period to another based on deductions.

Child maintenance

Child maintenance is another mandatory deduction you have to take from an employee's pay if they’re eligible. The Child Maintenance Service may ask you to:

• Provide information about an employee.
• Deduct child maintenance from their earnings.
• Send payments to the Child Maintenance Service.

The amount you must take will be stated on the Deduction From Earnings order, which will be sent to you by the service. But, you must ensure that your employee still has 60% of their net pay remaining after deductions - this is known as their protected earnings.

Student loan deductions

You must also take student loan deductions from the pay of staff it applies to. For example, if your:

• Employees’ P45 shows that deductions should continue.
• Employees tell you they're repaying a student loan or postgraduate loan.

This is also the case if HMRC sends you a form SL1 or PGL1, and your staff member earns over the income threshold for their loan.

If you need to stop making these deductions, the HMRC will inform you by sending forms SL2 or PLG2. You must not stop deductions just because an employee asks you to.

Do all employees have to be on payroll?

Yes, all of your employees must be on your payroll, such as part-time and full-time staff. This also includes casual workers, for instance, agency staff and those on zero-hour contracts.

If you fail to pay staff correctly, your company could face serious consequences. For example, if an employee is not paid correctly in terms of monetary value, they could make a claim for unlawful deductions from wages at an employment tribunal.

HMRC may also hold the employer liable for any Tax and NI deductions not made. And possibly tax evasion - if they believe the failure to put staff on PAYE was deliberate.

Can you run payroll without an accountant?

Yes, you can run payroll without a payroll accountant, or accounting department. Small business owners might opt to handle payroll themselves, as they might not have the resources to hire an accountant.

But, some companies prefer to include an accounting department in their business structure. Or outsource their payroll to another company, as it saves them time and ensures they get it right.

How does payroll work?

Payroll works differently for each company. But there is general guidance you can follow to form your company payroll. The steps you should take to ensure each employee receives the correct pay include:

Use payroll software

Firstly, if you can, your business should use payroll and accounting software. This can automate a number of things, including:

• Staff's annual salary and benefits. Such as, if they are receiving private healthcare.
• Employee hours. For example, if they work at an hourly rate you'll need to track these to ensure you provide the right hourly pay.
• Employee attendance. For example, if an employee is on holiday, you should ensure your payroll system keeps a record of this.

It will also track when employees take a leave of absence, such as sick leave. So you can calculate their sick pay, if this is in their contract. Payroll software helps save time and reduces the chances of mistakes occurring. So, if you're able, you should use it.

New starter processing

When pay check processing, you must ensure you consider your new starters. This means using a new starter checklist and checking what deductions you need to make. This will establish a number of their details which will be relevant to your payroll processing.

For example, it will include items like:

• What bank accounts they want you to pay their salary into.
• Whether they are repaying their student loan.
• Whether they have another job.
• If they receive any payments from the government, or a workplace or private pension.
• Whether they've received any taxable benefits.

Calculate employee earnings

Next, you need to calculate your employee's earnings. For hourly employees, you can calculate this by multiplying the hours worked by their hourly wage. Salaried employees tend to have the same gross and net pay each month.

But this isn't the case if they've taken unpaid leave, have begun paying into their pension, or have worked overtime. If they are entitled to any other benefits, such as bonuses or commission, ensure they are included too.

Pre and post-tax contributions

As well as including any benefits staff receive, you need to ensure you calculate their income taxes, National Insurance and any other deductions. The income tax threshold is:

• 20% for those earning £12,571 to £50,270.
• 40% for earners of £50,270 to £125,140.
• 45% for those earning over £125,140.

National Insurance is 12% of weekly earnings which are between £242 and £967, and 2% of weekly earnings for those earning over £967 per week.

Payslips

Under the Employment Rights Act 1996, companies must give all their staff (including workers) payslips from their very first day of employment. This must be given on or before the day employees get paid. It should show:

• Staff earnings before and after deductions.
• The amount of deductions that may change when they're paid.

A payslip should be received no later than the date the payment is made.  From April 2019, the legislation for payslips was amended to dictate that the payslip should also reflect the hours and pay rate for variably paid workers, or those paid hourly.

Workplace pensions

In 2008, the government introduced legislation (The Pensions (Extension of Automatic Enrolment) (No.2) Act 2023) that effectively dictates that employers must offer a workplace pension to their employees.

Known as automatic enrolment, an employer must enroll eligible employees into a qualifying pension scheme. To be eligible, they must:

• Work in the UK.
• Earn more than £10,000 a year (tax year 2016-17).
• Not already be in a suitable workplace pension scheme.
• Be at least 22 years old, but under State Pension age.

Report to HMRC

Each time an employee is paid, a report must be sent to HMRC to inform them of the payment on or before the date of payment. This is called Real Time Information (RTI) and the report is referred to as a Full Payment Submission (FPS).

You must send the FPS on or before your employees’ payday, even if you pay HMRC quarterly instead of monthly. Your FPS should include a wide variety of information relating to:

• Your place of employment.
• The employee.
• Pay.
• Deductions.
• National Insurance information.

What happens if National Minimum Wage is not paid?

If National Minimum Wage is not paid – and the employee qualifies – it could have serious consequences for your business.

If you make an underpayment of £500 or more, the government will put you on their ‘name and shame’ list. And, if there’s evidence to suggest that the employer deliberately paid below minimum wage, it might lead to criminal prosecution.

As a result, you could end up paying an unlimited fine. For example, you might be asked to pay £20,000 per employee you have paid incorrectly.

Get expert advice on payroll from Peninsula

Failure to pay employees properly can have serious consequences. For example, depending on the situation, if you don't pay their yearly salary correctly, your employee could raise a breach of contract claim against you to an employment tribunal.

Consequently, your business could face legal costs, paying compensation, and even reputational damage.

Peninsula offers expert advice on payroll services and other accounting tasks. Our teams provide 24/7 HR advice which is available 365 days a year. We take care of everything when you work with our HR experts.

Want to find out more? Contact us on 0800 028 2420 and book a free consultation with an HR consultant today.