If you’re an employer or employee in the UK, understanding how PAYE tax is calculated is essential for accurate payroll management. PAYE — short for Pay As You Earn — is the system HMRC uses to collect Income Tax and National Insurance contributions (NICs) directly from an employee’s wages.
In this guide, we’ll break down exactly how PAYE works, how to calculate it step by step, and what you need to consider to stay compliant in 2025.
What Is PAYE?
PAYE (Pay As You Earn) is a UK tax system introduced by HMRC to ensure that employees pay tax and National Insurance throughout the year rather than in one large lump sum. Employers are responsible for deducting these amounts from staff wages and sending them to HMRC each month.
PAYE ensures taxes are collected efficiently and employees stay up to date with their contributions — avoiding unexpected tax bills later.
What You Need Before Calculating PAYE
Before you can calculate PAYE for any employee, you’ll need:
The employee’s tax code – issued by HMRC and shown on their payslip (e.g., 1257L, BR, or K).
Gross pay – total earnings before any deductions.
National Insurance category – usually Category A for most employees.
Pension and other deductions – e.g., student loan repayments or salary sacrifices.
With these details, payroll software or manual calculations can determine how much tax and NICs need to be deducted.
Step-by-Step: How PAYE Tax Is Calculated
Let’s go through the process step by step.
Step 1: Determine Gross Pay
This includes all employee earnings before deductions — such as:
Basic salary or hourly pay
Bonuses and commissions
Overtime pay
Statutory payments (like sick pay or maternity pay)
Step 2: Apply the Tax Code
The tax code tells you how much of the employee’s income is tax-free (their Personal Allowance).
For example, in the 2025/26 tax year, the standard tax code 1257L gives an annual tax-free allowance of £12,570.
That means the employee can earn £12,570 per year (or £1,047.50 per month) before paying any tax.
If the tax code is different — such as BR (Basic Rate) or K codes — it will change how much tax-free allowance (if any) applies.
Step 3: Calculate Taxable Income
Subtract the tax-free allowance from the employee’s total gross income.
For example:
Gross monthly pay: £3,000
Monthly allowance (based on 1257L): £1,047.50
Taxable pay = £3,000 - £1,047.50 = £1,952.50
Step 4: Apply Income Tax Rates
For 2025/26, the UK Income Tax bands remain:
| Band | Annual Income Range | Tax Rate |
|---|---|---|
| Personal Allowance | Up to £12,570 | 0% |
| Basic Rate | £12,571 – £50,270 | 20% |
| Higher Rate | £50,271 – £125,140 | 40% |
| Additional Rate | Above £125,140 | 45% |
So, for our example employee earning £3,000 a month (£36,000/year), all taxable income beyond £12,570 would be taxed at 20%.
Tax due:
£1,952.50 × 20% = £390.50 per month
Step 5: Calculate National Insurance (NI) Contributions
National Insurance is calculated separately from Income Tax.
For 2025/26, Class 1 NI contributions apply:
| Category | Earnings Range | NI Rate (Employees) |
|---|---|---|
| Below £1,048/month | No NI due | 0% |
| £1,048 – £4,189/month | 8% | |
| Above £4,189/month | 2% |
Using our example (£3,000/month):
Earnings above £1,048 = £1,952
NI = 8% × £1,952 = £156.16
Step 6: Deduct Student Loans (if applicable)
If the employee is repaying a Student Loan, the deduction depends on the repayment plan:
Plan 1: 9% of earnings above £22,015
Plan 2: 9% of earnings above £27,295
Plan 4 (Scotland): 9% of earnings above £27,660
Postgraduate Loan: 6% above £21,000
Step 7: Add Other Deductions
Other possible deductions include:
Pension contributions
Salary sacrifice arrangements
Child maintenance
These must be applied before calculating the final net pay.
Step 8: Calculate Net Pay
Finally, subtract all deductions (tax, NI, student loans, etc.) from the gross pay.
Example:
| Item | Amount |
|---|---|
| Gross pay | £3,000.00 |
| Income Tax | £390.50 |
| National Insurance | £156.16 |
| Student Loan | £0.00 |
| Net Pay | £2,453.34 |
So, the employee takes home £2,453.34 after PAYE deductions.
Why PAYE Accuracy Matters
Incorrect PAYE calculations can cause major issues — underpayments lead to HMRC penalties, while overpayments frustrate employees. That’s why many businesses choose to outsource payroll to professionals.
Expert providers of Payroll Services in London ensure all PAYE calculations, deductions, and submissions are handled accurately and on time. This helps companies stay compliant with HMRC while saving valuable administrative time.
Common PAYE Calculation Mistakes
Using the wrong tax code.
Forgetting to update tax codes after a change in employment or benefits.
Miscalculating National Insurance thresholds.
Missing submission deadlines for Full Payment Submissions (FPS).
Failing to apply student loan or pension deductions properly.
Using modern payroll software or working with experienced payroll professionals can help avoid these errors.
Final Thoughts
PAYE might seem complex at first, but once you understand how tax codes, income tax bands, and NI contributions work together, the process becomes much clearer.
Employers must ensure accuracy and compliance with every payslip issued — and with the right support, it’s simple to stay on top of it.
Whether you’re managing payroll for the first time or looking to improve efficiency, expert payroll assistance can make all the difference.
