How to Set Up Payroll for Your Small Business

TL;DR Summary

1. Introduction: Why Payroll Matters for Your Small Business

Setting up and running payroll can seem daunting for small business owners in the UK, but it's a fundamental aspect of employing staff. Beyond simply paying your employees, payroll involves a complex web of legal obligations, tax deductions, and reporting requirements to HM Revenue & Customs (HMRC). Getting it right ensures your business remains compliant, avoids penalties, and keeps your employees happy and motivated. This comprehensive guide will walk you through every essential step to confidently set up and manage payroll for your small business in the UK.

2. Registering as an Employer with HMRC

Before you can pay employees, you must register your business as an employer with HMRC. You need to do this when you start employing staff or using subcontractors for whom you need to operate PAYE. The registration process typically takes a few days, and you'll receive a PAYE reference and an Accounts Office reference, which are crucial for all future payroll communications and payments.

3. Choosing the Right Payroll Software

Operating payroll manually is prone to errors and time-consuming. HMRC-recognised payroll software automates calculations, manages deductions, and facilitates Real Time Information (RTI) submissions, making your life significantly easier. When choosing software, consider your business size, budget, and specific needs.

Pros and Cons of Payroll Software

4. Setting Up Employee Records

Accurate employee records are the backbone of efficient payroll. For each new employee, you'll need to collect specific information to ensure correct tax and National Insurance deductions.

Key Information Required:

1. Personal Details: Full name, address, date of birth, gender, and National Insurance number.
2. Starter Checklist or P45: If the employee has a P45 from a previous job, they should provide it. Otherwise, they'll need to complete a Starter Checklist to determine their tax code.
3. Bank Details: Account name, sort code, and account number for salary payments.
4. Employment Details: Start date, job title, salary/wage, and working hours.
5. Pension Information: If applicable, details for auto-enrolment.

5. Understanding UK Tax Codes (2026/27)

A tax code tells you how much tax-free income an employee gets in a tax year. The most common tax code is 1257L, which indicates that an employee receives the standard Personal Allowance of £12,570. The 'L' means they are entitled to the standard tax-free Personal Allowance. Other letters and numbers can signify different circumstances, such as multiple jobs or specific benefits.

Emergency Tax Codes

When an employee starts a new job and doesn't provide a P45, they might be put on an emergency tax code. These codes (e.g., 1257L W1, 1257L M1, 1257L X) are temporary and ensure some tax is deducted until HMRC can issue the correct code. W1 (Week 1) and M1 (Month 1) mean tax is calculated on a non-cumulative basis for that pay period only, while X means tax is calculated on a non-cumulative basis for the entire tax year.

Income Tax Rates and Thresholds (2026/27)

Below are the income tax rates and thresholds for the 2026/27 tax year, which runs from 6 April 2025 to 5 April 2026 [1].

6. National Insurance (NI) Categories and Contributions (2026/27)

National Insurance Contributions (NICs) are paid by employees, employers, and the self-employed to qualify for certain state benefits, such as the State Pension. Employees are assigned a National Insurance category letter based on their employment type and age. The most common category is 'A' for most employees.

Class 1 National Insurance Thresholds (2026/27)

These thresholds determine when NICs start and stop being paid [1].

Employee (Primary) Contribution Rates (2026/27)

These are the rates deducted from an employee's pay [1].

Employer (Secondary) Contribution Rates (2026/27)

These are the rates employers pay on their employees' earnings [1].

7. Pension Auto-Enrolment Setup (2026/27)

As an employer in the UK, you have a legal duty to provide a workplace pension for eligible staff and automatically enrol them into it. This is known as 'automatic enrolment'. Both you and your employees will contribute to the pension scheme.

Eligibility Criteria

Employees must be automatically enrolled if they [2]:

• Are aged between 22 and State Pension age.
• Earn over the earnings trigger of £10,000 a year.
• Work in the UK.

Minimum Contribution Rates

For the 2026/27 tax year, the total minimum contribution to a workplace pension is 8% of an employee's 'qualifying earnings'. At least 3% of this must come from the employer, with the remaining 5% from the employee (which includes tax relief) [2]. Qualifying earnings are generally earnings between the Lower Earnings Limit (LEL) and the Upper Earnings Limit (UEL).

Auto-Enrolment Earnings Thresholds (2026/27)

These thresholds define qualifying earnings for auto-enrolment [2].

8. Running Your First Payroll

Once everything is set up, running payroll involves calculating each employee's gross pay, deducting PAYE tax, National Insurance, pension contributions, and any other deductions (e.g., student loan repayments) to arrive at their net pay. Your chosen payroll software will automate most of these calculations.

Steps to Run Payroll:

1. Calculate Gross Pay: This is the employee's total earnings before any deductions.
2. Apply PAYE Tax: Based on the employee's tax code and income tax thresholds.
3. Calculate National Insurance: Based on the employee's NI category and earnings.
4. Deduct Pension Contributions: For auto-enrolled employees, deduct their share of pension contributions.
5. Other Deductions: Apply any other deductions, such as student loan repayments or attachments of earnings.
6. Calculate Net Pay: Gross pay minus all deductions.
7. Generate Payslips: Provide each employee with a payslip detailing their pay and deductions.
8. Submit RTI to HMRC: Send a Full Payment Submission (FPS) to HMRC on or before payday.

9. Real Time Information (RTI) Submissions

Real Time Information (RTI) is how employers report PAYE information to HMRC online, each time they pay their employees. This ensures HMRC has up-to-date information on tax and National Insurance deductions. The main types of RTI submissions are:

• Full Payment Submission (FPS): Sent on or before each payday, detailing payments and deductions for each employee.
• Employer Payment Summary (EPS): Used to report other payments to HMRC, such as claiming Employment Allowance or if no employees were paid in a period.

10. PAYE Payment Schedule

You must pay the PAYE tax and National Insurance you owe to HMRC monthly or quarterly, depending on your average monthly payment. Most small businesses pay quarterly if their average monthly payment is less than £1,500. You can pay HMRC in several ways, including online, by Bacs, or through your online bank account.

Payment Deadlines:

• Monthly: By the 22nd of the next tax month (19th if paying by post).
• Quarterly: By the 22nd after the end of the quarter (19th if paying by post).

11. Payslip Requirements

By law, every employee must receive a payslip on or before payday. Payslips must include specific information to be legally compliant. Your payroll software will automatically generate compliant payslips.

What a Payslip Must Show:

• Employee's gross pay.
• Any fixed deductions (e.g., trade union subscriptions).
• Any variable deductions (e.g., tax, National Insurance, student loan).
• The net amount of pay.
• The amount and method of payment (if paid in different ways).
• The number of hours worked (if pay varies by time worked).

12. Year-End Process: P60s and Final Declarations

At the end of each tax year (5 April), you have specific duties to complete the payroll year-end process.

Key Year-End Tasks:

1. Issue P60s: Provide a P60 to every employee working for you on 5 April. This summarises their total pay and deductions for the tax year.
2. Final FPS/EPS: Ensure all final payroll submissions (FPS and EPS) for the tax year are sent to HMRC by 19 April.
3. Reconciliation: Reconcile your payroll records with HMRC's records to ensure everything matches.

Conclusion

Setting up and managing payroll for your small business in the UK requires careful attention to detail and adherence to HMRC regulations. By understanding the key steps - from registration and software selection to tax, NI, and pension auto-enrolment - you can ensure your payroll is accurate, compliant, and efficient. Leveraging HMRC-recognised payroll software can significantly ease the burden, allowing you to focus on growing your business with confidence.

References

• [1] GOV.UK. (2026, March 1). Rates and thresholds for employers 2025 to 2026. Retrieved from https://www.gov.uk/guidance/rates-and-thresholds-for-employers-2025-to-2026
• [2] MoneyHelper. (n.d.). How pension auto-enrolment works. Retrieved from https://www.moneyhelper.org.uk/en/pensions-and-retirement/pensions-basics/automatic-enrolment-an-introduction