Pay calculation sounds like it should be simple. Your employer agrees a salary, you show up and do the work, and a number lands in your bank account. But between gross pay and net pay sits a surprisingly complicated set of deductions — income tax, National Insurance, student loan repayments, pension contributions — each with its own thresholds, rates, and rules.

We find this comes up constantly with owner-managed business clients, whether they are setting up their first payroll, taking a salary for the first time as a director, or trying to understand why a new employee’s take-home looks different from what was discussed at interview. The confusion is understandable. PAYE operates as a real-time system, thresholds shift each tax year, and small errors compound quickly.

What follows is our take on how pay calculation actually works in 2026-27, why the numbers look the way they do, and where the common pitfalls tend to appear for small employers in particular.

Every pay calculation starts in the same place: gross pay. That is the agreed salary or wage before anything is taken off. From there, three main deductions apply for most employees in England and Northern Ireland.

Income tax via PAYE. For 2026-27, employees can earn up to £12,570 tax-free — that is the standard personal allowance. Above that, the basic rate of 20% applies on earnings up to £37,700. From £37,701 to £125,140 the higher rate kicks in at 40%, and above £125,140 the additional rate is 45%. Most employees never touch the higher or additional bands, but it matters to flag them for anyone receiving a meaningful salary increase or bonus.

Employee National Insurance (Class 1). Employees pay National Insurance on earnings above the primary threshold, which stands at £242 per week (approximately £12,570 annually) for 2026-27. Below £129 per week — the lower earnings limit — no NI is paid and none accrues toward state pension entitlement either, which is worth knowing for part-time or low-hour workers.

Other deductions. Student loan repayments, auto-enrolment pension contributions, and any salary sacrifice arrangements all come off before the employee sees their net figure. None of these are optional once the relevant thresholds are triggered — they operate automatically through payroll software.

Net pay, then, is simply what remains after all of these deductions are applied correctly. Get any one element wrong and the figure shifts.

A common source of confusion — particularly among business owners setting up payroll for the first time — is that pay calculation is not just about what the employee receives. There is a second set of numbers the employer carries that never appear on a payslip.

Employers must register for PAYE and begin making deductions as soon as an employee is paid £96 or more per week (the secondary threshold for 2026-27), receives taxable benefits, or is enrolled in a pension scheme. Once registered, the employer is also liable for employer’s National Insurance contributions — a percentage of the employee’s earnings above that same secondary threshold — which represents an additional cost on top of gross salary.

This distinction matters enormously when a business is budgeting for its first hire. The cost of employing someone is not simply their quoted salary. It includes employer NI, any employer pension contribution, and the administrative overhead of running compliant payroll. We always encourage owner-managers to model the full employment cost before making a hiring decision, not just the gross pay figure.

There is also the question of employer’s obligations after payday. Full Payment Submissions must reach HMRC on or before each pay date — not retrospectively. Small employers expecting to pay less than £1,500 per month to HMRC can apply to pay quarterly rather than monthly, which helps with cash flow, but the RTI submission still runs in real time regardless.

In our experience, payroll errors fall into a handful of recurring categories — and most of them are avoidable with the right setup from the start.

Wrong tax codes

An employee starting a new job without a P45 may be placed on an emergency tax code, which can mean over- or under-deducting income tax from day one. The employee notices. It creates friction. Checking that the correct tax code is in place before the first payrun is a basic step that gets missed more often than it should.

Missing RTI deadlines

HMRC requires a Full Payment Submission on or before each payday. Late submissions attract penalties, and repeated lateness flags the employer for closer scrutiny. Payroll software handles this automatically — but only if someone actually runs the submission on time.

Incorrect rates for the tax year

The thresholds that govern income tax and National Insurance are reviewed annually. Using last year’s figures — even by accident — produces wrong deductions across every payrun until someone spots it. Payroll software from a reputable provider updates automatically, but manual processes do not.

Poor record-keeping

Employers are required to retain payroll records for at least three years from the end of the relevant tax year. Gaps in records make HMRC investigations significantly harder to defend and can result in penalties that bear no relation to the original error. Keeping clean, complete records is not glamorous work, but it protects the business.

For owner-managed limited companies, pay calculation carries an extra layer of complexity — and opportunity. Most directors do not take a straightforward salary in the same way an employed worker does. Instead, a common approach is a small salary pitched at or just above the National Insurance lower earnings limit, combined with dividends drawn from the company’s post-tax profits.

The reasoning is tax efficiency. By keeping the salary below the point at which income tax starts but at or above the threshold that preserves state pension entitlement (the lower earnings limit of £129 per week for 2026-27), a director can receive a wage without triggering income tax or significant NI, then take the bulk of their income as dividends, which are taxed at lower rates than employment income.

This approach is entirely legitimate and widely used, but it requires careful pay calculation to implement correctly. Setting the salary at the wrong level — even slightly — can result in unnecessary tax or a missed year of state pension contributions. It also interacts with other variables: whether the company has other employees, whether the Employment Allowance applies, and what the company’s corporation tax position looks like.

We tend to review director salary levels at the start of each tax year when thresholds reset. It is a short exercise that frequently produces a meaningful saving, and it is one of the areas where having an accountant who does payroll and tax planning together pays for itself relatively quickly.