Step by Step Guide to Setting Up Payroll

Paying someone for the first time can feel like a big step. Whether you are taking on a labourer, an office assistant, a driver or a family member to help the business, you become responsible for more than making a bank transfer. This step by step guide to setting up payroll explains the practical UK process, so you can pay people correctly, report to HMRC on time and avoid preventable penalties.

Payroll is not just relevant to growing limited companies. A sole trader may need a payroll if they employ staff, while a company director will often use payroll to take a salary alongside dividends. The right approach depends on how your business is set up, who you are paying and how regularly they work for you.

Step by step guide to setting up payroll in the UK

1. Confirm that the worker is an employee

Start with employment status. Someone is not automatically self-employed because they send you an invoice or work in the construction industry. If you control when, where and how they work, provide their equipment, or they work personally for your business on an ongoing basis, they may be an employee for tax purposes.

This matters because employees normally need to be paid through PAYE. Contractors can be different, particularly where the Construction Industry Scheme applies. A subcontractor paid under CIS is not usually put through standard payroll, but the position needs checking carefully. Getting status wrong can lead to unpaid tax, National Insurance and interest later.

Agree the pay arrangement in writing before the first payday. Set out the rate of pay, hours, overtime, holiday entitlement, pay frequency and whether any deductions may apply. Payroll works best when the information going into it is clear from day one.

2. Register as an employer with HMRC

You must register for PAYE with HMRC before your first payday. Do not leave this until the employee has already started or been paid. Once registered, HMRC provides a PAYE reference and an Accounts Office reference. Keep both secure, as you will need them for payroll submissions and tax payments.

Registration can take time, so allow a margin before the first payment date. If you are a company director paying yourself for the first time, the same principle applies. Even a small or irregular salary can create payroll reporting obligations.

You should also decide who will manage the process. Some business owners run payroll themselves using recognised software. Others choose an accountant because the cost of getting a regular task wrong can quickly outweigh the apparent saving. For a small team with stable pay, software may be manageable. For variable hours, CIS workers, statutory pay or several different deductions, professional support can remove a lot of pressure.

3. Choose payroll software that reports through RTI

UK employers must report payroll information to HMRC through Real Time Information, usually called RTI. Your software needs to calculate deductions and send the right submission to HMRC.

Choose a system that suits the way you work rather than one with features you will never use. At a minimum, it should produce payslips, calculate PAYE tax and National Insurance, deal with pensions where needed, retain records, and submit a Full Payment Submission. Check that it can also deal with student loan deductions, statutory sick pay and maternity, paternity or adoption pay if these could apply to your staff.

Set a regular payroll timetable. A monthly payroll is common for office staff and directors, while weekly pay may suit trades and labour-only workers. The key is consistency: collect timesheets, approve overtime and finalise pay early enough to meet the reporting deadline.

4. Collect the right employee information

Before adding a new starter to payroll, obtain their full name, address, date of birth, National Insurance number, start date and bank details. You also need their tax code and details of any student or postgraduate loan.

The best source of tax information is the employee's P45 from their previous job. If they do not have one, they should complete HMRC's new starter declaration. This tells you whether to use the appropriate starter tax code while HMRC confirms their correct code.

Check spellings, dates and National Insurance numbers carefully. Small input errors can cause rejected submissions, incorrect tax codes or confusion when an employee tries to access their PAYE information. For directors, do not assume their details are already correct simply because they appear at Companies House. Payroll records and company records are separate.

5. Set up workplace pension duties

Most employers must assess staff for automatic enrolment into a workplace pension. This is often missed by businesses taking on their first worker because it is separate from HMRC registration.

You need to choose a qualifying pension scheme and assess each worker based on age and earnings. Eligible employees must normally be enrolled and receive employer contributions. Other workers may have a right to join or opt in, and you must communicate the position in writing. Employees can opt out after enrolment, but the choice must be theirs.

A postponement period can sometimes be used for new starters or fluctuating staff, but it is not a way to avoid pension duties. Your payroll system should calculate pension contributions correctly, including tax relief arrangements where relevant. You must also complete a declaration of compliance with The Pensions Regulator within the required timeframe, generally five months after your duties start.

6. Run the payroll and issue payslips

Each pay period, enter the gross pay due. That may include basic wages, overtime, commission, bonuses, holiday pay or statutory payments. The payroll software then calculates the deductions, which can include income tax, employee National Insurance, pension contributions, student loan repayments and authorised deductions such as attachment of earnings orders.

You will also see the employer's National Insurance liability and employer pension contribution. These are real business costs, so budget for them rather than focusing only on the employee's agreed gross wage. If you are employing someone on a tight-margin contract, calculate the full employment cost before agreeing the rate.

Give each employee an itemised payslip on or before payday. It should show gross pay, deductions and net pay, plus the number of hours where their pay varies by time worked. Then pay the net amount into their bank account on the agreed date.

7. Send the right information to HMRC

The Full Payment Submission, or FPS, tells HMRC what you have paid and deducted. It must normally be sent on or before the date employees are paid. This is not a month-end task to catch up when you have time.

If no one is paid in a tax month, you may need to send an Employer Payment Summary, known as an EPS, rather than simply doing nothing. An EPS is also used for certain adjustments and statutory payment recovery claims. Your software or payroll adviser can help identify when it is required.

HMRC will issue tax code notices when an employee's circumstances change. Apply them promptly. Continuing to use an old code may mean an employee pays too much or too little tax, which then needs sorting out later.

8. Pay HMRC and keep clear records

PAYE tax and National Insurance deductions must reach HMRC by the 22nd of the following tax month if paying electronically. If you pay by post, the deadline is the 19th. For very small employers, quarterly payment arrangements may be available, but only if HMRC agrees.

Keep payroll records for at least three years from the end of the tax year they relate to. This includes pay, deductions, reports, employee details, pension records and evidence supporting statutory payments. Good records make it far easier to answer an HMRC query, resolve an employee question or prepare accounts.

A separate payroll bank account is not compulsory, but it can help cash flow. Ring-fencing the PAYE, National Insurance and pension money reduces the risk of spending funds that are already committed.

9. Finish the tax year properly

At the end of the tax year, complete your final payroll submission on time and give each employee a P60 by 31 May. The P60 shows their total pay and deductions for the year. Employees often need it for mortgages, benefit claims and tax queries, so do not treat it as an afterthought.

If you provide taxable benefits, such as private medical insurance or a company vehicle, further reporting may be needed. Some benefits can be payrolled during the year, while others may require a P11D after year end. This is an area where early advice is worthwhile, especially for directors using company vehicles or receiving benefits through their company.

Common payroll mistakes worth avoiding

The most common errors are simple: registering late, treating employees as subcontractors without checking, missing the FPS deadline, using the wrong tax code, overlooking pension duties and forgetting that employer National Insurance affects the true cost of staff.

Another frequent issue is paying a director randomly from the company bank account without deciding whether the payment is salary, dividends, repayment of expenses or a director's loan. Each route has different paperwork and tax implications. A clean, planned approach is safer than trying to reclassify payments at the year end.

If payroll is becoming a distraction from jobs, customers and cash flow, call Short and Sons Accountants for a free no obligation quote if you have further questions on any topics covered in this article. A well-run payroll should give you confidence that your people are paid properly and your HMRC responsibilities are under control.

Resource material

• HM Revenue & Customs, Running payroll: Overview.

• HM Revenue & Customs, PAYE: Getting started as an employer.

• The Pensions Regulator, Automatic enrolment duties for employers.

• GOV.UK, Paying HMRC: PAYE and National Insurance.