The moment you hire your first employee, payroll becomes one of the most recurring and consequential accounting tasks in your business. Yet many SME owners treat it as an administrative chore rather than a core part of their financial management — and that disconnect leads to errors that can cost real money, damage supplier and HMRC relationships, and distort your understanding of what it actually costs to employ someone. This guide covers how payroll accounting works: what happens between gross pay and net pay, how wages appear in your books, what you owe on top of salaries, and the journal entries that tie it all together.
Gross Pay, Deductions and Net Pay: The Payslip Explained
Every payslip starts with gross pay — the total amount an employee earns before any deductions. This is the figure agreed in the employment contract and the number your business is obligated to honour.
From gross pay, two main categories of deduction are made before the employee receives anything:
Employee deductions are amounts withheld from the employee’s gross pay and remitted to HMRC or a pension provider on the employee’s behalf. These include:
- Income Tax (PAYE) — collected under the Pay As You Earn system and calculated based on the employee’s tax code and earnings in the period.
- Employee National Insurance Contributions (NICs) — a percentage of earnings above the primary threshold, currently charged at set rates (check the HMRC website for current rates, as these change each tax year).
- Employee pension contributions — under auto-enrolment rules, eligible employees contribute a minimum percentage of qualifying earnings to a workplace pension.
After all deductions, the employee receives net pay — the actual amount deposited into their bank account.
Key insight: Net pay is not your cost — it is what your employee receives. Your actual cost as an employer is higher than gross pay, because you also pay employer National Insurance contributions and employer pension contributions on top. Understanding the difference between what you pay the employee and what you pay in total is essential for accurate budgeting and financial reporting.
The True Cost of an Employee: What You Pay Beyond the Salary
The employer’s total payroll cost has two components beyond the gross salary itself:
Employer National Insurance Contributions are charged on earnings above the secondary threshold at a set percentage. Unlike employee NICs, employer NICs are an additional cost to your business — the employee does not see them on their payslip. They appear in your profit and loss account as part of staff costs.
Employer pension contributions — under auto-enrolment, employers must contribute a minimum percentage of qualifying earnings to the employee’s workplace pension. Again, this is a cost on top of gross salary.
To see how this plays out in practice, consider a simple worked example for one employee:
| Item | Monthly Amount | Who Pays | Where It Goes |
|---|---|---|---|
| Gross salary | £3,500 | Employer | Baseline cost; split below |
| Less: Income tax (PAYE) | −£480 | Deducted from employee | Paid to HMRC |
| Less: Employee NICs | −£195 | Deducted from employee | Paid to HMRC |
| Less: Employee pension (5%) | −£175 | Deducted from employee | Paid to pension provider |
| Net pay to employee | £2,650 | Employer pays employee | Employee’s bank account |
| Plus: Employer NICs | +£375 | Employer (additional cost) | Paid to HMRC |
| Plus: Employer pension (3%) | +£105 | Employer (additional cost) | Paid to pension provider |
| Total employer cost | £3,980 | Employer | Total monthly outlay |
Note: figures are illustrative. Tax codes, NIC thresholds, and pension rates vary — always use HMRC’s current rates and your employee’s specific tax code when processing payroll.
In this example, the employer spends £3,980 per month to employ someone who takes home £2,650. The £1,330 gap is made up of taxes and contributions that flow to HMRC and the pension provider. This is why payroll costs in your profit and loss account will always exceed the net salaries you actually pay out — and why budgeting based on net pay is a common and costly mistake.
How Payroll Appears in Your Financial Statements
Payroll touches both the profit and loss account and the balance sheet every time you run it.
In the profit and loss account, the full employer cost — gross wages plus employer NICs plus employer pension — is recorded as an operating expense, typically under “staff costs” or “wages and salaries.” This reduces your operating profit for the period regardless of when cash actually leaves your account. For a full explanation of the income statement structure, see our guide to understanding the income statement.
On the balance sheet, several payroll-related liabilities typically appear under current liabilities at month-end:
- PAYE/NIC payable — income tax and National Insurance collected but not yet remitted to HMRC (usually paid by the 22nd of the following month).
- Pension contributions payable — employee and employer contributions collected but not yet paid to the pension provider.
- Accrued wages — if your payroll period does not align perfectly with your accounting period, wages earned but not yet paid at period-end are accrued as a liability.
Understanding these balance sheet movements is important for reading your working capital position accurately. A large PAYE liability sitting in current liabilities, for example, represents a cash outflow that will happen within days — it should not be mistaken for freely available cash.
The Payroll Journal Entry
For businesses that record payroll manually or want to understand what their payroll software is doing in the background, the payroll journal entry records the full economic event each pay period. A typical set of entries for the example above would look like this:
Step 1 — Record the gross wages expense and the liabilities created:
| Account | Debit | Credit |
|---|---|---|
| Wages expense (P&L — gross wages) | £3,500 | |
| Employer NIC expense (P&L) | £375 | |
| Employer pension expense (P&L) | £105 | |
| PAYE/NIC payable (balance sheet liability) | £1,050 | |
| Pension contributions payable (balance sheet liability) | £280 | |
| Net wages payable (balance sheet liability) | £2,650 |
Step 2 — Record the cash payments as they leave your bank:
| Account | Debit | Credit |
|---|---|---|
| Net wages payable | £2,650 | |
| Bank | £2,650 |
The PAYE/NIC payable and pension payable balances are then cleared in the same way when those payments are made to HMRC and the pension provider. This two-step approach — recording the expense when it is incurred, then clearing the liability when cash is paid — is the correct accruals-basis treatment for payroll. For a broader introduction to how journal entries and double-entry bookkeeping work, see our guide on double-entry bookkeeping explained.
Common Payroll Accounting Mistakes to Avoid
Even businesses using payroll software make these errors — often because the accounting side is not checked as carefully as the payroll calculations themselves.
- Budgeting on net pay instead of total employer cost. When forecasting staff costs, always use gross salary plus employer NICs plus employer pension. The shortfall can be 10–15% above gross salary for a typical employee.
- Missing the PAYE payment deadline. PAYE and NICs must reach HMRC by the 22nd of the month following the payroll period (19th for cheque payments). Late payments attract interest and potential penalties. Set a recurring reminder.
- Failing to accrue wages at period-end. If your payroll runs on the 25th and your accounting period ends on the 30th, five days of wages are earned but unpaid. These should be accrued as a liability to give an accurate picture of your costs for the period.
- Misclassifying directors’ remuneration. Directors’ salaries and dividends are treated differently for tax purposes. Mixing them up creates errors in both your management accounts and your corporation tax calculation.
- Not reconciling payroll to the general ledger. Run a monthly reconciliation between your payroll software totals and your accounting software. Discrepancies are much easier to find in-month than at year-end.
Key Takeaways
- Gross pay is what your employee earns. Net pay is what they take home after income tax, employee NICs, and pension contributions are deducted.
- Your total employer cost is higher than gross pay — you also pay employer NICs and employer pension contributions on top.
- Payroll costs appear in the profit and loss account as staff costs, and on the balance sheet as PAYE, pension, and wages payable until the cash is remitted.
- The payroll journal entry uses a two-step approach: record the expense and create the liabilities when payroll runs; clear each liability when the cash payment is made.
- Always budget on total employer cost, not net pay or even gross salary — the difference can be material for staffing decisions.
- Reconcile payroll records to your general ledger monthly and never miss the PAYE payment deadline.
Related reading: For more context on where payroll sits within your financial statements, explore our guides on understanding the income statement, double-entry bookkeeping and journal entries, the balance sheet explained, and working capital management.