How payroll processing works and how to choose the right software for your small business

Published Tuesday 23 December 2025

Table of contents

• What is payroll processing?
• 6 areas of the law to understand for processing payroll
• How to choose the right payroll processing software
• Weighing the options: Outsourcing payroll processing
• A six-point checklist for a seamless payroll process
• Adapting to payroll fluctuations
• Streamline your payroll with Xero
• Here are answers to some common questions you might have about using Xero for your payroll needs.

Key takeaways

• Implement automated payroll software to handle complex calculations, HMRC submissions, and compliance requirements, reducing manual errors and saving significant administrative time.

• Submit Full Payment Submissions (FPS) to HMRC on or before each payday to avoid automatic penalty charges that start at £100 per month for late filings.

• Establish proper record-keeping systems that maintain accurate payroll documentation for potential HMRC audits and ensure compliance with legal requirements for taxation, National Insurance, and pension auto-enrolment.

• Choose integrated accounting and payroll software that grows with your business, offers cloud-based access, and provides employee self-service features to streamline operations as your team expands.

What is payroll processing?

Payroll processing is calculating employee wages, deductions, and tax obligations for each pay period. This ensures you pay staff correctly and comply with HM Revenue & Customs (HMRC) requirements.

The process involves four key steps:

• Track hours worked: Record all employee hours and overtime accurately
• Calculate gross pay: Apply hourly rates or salaries to hours worked
• Deduct taxes and contributions: Remove Income Tax, National Insurance, and pension contributions
• Submit HMRC reports: File Full Payment Submissions (FPS) by each payday

Missing deadlines triggers penalties from HM Revenue & Customs (HMRC). Late filing penalties start at £100 per month, so accuracy and timing matter.

Alongside the legal and tax implications, paying employees correctly helps you build trust and retain your team. Fortunately, the right payroll processing software makes it much easier to fulfil your obligations as an employer.

Understanding the key elements of payroll processing

UK payroll processing follows these key steps:

1. Track employee hours: Record all hours worked, pay types, and work categories for each employee. Accurate tracking prevents payroll errors and HMRC compliance issues.
2. Calculate gross pay: Multiply hours worked by hourly rates (or use fixed salaries). Gross pay represents total earnings before deductions. Ensure all calculations meet National Minimum Wage requirements; for instance, from April 2025, the minimum wage rates will include £12.21 per hour for those 21 and over.
3. Calculate deductions: Use employee tax codes and earnings to determine Income Tax and National Insurance amounts. Include additional deductions like pension contributions and student loan repayments.
4. Calculate net pay: Subtract all deductions from gross pay to determine final payment amounts.

HMRC reporting requirements ensure compliance and avoid penalties:

• Full Payment Submission (FPS): Submit every payday with employee wages and deduction details
• Employer Payment Summary (EPS): File when claiming reliefs, allowances, or reporting no payments
• Record keeping: Maintain accurate payroll records for potential HMRC audits
• Audit readiness: Keep detailed documentation proving correct payments and contributions

Payroll software automates complex calculations and compliance tasks. Modern systems handle pay calculations, deduction processing, and HMRC report generation automatically, reducing admin time and error risk.

6 areas of the law to understand for processing payroll

UK payroll compliance requires understanding five critical legal areas that affect every business with employees.

1. Taxation

Taxation compliance means withholding Income Tax from employee wages and remitting payments to HMRC. You act as both employer and tax collector, making accurate calculations essential.

2. National insurance contributions

National Insurance contributions fund state pensions and benefits through dual payments:

• Employee contributions: Deduct from wages based on earnings thresholds
• Employer contributions: Pay additional amounts on top of employee deductions. For the 2024/25 tax year, this means employers pay a 13.8% contribution on most employee earnings above the secondary threshold.

Our guide to National Insurance contributions can help get you started.

3. Pension auto enrolment

Pension auto enrolment requires assessing all workers and providing workplace pension schemes, which generally applies to staff aged 22 to the state pension age with qualifying earnings over £10,000 a year. Contributions typically calculate as salary percentages, with both employer and employee payments required. You can find more guidance on The Pensions Regulator website.

4. Fines and penalties

Fines and penalties apply when missing HMRC deadlines or payment obligations:

• Late FPS/EPS submissions: Trigger automatic penalty charges, and failures in other areas like auto-enrolment can lead to a £400 fixed penalty plus escalating penalties of up to £10,000 a day.
• Overdue payments: Accrue interest charges over time
• Resolve issues quickly: Settle outstanding amounts immediately to minimise costs

5. Reporting

Reporting deadlines ensure HMRC compliance:

• FPS submission: File on or before each payday
• EPS filing: Submit by 19 of the following month to apply any reductions
• Automated solutions: Use payroll software to meet deadlines consistently

Check HMRC’s guidance for payroll deadlines and see how payroll processing software can help you prepare and submit compliant reports.

6. Payroll is for employees

Payroll scope covers direct employees only, not freelancers or contractors invoicing through their own businesses.

IR35 workers may need different treatment – get professional advice for complex employment status questions. Read our guide on IR35 for more information.

How to choose the right payroll processing software

Some accounting software comes with payroll features built-in or as an add-on option and there are also stand-alone payroll processing software options available. Alternatively, you can outsource to a payroll processing company if you’d rather have the admin off your plate.

Which option you choose will depend on the requirements of your specific business, but here are some points to bear in mind.

1. Work with what you have

Does your business already use accounting software? See if it has an in-built payroll or if you can add a payroll application to it. If not, it’s time to upgrade.

2. Find out if it’s easy to use

Choose a payroll package or payroll accounting software add-on that your accountant or financial advisor can also use. Keep it simple to avoid swapping files in different formats.

3. Go online and use the cloud

Use cloud-based accounting and payroll software so you can access your data from anywhere and share it securely. You can access your payroll information anywhere and at any time, and safely share information with trusted partners. Plus, there’s less IT support work required.

4. Make sure it can grow with you

You may only have one or two employees now, but what if that changes? With scalable payroll software, you won’t have to switch systems as your company grows.

5. Ensure it can do real-time recording

Make sure the payroll application you choose keeps accurate, up-to-date, real-time records of payroll operations.

6. Get recommendations

Ask your accountant or bookkeeper, financial advisor, bank, business partners or owners of similar companies to yours. Recommendations from trusted professionals can help you make the best decision for your small business payroll needs.

7. Check the reporting requirements

See what types of reports are available with your chosen accounting or payroll package. Ask your accountant which ones might be useful for your business, and whether mandatory reporting requirements are supported.

8. Look into other useful features

Automated calculations of taxes, direct deposit management and timesheet handling can be a great help. By automating data admin, modern payroll processing software automatically applies pay, tax and National Insurance rates. So you don’t need to do the complex calculations yourself.

Think carefully about what you’ll need so you can choose a payroll system that will support your business as it grows, without needing to switch later.

Weighing the options: Outsourcing payroll processing

For small businesses that want to reduce their workload, outsourcing to a payroll processing company is an option. There are plenty of benefits such as:

• Reduced administrative burden
• Access to expertise and compliance support
• Fewer errors and timely report submissions
• Time savings for your team

There are some drawbacks to note, too. Outsourcing payroll can be quite costly compared to using an in-house system. Your payroll company will handle sensitive employee data outside your business, so check their security measures carefully.

You must report data breaches to the Information Commissioner’s Office within 72 hours. If you do opt for payroll outsourcing, shop around to find the best choice for your business.

A six-point checklist for a seamless payroll process

Having the right payroll processing software is only part of the solution. Now you need to set it up properly to save you time and headaches later. Here are some guidelines:

1. Register your business

Ensure your registered business number is included in all your payroll documentation and any forms you submit to HMRC.

2. Record your employees' data

Enter all your employees’ information in your payroll system, such as their name, address, National Insurance number and deductions (if taxes need to be taken out). Also include contact details, salary, days off, sick days, overtime and any other compensation. Check HMRC regulations to find out what data you must include.

3. Do the 'paperwork'

Make sure your staff provide all necessary tax forms and return them. Do the same with your own forms.

4. Decide on payment periods

When will you be paying employees? Common payment periods include weekly, monthly and fortnightly.

5. Keep up to date

Plan on having payroll information updated regularly. You can find a bookkeeper or accountant to support you with this. Make sure you familiarise yourself with law and regulatory changes that affect payroll. Seek payroll advice from a trusted advisor if you’re stuck.

6. Set up an archive

For records that need to be kept for several years, think about how you’ll archive them. Good payroll accounting software will do some of this for you but you may still need some paper archives for documents like tax forms.

Adapting to payroll fluctuations

Your payroll process will change as you hire new employees. Whenever a new employee joins your business, make sure all the correct tax documentation is completed and filed. Check international payroll processing rules if you’re operating overseas.

Payments to the people on your payroll will vary too and you’ll need to include them in your system in different ways. Some examples include:

• Salaried worker: Someone who’s paid a fixed salary for each pay period
• Regular hourly or casual employee: Paid an hourly rate for the hours worked each week
• Commission: Paid for services rendered, products or services sold, usually on a percentage basis
• Bonus: Paid for good performance over and above expected levels
• Supplemental wages: A catch-all term that includes commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, retroactive pay increases, and payments for nondeductible moving expenses

Streamline your payroll with Xero

Xero Payroll can automate tasks – such as calculating tax deductions – to reduce errors and streamline the entire process. With an integrated accounting and payroll system, like Xero, you’ll have access to all your data in one place and avoid the need to copy information across from separate software.

Tasks that used to be manual — like tracking time, generating reports and sending out payslips — can now be automated thanks to digital record keeping tools. In Xero Payroll, payslips are automatically available to your team in their Xero Me app. Learn more about Xero's payroll software.

Here are answers to some common questions you might have about using Xero for your payroll needs.

Here are answers to some common questions about using Xero for your payroll needs.

Can you do payroll with Xero?

Yes, you can. Xero Payroll is a fully featured, HMRC-recognised tool that helps you pay employees, manage deductions, handle pension auto-enrolment, and submit Real Time Information (RTI) filings directly to HMRC. It’s integrated with Xero Accounting to give you a complete financial picture.

How much does payroll cost on Xero?

Payroll is included in some Xero subscription plans. The cost depends on the plan you choose and the number of employees you need to pay. Our plans are designed to be flexible and scale with your business as it grows.

Is Xero payroll better than QuickBooks?

Both Xero and QuickBooks offer robust payroll solutions. Business owners often find Xero's interface more intuitive and easier to navigate, which can lead to faster pay runs. Xero also offers unlimited users on all plans, which provides greater flexibility for growing teams.

How easy is it to switch to Xero payroll?

Switching to Xero is straightforward. You can set up your payroll records by entering your employee details and pay history. If you’re moving from another software, you can import your data. We also provide detailed guides and support to help you make the transition smoothly.

Does Xero handle HMRC submissions automatically?

Xero makes HMRC submissions simple. After you process a pay run, Xero prepares the required Real Time Information (RTI) filing. You can then submit it directly to HMRC from within the software in just a few clicks, helping you stay compliant.