Published: September 2026 | Fact-Checked & Audited By: Tax Calculators for UK Editorial Team (Chartered Tax Advisor & Accountant)
This guide is fully updated for the 2026/27 UK tax year. All statutory redundancy formulas, £30k exemption thresholds, and PENP notice rules are audited against active HMRC manuals and Section 401 ITEPA 2003.
When an employment contract is terminated in the United Kingdom, employees frequently receive a lump-sum payment rather than working out their contractual notice period. Known as Payment in Lieu of Notice (PILON), this payment is governed by strict HM Revenue and Customs (HMRC) statutory anti-avoidance legislation called Post-Employment Notice Pay (PENP) under Section 402D of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). Understanding how PENP is calculated is vital when reviewing a settlement agreement or severance offer in the 2026/27 tax year.
1. Why PILON is Fully Taxable in the UK
Prior to April 2018, non-contractual payments in lieu of notice could sometimes be included within the £30,000 tax-free redundancy exemption. However, the UK Parliament passed legislation standardizing the tax treatment of notice pay:
- All Notice Pay is Treated as General Earnings: Whether notice pay is contractual or non-contractual, it is classified as ordinary employment earnings.
- Subject to Full Tax and NI: PILON is subject to PAYE Income Tax (20%, 40%, or 45%) and employee Class 1 National Insurance (8% or 2%) from the very first pound.
- Excluded from the £30,000 Exemption: PILON can never be sheltered by the £30,000 tax-free redundancy threshold.
2. The Statutory Post-Employment Notice Pay (PENP) Formula
To prevent employers from artificially disguising notice pay as tax-free redundancy compensation, HMRC mandates that employers apply the statutory PENP formula to every termination package:
PENP = ((BP × D) / P) – T
| Variable | Statutory Definition | Explanation & Calculation Basis |
|---|---|---|
| BP (Basic Pay) | Basic pay in the last pay period. | Your gross basic salary in the pay period immediately prior to notice being served (excluding bonuses, overtime, and benefits). |
| D (Notice Days) | Post-Employment Notice Period. | The number of unworked calendar days in your statutory or contractual notice period. |
| P (Pay Period Days) | Calculation Period. | The number of calendar days in the pay period (e.g. 30, 31, or standard 30.42 for monthly paid staff). |
| T (Taxable Paid Notice) | Contractual notice already paid. | Any amounts paid under the employment contract that are already subject to tax and NI as notice pay. |
Any amount calculated as PENP is immediately carved out of the settlement package and taxed as standard earnings. Only whatever compensation remains after deducting PENP can qualify for the £30,000 tax-free exemption. You can calculate your net severance with our Redundancy Pay Calculator.
3. Step-by-Step Mathematical Calculation: PENP in Action
Let us walk through a worked example for an employee earning £60,000 per year (£5,000 gross basic pay per month) with a 3-month (90 days) contractual notice period who is dismissed immediately with a £40,000 settlement agreement:
- Basic Pay (BP): £5,000.00 (Monthly Pay)
- Notice Days (D): 90 days unworked notice
- Pay Period Days (P): 30.42 days (monthly standard)
- Calculate PENP: ((£5,000 × 90) / 30.42) – £0 = £14,792.90
- Tax Treatment of PENP (£14,792.90):
- PAYE Income Tax at 40%: £5,917.16
- Employee Class 1 NI at 2%: £295.86
- Net Cash Retained from Notice: £8,579.88
- Remaining Termination Compensation: £40,000.00 – £14,792.90 = £25,207.10
- Tax Treatment of Remaining Compensation: Because £25,207.10 is under the £30,000 threshold, it is 100% Tax-Free and NI-Free!
- Total Net Take-Home Payout: £8,579.88 + £25,207.10 = £33,786.98
4. PILON vs. Garden Leave: Which is More Tax-Efficient?
Employees often wonder whether taking PILON or going on Garden Leave is better financially:
| Feature | Payment in Lieu of Notice (PILON) | Garden Leave |
|---|---|---|
| Employment Status | Employment terminates immediately on the agreed date. | You remain an active employee until the notice period expires. |
| Tax & NI Treatment | Taxed as earnings via PENP formula in a lump sum. | Taxed normally on standard monthly payroll. |
| Company Benefits | Benefits stop immediately unless compensated in package. | Medical insurance, pension contributions, and car benefits continue. |
| Starting a New Job | You can start a new job immediately without restriction. | You cannot work for a competitor or new employer while on garden leave. |
5. Frequently Asked Questions (FAQ)
Q: Can PILON ever be tax-free in the UK?
A: No. Under current HMRC legislation, all payments in lieu of notice (PILON) are treated as general employment earnings and are subject to Income Tax and National Insurance.
Q: What is the difference between PILON and redundancy pay?
A: Redundancy pay is statutory compensation for the loss of your job and is tax-free up to £30,000. PILON is money paid instead of working your contractual notice period and is fully taxable.
Q: What happens if I work part of my notice period?
A: The PENP formula only applies to the unworked portion of your notice period. The days you actually worked are paid as standard salary.
Q: Does PILON include pension contributions and bonuses?
A: Basic PENP calculations include only basic salary. However, your employment contract may state whether employer pension contributions and contractual benefits must be added to your PILON sum.
Q: Can I sacrifice PILON into my pension?
A: Yes! Because PILON is treated as ordinary employment earnings, you can arrange a salary sacrifice agreement with your employer to direct some or all of your notice pay into your pension scheme.
Q: Why did my employer deduct tax from my settlement agreement before the £30k limit?
A: Your employer was legally required to apply the statutory PENP formula to deduct tax and NI from the notice pay portion before applying the £30,000 exemption to the remaining redundancy balance.
Q: How do I verify my employer’s PENP calculation?
A: Check the settlement agreement schedule. The agreement must explicitly show the PENP breakdown and the separate ex-gratia redundancy amount.
Q: Is statutory notice pay taxed differently from contractual notice pay?
A: No. Both statutory notice and enhanced contractual notice are treated as general earnings under the PENP framework.
Calculate Your Exact Figures (2026/27 Tax Year)
Put the figures from this guide into practice with our free, HMRC-audited interactive calculation tools: