PILON and the PENP Formula: How Notice Pay Tax Actually Works (2026)
A plain-English walkthrough of the Post-Employment Notice Pay (PENP) formula HMRC uses to tax PILON, why it exists, and how it interacts with the £30,000 tax-free termination payment threshold in 2026/27.
PILON in plain English
If your employment ends and your employer pays you a lump sum instead of requiring you to work your notice period, that payment is a PILON — Payment In Lieu of Notice. Instead of continuing to attend work, or sitting on garden leave, for however many weeks or months your notice period would have run, the employment ends straight away and you receive a payment broadly equivalent to the pay you'd have earned had you worked it.
PILON is common in redundancy situations, settlement agreements, and any termination where neither side wants the employee to keep working through notice.
Why HMRC introduced PENP
Before 6 April 2018, the tax treatment of PILON depended heavily on the wording of the employment contract. If a contract had a clear PILON clause, the payment was taxed as earnings. But if it didn't, some employers and employees structured the same underlying payment — pay that was, in substance, for the notice period — as part of a tax-free "compensation for loss of employment" package instead, sheltering it under the £30,000 threshold even though it was economically identical to notice pay.
HMRC's response was PENP: a statutory formula that calculates what notice pay should be, and taxes at least that amount as earnings regardless of how the payment is labelled in the settlement documentation. It removed the incentive to draft around the rules through careful contract wording, replacing it with a single calculation that applies consistently.
The formula itself
PENP = ((BP × D) ÷ P) − T
| Term | Meaning |
|---|---|
| BP | Basic pay for the last full pay period before the notice period began (or before termination if working notice) |
| D | Number of calendar days in the unworked part of the notice period |
| P | Number of days in the pay period that BP relates to |
| T | Any contractual PILON already paid and already taxed as earnings |
The result is treated as earnings — fully subject to Income Tax and Class 1 National Insurance — no matter what the settlement agreement calls the payment.
Worked example
Consider an employee on a monthly salary of £4,500, with a 3-month contractual notice period, whose employment is terminated immediately with no notice worked at all. Their contract has no separate contractual PILON clause providing for automatic taxation of a notice payment.
- BP (basic pay for the last full monthly pay period): £4,500
- D (unworked notice days): 3 months, treated as 91 days
- P (days in the pay period BP relates to): 30 days (a calendar month, approximated)
- T (contractual PILON already taxed): £0, since there's no separate contractual clause
PENP = ((£4,500 × 91) ÷ 30) − £0 = £13,650
So £13,650 of this employee's termination payment must be taxed as ordinary earnings — full Income Tax and Class 1 National Insurance — regardless of how the rest of the settlement agreement describes the payment.
If the total termination package agreed is £45,000 (made up of this notice element plus an "ex gratia" compensation payment), the remaining £45,000 − £13,650 = £31,350 is available to be tested against the £30,000 threshold:
| Portion | Amount | Tax treatment |
|---|---|---|
| PENP (notice pay) | £13,650 | Fully taxed as earnings (Income Tax + Class 1 NI) |
| Remaining payment | £31,350 | First £30,000 tax-free (and NIC-free for the employee); excess £1,350 taxed (Income Tax, plus employer NI) |
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Once the PENP portion has been carved out and taxed as earnings, the remaining part of a termination payment — which can include genuine redundancy pay, whether statutory or enhanced, plus any leftover "compensation for loss of employment" — is tested against the combined £30,000 threshold:
- Up to £30,000: free of Income Tax and free of employee National Insurance
- Above £30,000: Income Tax applies, and employer (though not employee) National Insurance applies to the excess
This is why the total headline figure in a settlement agreement can be misleading — two offers of the same total amount can produce very different take-home sums depending on how much of each is captured by PENP versus how much benefits from the £30,000 threshold.
Why the "BP" figure sometimes surprises people
One detail that regularly catches employees out is how "basic pay" is defined for the BP term in the formula. It's generally your basic salary for the relevant pay period — not necessarily your total take-home earnings including regular bonuses, commission, or benefits in kind, depending on how those are structured. Someone with a modest base salary topped up by a large regular bonus or commission scheme might find their PENP calculation, based only on basic pay, produces a smaller "earnings" portion than their overall total pay would suggest — which in turn means proportionally more of their termination package can potentially benefit from the £30,000 threshold rather than being taxed in full as earnings. This is a genuine, lawful feature of how the formula is defined, not an avoidance technique, but it's worth understanding if your normal pay includes significant variable elements beyond basic salary.
A second worked example: notice partly worked
PENP calculations aren't always for a case where no notice at all is worked. Consider an employee with a 2-month (60-day) contractual notice period and a monthly basic salary of £3,200, who works 20 days of their notice before the employer decides to end things early and pay the remaining notice as PILON.
- BP: £3,200 (last full monthly pay period)
- D: 40 days (60-day notice period minus the 20 days actually worked)
- P: 30 days (the pay period BP relates to, approximated as a calendar month)
- T: £0 (assume no separate contractual PILON clause already taxed)
PENP = ((£3,200 × 40) ÷ 30) − £0 = £4,266.67
So £4,266.67 of the payment covering the unworked balance of notice must be taxed as earnings. If the total termination payment (including this notice-related element plus any additional ex gratia compensation) comes to £10,000, then £10,000 − £4,266.67 = £5,733.33 remains to be tested against the £30,000 threshold — comfortably within it, so that remaining portion would be paid tax-free and free of employee National Insurance.
PENP and redundancy pay working together
It's worth being clear about how PENP sits alongside a genuine redundancy payment in a combined termination package, since the two are often paid together. The PENP calculation only ever looks at the notice-pay element — the amount that represents what the employee would have earned by working out their notice. Statutory or enhanced redundancy pay is a separate component of the package, calculated on entirely different principles (length of service, age, and weekly pay, subject to the statutory cap for the statutory element), and isn't touched by the PENP formula at all. In a combined package, the order is generally: calculate and set aside the PENP amount as taxed earnings first, then add the redundancy pay and any other compensation together, and test that combined remaining figure against the £30,000 threshold as a whole — not test redundancy pay and other compensation separately against £30,000 each.
Employer obligations and payroll reporting
Employers processing a termination payment that includes a PENP element have specific reporting obligations too. The PENP amount must be run through PAYE payroll as ordinary earnings, with Income Tax and Class 1 National Insurance deducted at source, just like a normal salary payment, rather than simply being paid gross alongside the rest of the settlement. The non-PENP portion, up to £30,000, is reported separately and isn't run through PAYE in the same way, though it still needs to be reported to HMRC. Getting this split wrong on the payroll side is a common source of errors that can leave an employee with an incorrect net payment, or trigger a later correction and potential underpayment or overpayment notice from HMRC once the figures are reviewed.
What to check before signing a settlement agreement
- Ask for a breakdown showing the PENP calculation separately from the rest of the payment, not just a single combined figure.
- Check whether your contract has an existing PILON clause — if so, the "T" term in the formula should already reflect it, avoiding double taxation.
- Confirm how much of the non-PENP portion is being tested against the £30,000 threshold, and whether any part of it exceeds that threshold.
- Check what "basic pay" has been used for the BP term, particularly if your normal earnings include significant bonus, commission or benefits-in-kind elements.
- If the numbers look complex or the headline figure is large, get independent advice on the PENP working before agreeing — the calculation directly affects your actual take-home amount, not just the headline total.
- Ask whether the employer has treated any benefits continuing after termination (such as private medical cover running on for a period) as part of the taxable package, since these can sometimes be overlooked in a PENP breakdown but still carry a tax value.
Frequently asked questions
What does PILON stand for and what is it?
PILON stands for Payment In Lieu of Notice — a lump sum paid to an employee instead of requiring them to work their contractual notice period. Rather than continuing to attend work (or being placed on garden leave) for the notice period, the employer ends the employment immediately and pays a sum broadly equivalent to what the employee would have earned had they worked their notice.
What is PENP and why did HMRC introduce it?
PENP stands for Post-Employment Notice Pay — a statutory formula HMRC introduced from 6 April 2018 to standardise how much of a termination payment is treated as taxable earnings versus how much can potentially fall within the £30,000 tax-free threshold. Before PENP, some employers structured termination payments so that pay genuinely owed for the notice period was labelled as 'compensation' and paid tax-free, even though it was really just salary in another name. PENP closed that gap by requiring a calculation of what notice pay should have been, and taxing at least that amount as full earnings regardless of how the payment is labelled in the settlement paperwork.
What is the PENP formula?
The formula is: PENP = ((BP × D) ÷ P) − T, where BP is basic pay for the last full pay period before the notice period began (or before termination, if working through notice), D is the number of calendar days in the unworked part of the notice period, P is the number of days in the pay period BP relates to, and T is any contractual PILON already paid and already taxed as earnings. The result, PENP, is treated as earnings — fully subject to Income Tax and Class 1 National Insurance — regardless of what the termination payment is called in the settlement agreement.
Is all termination pay taxed under PENP, or just some of it?
Only the PENP amount itself is automatically treated as earnings. Any part of the total termination payment that exceeds PENP can potentially qualify for the standard termination payment tax treatment — tax-free up to the combined £30,000 threshold (which also covers genuine redundancy pay), and subject to Income Tax but not employee National Insurance above that. So a termination payment is effectively split into two portions for tax purposes: the PENP portion (always fully taxed as earnings) and the excess above PENP (which gets the more favourable £30,000-threshold treatment).
How does PENP interact with the £30,000 tax-free threshold for redundancy?
The £30,000 threshold is a combined allowance covering the non-PENP portion of a termination payment, which can include statutory and enhanced redundancy pay together with any excess notice-related payment above the calculated PENP amount. Once the PENP portion has been carved out and taxed as ordinary earnings, whatever remains of the total payment — up to £30,000 in total — can be paid free of Income Tax, and free of employee National Insurance, though employer National Insurance does apply to the excess above £30,000.
Does PENP apply if my contract already has a PILON clause?
PENP still applies, but the calculation typically results in the contractual PILON itself simply being taxed as earnings in the ordinary way, since a properly drafted contractual PILON clause usually already reflects what the employee would have earned during the notice period. The 'T' term in the formula (any contractual PILON already paid and taxed) is specifically there to avoid double-counting when a contract already provides for a taxed PILON — the formula reduces the calculated PENP by whatever's already been taxed under the contractual clause.
Does PENP apply to genuine redundancy payments too?
PENP applies to the notice element of any termination package, including one that also includes redundancy pay — it isolates and taxes the portion representing pay in lieu of notice as earnings, separately from the redundancy element. Genuine statutory or enhanced redundancy pay itself isn't earnings and continues to benefit from the £30,000 threshold in the normal way; PENP is specifically about making sure notice-period pay doesn't get mislabelled as redundancy or 'ex gratia' compensation to avoid tax.
What if my notice period is worked in full — does PENP still apply?
If an employee works their full notice period, there's no unworked notice to calculate PENP on, so the 'D' figure in the formula would be zero (or very small if only a short balance of notice is paid off), meaning little or nothing is added to earnings under PENP beyond normal salary already taxed through payroll as usual. PENP is specifically about payments made instead of working some or all of the notice period.
Can my employer or I choose not to apply the PENP calculation?
No — PENP is a statutory formula, not an optional method employers or employees can opt out of. Any UK employer processing a termination payment that includes an unworked notice element is required to calculate and apply PENP correctly when working out what's taxable as earnings versus what can benefit from the £30,000 threshold, and getting it wrong can leave either the employer or employee exposed to an unexpected tax bill or penalty later.
Does employer National Insurance apply to termination payments above £30,000?
Yes — while employee National Insurance doesn't apply to the portion of a termination payment above £30,000 that isn't caught by PENP, employer National Insurance (Class 1A) does apply to that excess above £30,000. This is a cost employers factor into negotiating settlement figures, and it's worth understanding as an employee too, since it can affect how flexible an employer is willing to be on the total headline figure offered.
Should I get advice before agreeing a settlement figure that includes PILON?
It's generally worth it, particularly for larger termination packages, because the PENP calculation directly affects how much of the headline settlement figure actually reaches you after tax. Two settlement offers with the same total headline number can produce very different take-home amounts depending on how the PENP calculation splits the payment between taxed earnings and the £30,000 threshold — an employment solicitor or tax adviser can check the employer's PENP working before you sign anything.
Related reading
UK Settlement Agreement Tax Treatment 2026: What is Taxable?
How settlement agreement payments are taxed in 2026 -- the £30,000 tax-free exemption, PENP formula for notice pay, payments in lieu of notice, and PILON tax rules.
From Redundancy to Universal Credit: The First 5 Weeks Explained
What actually happens financially in the weeks between being made redundant and your first Universal Credit payment landing — the waiting period, how redundancy pay is treated, advances, and the gap most people don't plan for.
Pay in Lieu of Notice (PILON) and Redundancy: How the Tax Actually Works in 2026/27
PILON is taxed differently from the statutory redundancy payment itself. How Payment in Lieu of Notice is treated for tax and National Insurance in 2026/27, with worked examples.