In the third and final part of our series on termination payments, we look at ex gratia payments, what they are, how they are used in termination agreements and how payroll teams should process them correctly.
In part one, we examined termination payments as a whole and what payroll teams need to be aware of. Part two is a guide for calculating PiLON payments after an employee’s contract is terminated.
For guidance or practical support on any of these subjects, please speak to our team and let us know how we can help.
What is an ex gratia payment?
HMRC describes an ex gratia payment as “a sum of money paid when there is no obligation or liability to pay it”. It is often deployed during negotiated settlement agreements, or as a goodwill gesture at the termination of an employee’s contract. An ex gratia payment is often linked to a binding agreement not to bring a claim against an employer. Ex gratia in Latin means “out of goodwill”, but we will see below that how a payroll team labels an end-of-contract payment will determine whether it meets the criteria for income tax and NIC exemptions.
Often, when discussing ex gratia payments, a tax-and-NI-free exemption on the first £30,000 is mentioned. We will discuss the criteria for meeting this below and why being clear about the reason for the payment is crucial for exemption status.
Which payments qualify for ex gratia status?
An ex gratia payment is one which is not paid as part of an established pattern or regularly over multiple periods. It should not be paid in a routine or used as a substitute for another payment which would normally be subject to NI or tax contributions. Essentially, an ex gratia payment should be an exceptional, one-off occurrence compensating the end of a worker’s employment. If the payment does not clearly meet these criteria, then HMRC will treat the payment as earnings and require tax and NI discrepancies to be paid.
If you need support processing termination payments, then please speak to our team.
Ex gratia payments and termination packages
As we’ve already covered in this series, a final package to an employee can be comprised of several termination payments. These could be a statutory or enhanced redundancy pay (with the enhancement being paid as ex gratia), standard notice pay (see our article on PiLON) or an ex gratia payment other than enhanced redundancy. Most commonly, an ex gratia payment covers the remaining balance of an employee’s final payment, once statutory obligations, contractual entitlements and PENP have been accounted for. The remainder, the ex gratia, is the amount agreed between the organisation and the employee as part of a compromise agreement or goodwill.
This must sit separately from anything the employee was already entitled to, and therefore may be subject to tax and National Insurance Contributions.
The £30,000 threshold
Once you have the confirmed amount to be paid as ex gratia, removing any entitlements as mentioned above, then up to £30,000 may be exempt from tax or NI. However, be aware that the criteria to meet this are strictly defined by HMRC as:
- The employee will not expect to receive it, i.e. it is not a routine payment or a normal payment as part of their pay package. It is a one-off.
- The employee is receiving it because of reasons not connected with services they provide – i.e. an agreement to compensate for the termination of their employment rather than a bonus based on performance.
- It is “not made because the individual is an employee”.
This last point is where ex gratia payments can fall foul of the £30,000 exemption. The payment should be clearly made as compensation for loss of employment. If it is not, then HMRC may class the payment as made to an employee, and the amount will be subject to NIC and tax contributions. Although there is no obligation on the employer to make the payment, and it is made in goodwill, it should also not be seen as a gift but as a payment because of the termination of employment.
The HMRC example for a termination ex gratia payment meeting the exemption threshold is as follows:
- An employee has their contract terminated by their employer. They are paid £33,000, with the payment comprising:
- £5,000 in earnings and £3,000 in PiLON (as per our article)
- £25,000 one-off payment as compensation for loss of employment (not earnings and not as part of compensation for a greivance).
- The £8,000 in earnings and payment in lieu of notice period are subject to Class 1 NICs and tax.
- The £25,000 one-off payment is below the £30,000 threshold and is therefore exempt from Class 1 NICs and tax.
The key aspect of the example above is that the lump sum payment does not:
- Include any payments which would normally be due in a pay period, holiday pay, bonuses achieved or benefits such as car allowances.
- Representing a gift to the departing employee for good work, a departing bonus or a leaving gift.
- Is clearly marked as a compensation payment for termination of their contract, but the compensation is not already included in the contract as a golden parachute or golden handshake. It is a payment that the employee wouldn’t be expecting before the termination of their contract of employment.
If the employee had received a lump sum payment over £30,000, then the first £30k would be NIC and tax-free, and the remainder would be subject to 15% Class 1 NICs and their normal tax band contribution.
MSP Payroll can calculate ex gratia payments, process them or assess their eligibility for tax exemption. Speak to our team to find out more.
Common errors when processing ex gratia payments and the consequences of miscalculation.
Often, colleagues from HR or other departments will use the term ex gratia for payments that strictly don’t qualify for exemption. For instance, confirming a golden handshake payment as defined in an employee’s contract, or a farewell gift from the company. These may be written down as ex gratia in documentation, but payroll teams should assess and confirm whether these payments are truly termination payments and then calculate eligibility for tax-free status.
Another common error that payroll teams may fall foul of is the breakdown of a final payment to an employee and the application of the tax exemption correctly. A payroll team must first identify the routine payments, i.e. final salary, PiLON, bonuses and benefits and apply tax and NIC to these as per usual; they are not included in the total lump sum amount that would be counted as compensation for termination under HMRC guidance.
An ex gratia payment must be seen as an exception rather than a rule. If the organisation makes the same payment regularly to employees when they leave, then HMRC may classify this as an established practice within the organisation and therefore routine rather than exceptional. In this instance, they would not accept that the payments met the exemption criteria.
How to correct errors after they occur
If errors are made, then they can largely be corrected through FPS filing. If the error is in the same tax year, then an amended Full Payment Submission can usually fix the issue. Once the tax year has closed, you may need to make a voluntary disclosure to HMRC.
MSP Payroll can provide guidance and review termination payments before submission, increasing accuracy and reducing the need for post-payment amendments. Speak to our team to find out more.
The consequences of getting ex gratia payments wrong
HMRC is actively monitoring payroll data and identifying employers who have underpaid Class 1A NI on termination payments. Where they suspect an error has occurred or a payment isn’t exempt from tax and NIC, they will write directly and request that the underpayment be made alongside interest accrued and penalties, depending on how the error occured.
Note the departing employee is not liable for rectifying any mistakes made in claiming tax or NIC as part of a termination payment. HMRC is clear that the responsibility sits with the employer.
If you’re concerned about calculations or compliance, then speak to our team, and we can help.
How can MSP Payroll help?
Our experts can provide comprehensive support for payroll teams processing termination payments. This could include:
- Reviewing any ex gratia payments before they are processed for eligibility and accuracy
- Calculating or processing ex gratia payments on your behalf
- A flexible hybrid payroll service, to suit your requirements
- Facilitating BACs payments for your organisation to employees
- Calculating or reviewing termination payments before they are completed
- Consultancy support on termination payments with guidance on PILON or PENP
- We are specialists in all payroll regulations and provisions, including SSP, SMP, pensions, seasonal payments, PAYE and National Insurance Contributions.
Contact us here if you would like to discuss implementing payroll support.
Ex Gratia Payments: Frequently Asked Questions
Is an ex gratia payment the same as redundancy pay?
No, statutory or enhanced redundancy is paid because a role is no longer needed and there is a defined calculation that should be used (see our termination payments article for more on this). An ex gratia payment is a non-routine, exceptional payment that an employer chooses to give the employee with no obligation to do so.
Should an ex gratia payment be written into an employee’s contract?
No, in fact, if it is included in a contract, then it is no longer ex gratia, but seen instead as an expected Golden Handshake, and the full amount will be subject to NIC and tax upon payment. To be eligible for the exemption, the payment must not be expected by the employee.
Does an ex gratia payment need to appear differently on a payslip than other payments such as PiLON?
Yes, PiLON and PENP are classified as earnings and should appear as such on the payslip. An ex gratia payment should be shown as a separate payment clearly marked as part of the termination. This will then ensure tax and NI calculations are made correctly.