What is ex gratia payment tax in the UK?

For UK employers, a well intended ex gratia payment can quickly become an HMRC scrutinised tax event. Since the 2018 PENP rules were introduced (Finance Act 2018), misclassifying PILON or PENP elements as ex gratia has become one of the most common termination-related PAYE errors flagged in HMRC compliance reviews, with inaccuracy penalties of up to 100% of the understated tax under Schedule 24, Finance Act 2007. Understanding ex gratia payment tax is therefore not just a technicality. It is a core compliance duty for finance directors and payroll teams handling 2026/27 terminations.

What is an ex gratia payment?

An ex gratia payment is a voluntary, discretionary payment an employer makes when an employee leaves, often in situations like redundancy, settlement agreements, or at the end of employment contracts. 

It is not contractually required and is often used:

• To support redundancy or settlement agreements 

• To resolve disputes 

• As a goodwill gesture on termination 

👉 To note: Where an ex gratia payment is made under a settlement agreement, the employee must receive independent legal advice for the agreement to be legally binding (s.203 Employment Rights Act 1996). Employers typically contribute to the cost of this advice, and the contribution is itself tax-exempt under EIM03050.

What is the difference between an ex gratia payment, PILON and PENP?

The difference between ex gratia payments, PILON and PENP lies in how they are classified and taxed.

Key differences explained

⚠️Warning: Even if labelled "ex gratia", any element of a termination payment that relates to a notice period not worked is reclassified as PENP under s.402D ITEPA 2003 and is fully subject to PAYE Income Tax and Class 1 NICs.

How is PENP calculated?

Post-Employment Notice Pay (PENP) is calculated using the formula in s.402D ITEPA 2003:PENP = ((BP × D) ÷ P) − T

Where:

• BP = basic pay in the last pay period before the trigger date

• D = unworked notice period in days

• P = number of days in the last pay period

• T = any payment already taxed as earnings (e.g. contractual PILON)

📌 Example: An employee on £4,000 monthly basic pay with 3 months' unworked notice has a PENP of approximately £12,000, fully subject to PAYE and Class 1 NICs.

Is an ex gratia payment taxable in the UK?

Ex gratia payment tax in the UK depends on whether the payment qualifies as a termination payment under HMRC rules.

Tax rules explained:

• The first £30,000 is tax-free for qualifying termination payments 

• Any amount above £30,000 is subject to Income Tax 

• Employer Class 1A NICs at 15% apply to any amount exceeding the £30,000 threshold, in line with HMRC employer NIC rates for the 2026/27 tax year as set out on GOV.UK.

Employer Class 1A NIC on termination payments above £30,000 is reported via P11D(b) and must be paid to HMRC by 22 July (electronic) or 19 July (post) following the end of the tax year in which the payment was made.

📌 Example: If an employee receives £40,000 as a qualifying ex gratia payment, £30,000 is tax-free and £10,000 is taxable.

👉 To note: Under s.406 ITEPA 2003, termination payments made on account of injury, disability or death are fully exempt from income tax, regardless of the amount, the £30,000 cap does not apply. Employers must document the qualifying reason in the settlement agreement.

💡 Good to know: Statutory redundancy pay (SRP) counts towards the £30,000 ITEPA 2003 exemption, it is not a separate allowance. If SRP is £15,000, only £15,000 of any further ex gratia payment can use the tax-free cap before Income Tax and Class 1A NIC apply on the excess.

What are the HMRC rules for ex gratia payments?

The rules around ex gratia payment tax require employers to correctly classify payments and apply HMRC guidelines.

Key rules to follow:

• Payments must be linked to termination of employment 

• They must not be contractual or guaranteed 

• Elements related to notice pay must be treated as PENP 

• Taxable elements must be Payments must be reported through PAYE on the FPS

⚠️Warning: Misclassifying payments can lead to HMRC penalties of up to 100% of the understated tax, plus interest and potential back-tax liabilities for the employer.

What are some worked examples of ex gratia payments?

Examples of ex gratia payment tax depend on how the payment is structured and classified.

Common scenarios include:

• A £25,000 redundancy compensation payment that is non-contractual is fully tax-free. 

• A £35,000 ex gratia payment is partially tax-free, with £30,000 exempt and £5,000 subject to Income Tax. 

• A payment covering a notice period is fully taxable, as it is treated as post-employment notice pay (PENP). 

• A settlement agreement with multiple elements may have mixed tax treatment, depending on how each component is classified. 

📌 Example: A settlement package may include both tax-free compensation and taxable notice pay.

💡 Good to know: The £30,000 exemption has been frozen since 1988. HMRC confirmed in its 2026/27 guidance that no uprating is currently scheduled, meaning the real-terms value of the exemption continues to fall as wages rise.

What are the best practices for managing termination payments?

Best practices for managing ex gratia payment tax involve clear classification, documentation, and compliance with HMRC rules.

Key steps for employers:

• Clearly separate payment components (ex gratia, notice pay, bonuses) 

• Ensure accurate PENP calculations 

• Apply correct PAYE treatment 

• Keep detailed documentation and agreements 

• Communicate tax implications clearly to employees 

💡Good to know: Using payroll software can help ensure accurate tax calculations and reporting for termination payments.

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