How do you calculate holiday pay?

Calculating holiday pay is a problem that companies face every month. The issue is a complex one and a surprisingly large number of companies remain non-compliant. 

In recent years, the number of employment tribunal cases has led HMRC to reassess how holiday pay is calculated to ensure that employees taking annual leave don't miss out on overtime, increased rates of pay or bonuses.

So, how do you calculate holiday pay?

How to calculate holiday pay

The assumption that many people hold is that holiday pay should be calculated using an employee's base salary. 

In reality, there are a couple of mitigating factors that have to be taken into account. These include: 

• the type of employment contract an employee has—e.g. whether the employee works fixed or irregular hours;

• whether the employee receives regular overtime, bonus or commission payments;

• and what the employer considers, or what the employee can prove to be, "regular"

The term "regular" complicates a lot of cases. There can be regular bonuses and regular overtime, but each situation is dependent on what an employer considers to be regular or what the employee can prove is regular. 

For example, an annual bonus would be considered as "regular", but one hour of non-guaranteed or exceptional overtime would not be. 

The law itself is a minefield and the fact that so much of it is up to individual interpretation means that rulings can sometimes differ from one case to another. 

Employees with irregular hours

Employees who work irregular hours need to have their holiday pay calculated using the last 52 weeks of paid earnings as the pay reference period. Previously, the period of time was set at just 12 weeks; however, on 6 April 2020, the rules changed meaning that 52 weeks needed to be calculated going as far back as a period of 104 weeks if there were weeks with no pay at all.

Employees with regular hours

Employees who work regular hours can have their holiday pay calculated using their base salary; however, where regular bonuses or overtime are paid, the 52-week pay reference period needs to be used to calculate an employee's average weekly earnings.

Pay reference period

The pay reference period is the length of time an employer must look back at an employee's variable earnings to determine the correct average pay for annual leave. To correctly calculate the pay reference period, employers must take the 52 paid weeks and divide all earnings in that period by the total number of hours that an employee has worked. This figure can then be used to calculate an employee's holiday pay.

Even if an employee's pay rate does not vary from pay period to pay period, it is best practice to adopt this approach for all variable pay workers.

Cases in law

There have been several cases in recent years that have looked to highlight the issues surrounding holiday pay. 

One of the most prominent was Lock vs British Gas. The dispute centred on Mr Lock, a sales consultant for British Gas, who claimed that he was owed money on the basis that his holiday pay was not reflecting what he would have earned from the results-based commission. 

The Court of Appeal’s ruling in October 2016 stated that holiday pay must include compensation for any results-based commission that would have been ordinarily earned by a worker. 

Another prominent case regarding holiday pay is Bear Scotland v Fulton. 

Mr Fulton claimed that Bear Scotland Ltd had made unjustified deductions from his wages by not including overtime and other payments associated with his work in calculating holiday pay due to him. 

The courts agreed, and the Employment Appeal Tribunal (EAT) ruled in November that 2014 that regular overtime, which employees are required to perform if requested to do so by their employer, should be included for holiday pay purposes. 

The Harpur Trust v Brazel was another significant case. The court ruled that holiday pay for staff employed to work only part of the year should be calculated using an employee’s average earnings over a 12-week period and not pro-rated.

Statistics

A recent Xpert HR survey showed that 31.8% of employers had no plans to include voluntary overtime in their holiday pay calculation. 

Stats such as these are worrying, particularly when case law and the Good Work Plan insist that employers take voluntary overtime into account when calculating holiday pay. 

But with the legislation being so complicated, and the guidance so vague, it's not really all that surprising that so many employers feel at a loss when it comes to ensuring compliance.

What are the issues?

Not all employees are paid weekly, so how does an employer running a monthly payroll convert their historic data into weekly pay?

The HMRC guidance, while okay, is not exhaustive—nor does it allow employers to simply divide employee earnings and hours by 12 months.

For variable paid employees who are paid monthly, employers need to start keeping weekly pay records to enable them to calculate holiday pay correctly. This is because the historic process of just paying accrued annual leave to variable paid workers every month, often referred to as “rolled-up holiday pay”, is no longer seen as an accepted method for managing annual leave in the eyes of HMRC. 

PayFit & calculating holiday pay

At PayFit, we take complicated pieces of legislation and make them straightforward and easy to understand.

In our app, we have automated holiday pay calculations for workers on variable pay with our “Pay Reference Period” feature.

Keen to find out more about PayFit? Why not book a demo with one of our product specialists?