How do we pay an employee in lieu of annual leave?

Holidays are both a right and an obligation for employees, to ensure that they rest for at least 28 working days during the year. Should the company decide to end a contract before these days have been taken, then the employee in question must be compensated for any untaken leave. Do you know how to pay an employee in lieu of annual leave?

The Working Time Regulations 1998 is the statutory instrument that regulates the relationship between the company and its employees. Its contents recognise that holidays are a right and must be taken and can neither be exchanged for cash. Employees can take 28 working days of paid annual leave per year (2.33 for every month worked).

Nevertheless, as we mentioned earlier, the company may decide to terminate a contract before the employee’s annual leave has been taken. What happens in such cases? The company must include the corresponding payment in lieu of annual leave together with the final payment.

We’ve provided a step-by-step explanation on how to calculate payments for untaken annual leave and work out the amount to be paid for every day owed.

How is payment in lieu of annual leave processed in the UK?

The right to rest is regulated in the Working Time Regulations 1998. It states that the amount of annual leave will be agreed between the company and the employee/collective agreement and that exchanging annual leave for cash is prohibited by law. A full-time employee is entitled to the statutory minimum of 28 working days. The employer may include up to eight bank holidays within this total.

The main points that relate to annual leave can be summarised as follows:

• Every employee has the right to at least 28 working days of annual leave.
• They should be taken during a period of one year.
• They are paid holidays.
• They cannot be exchanged for cash.
• Collective agreements can extend annual leave entitlement.

It’s worth pointing out, however, that there are only a few cases in which a company can pay an employee in exchange for holidays:

• Termination of contract: when an employee leaves the company, for any reason including resignation, dismissal, disability or retirement, they must be compensated for any remaining annual leave they may have been entitled to. This is by far the most common scenario.
• Temporary agency workers who have exceeded the 12-week qualifying period: in the UK, such workers are awarded the same rights as directly employed staff and should be paid in lieu of annual leave upon termination of contract.

In either of the above scenarios, the company should therefore arrange payment in lieu of annual leave together with other outstanding extra payments and their salary for any outstanding days worked. The amount that an employee receives when a working relationship terminates is referred to as the final payment.

Formula for calculating payments for untaken annual leave

In an ideal world, employees would leave the company on the last day of the month. That isn’t always the case, however, so you might have to do a few calculations to work out their final pay.

• Work out how many days of annual leave they are entitled to depending on how many months have passed. Then subtract any days they may have already taken to give you the total number of days they are owed.

• Calculate how much they earn in a day:

• 1. For employees on an annual salary, divide it by 52 to get to a weekly amount. Then divide that by five (if they work five days a week) to work out their daily pay.
  2. For employees on a monthly rate, multiply that monthly rate by 12 (months) to calculate their annual salary. Then continue as you would in the example (a) above to determine their daily pay.
• Multiply the number of days owed by the rate of weekly pay.

Example of paying in lieu for untaken annual leave

Let’s look at an example to better understand how to pay an employee in lieu for untaken annual leave.

An employee receives a salary of £25,000 per year and the company terminates their contract on 30 June. They have already taken 6 of the 28 days of annual leave entitlement up until that point.

Then apply the formula (A X B) – C:

• A = the total annual leave entitlement for the year (5.6 weeks).
• B = the proportion of the year that has passed before the end of the contract (number of months divided by total of month in the year).
• C = the number of days’ holiday the employee has already taken divided by 5 (days in a week).

In the case of our example, the formula looks like this:

--> 5.6 X (6 ÷ 12) – (6 ÷ 5)
OR
--> 5.6 x 0.5 – 1.2 = 1.6 weeks to be paid in lieu (8 days)

How do we calculate payment in lieu of annual leave? We now need to determine the daily rate of pay for this employee:

The weekly rate above should now be multiplied by the number of days of annual leave owed.

£96.16 X 8 = £769.28 to be paid in lieu of annual leave.

By following these steps, you will already have the amount that the company must include in the employee’s final pay. Cases may arise where the employee has taken more leave than they were entitled to, in which case they would “owe” the company money. The corresponding amount can be subtracted from the total included in the final payment.

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