Calculating Payment in Lieu of Unused Annual Leave upon Termination

Payment in lieu of accrued, untaken annual leave is typically one of the final financial items resolved upon the termination of employment — and one of the most frequently disputed before the Employment Tribunal. The root cause almost always lies in determining accrued remaining leave entitlement upon departure and correctly calculating the reference holiday pay rate, rather than straightforward arithmetic.

The Statutory Entitlement

Regulation 14 Working Time Regulations 1998 / Art. 7 (2) Directive 2003/88/EC

Where a worker's employment is terminated during the course of a leave year, and the proportion of statutory annual leave they have taken is less than the proportion of the leave year that has expired, the employer must make a payment in lieu of the untaken statutory leave.

Under Regulation 14 of the Working Time Regulations 1998 (WTR 1998), the statutory entitlement to payment in lieu arises strictly upon termination of the employment relationship, not before. Paying cash in lieu of the statutory 5.6 weeks' annual leave (Regulations 13 and 13A WTR 1998) during an ongoing contract is strictly prohibited by law. Statutory annual leave is designed to ensure worker health, safety, and rest, and cannot be replaced with monetary compensation during employment.

Step 1: Determining Outstanding Accrued Days

Upon termination, the employer must calculate the worker's accrued statutory leave entitlement for the current leave year up to the effective date of termination (EDT), add any valid carried-over leave, and deduct any leave days already taken.

Statutory Accrual Formula (Regulation 14(3) WTR 1998):

Unless a relevant agreement (such as a contract of employment) provides an alternative formula, the statutory proportion is calculated as:

$$\left(A \times B\right) - C$$

Where:

• A is the worker's total annual statutory leave entitlement (minimum 5.6 weeks / 28 days for a 5-day week worker).
• B is the proportion of the leave year elapsed up to the termination date (days elapsed divided by 365, or completed months/weeks).
• C is the amount of leave already taken by the worker in that leave year.

If the result is positive, the balance must be paid in lieu. If the worker has taken more leave than accrued ($C > A \times B$), the employer may only deduct the excess pay from the final wage packet if an express written contractual clause or prior written agreement permits deductions under Section 13 of the Employment Rights Act 1996 (ERA 1996).

Step 2: Calculating the Pay Rate (Holiday Pay)

Holiday pay and payments in lieu are calculated in accordance with Sections 221 to 224 of the Employment Rights Act 1996 and Regulations 16 and 14 WTR 1998.

Workers with Fixed Hours and Fixed Pay: For workers with normal working hours whose remuneration does not vary, holiday pay is based on their basic contractual rate of pay for a normal working week or day.

Workers with Variable Hours, Overtime, or Commission: For workers with variable hours, shift patterns, or irregular remuneration (including regular non-guaranteed overtime, commission, and performance-related bonuses forming part of normal remuneration):

1. Determine average weekly earnings across the statutory 52-week reference period immediately preceding the termination date.
2. In accordance with Section 224 ERA 1996, any weeks in which the worker received no remuneration are excluded, stepping back up to a maximum of 104 weeks to capture 52 paid weeks.
3. Include regular overtime, commission, and shift allowances that form an intrinsic part of the employee's normal remuneration.
4. Divide the weekly average by the number of days normally worked per week to establish the daily holiday pay rate.
5. Daily rate × accrued untaken leave days = Total payment in lieu of annual leave.

Weeks during statutory maternity, paternity, or certified sickness where full pay was not received must be replaced with earlier normal working weeks to prevent distorting the reference average.

Step 3: Tax and National Insurance Contributions (PAYE)

A payment in lieu of accrued annual leave constitutes earned employment income and taxable remuneration. It is not compensatory severance or damages for loss of office:

• PAYE Income Tax & Class 1 NICs: The payment must be processed through payroll via Real Time Information (RTI) for the final pay period, subject to standard PAYE income tax and Class 1 National Insurance Contributions (both employee and employer NICs).
• Exemption from £30,000 Tax Exemption: Unlike statutory redundancy pay or qualifying ex-gratia termination payments (which benefit from the £30,000 income tax exemption under Section 403 ITEPA 2003), payments in lieu of accrued leave are fully taxable earnings and cannot be paid tax-free.

Limitation Periods and Employment Tribunal Claims

A payment in lieu of unused annual leave becomes payable on the termination date or in the final payroll cycle. If an employer fails to pay or underpays the entitlement:

• Unlawful Deduction from Wages (Section 13 ERA 1996) / Breach of WTR 1998: The worker must initiate ACAS Early Conciliation and lodge a claim with the Employment Tribunal within three months less one day from the date the payment was due.
• Breach of Contract: If pursued as a common law breach of contract claim in the civil courts (County Court or High Court), the limitation period is six years from the date of breach.

Failure to pay accrued statutory leave leaves employers exposed to tribunal awards, including compensation for financial loss suffered by the worker.

Garden Leave and Notice Periods

Where an employee is placed on garden leave during their notice period, an employer may seek to offset outstanding annual leave against the garden leave period.

To do so lawfully:

1. Contractual Authority or Statutory Notice: The employer must have express contractual authority to require annual leave during notice, or issue formal statutory notice under Regulation 15 WTR 1998.
2. Notice Requirements: Under Regulation 15(2)(a), read with the timing rules in Regulation 15(4)-(5), the employer must give advance notice at least twice the length of the leave period required to be taken (e.g., 10 working days' notice to require an employee to take 5 days of leave), unless the contract of employment specifies an alternative notice mechanism.
3. Sickness during Garden Leave: If the employee becomes medically incapacitated and submits a medical fit note during garden leave, the days covered by sickness do not count as taken annual leave and must instead be treated as sick leave, leaving the holiday entitlement to be paid out upon termination.

Death in Service

Where an employment contract is brought to an end by the death of the worker, the statutory right to payment in lieu of accrued, untaken annual leave does not extinguish. In accordance with established ECJ jurisprudence (Joined Cases C-569/16 and C-570/16 Bauer) and UK employment law, the monetary compensation for accrued annual leave forms part of the deceased's estate and must be paid to their personal representatives.

Contractual vs. Statutory Annual Leave

Employment contracts often grant holiday entitlements in excess of the statutory minimum 5.6 weeks (known as contractual or supplemental leave):

• Statutory 5.6 Weeks: Governed strictly by the Working Time Regulations 1998, non-derogable, and protected against unlawful forfeiture.
• Contractual Leave in Excess of 28 Days: Employers and employees may agree bespoke contractual terms governing the accrual, carry-over, and calculation of pay in lieu for contractual leave upon departure (such as requiring forfeiture if the employee resigns without full notice or is dismissed for gross misconduct), provided this is set out unambiguously in the written statement of employment particulars or contract of employment.

Statutory Framework and Key Authorities

Legislation and Statutory Instruments

• Working Time Regulations 1998 (SI 1998/1833) — Regulations 13, 13A, 14 (Payment in lieu on termination), 15 (Notice of leave), and 16 (Payment in respect of periods of leave)
• Employment Rights Act 1996 — Section 13 (Protection of wages), Sections 221–224 (Calculation of a week's pay and the 52-week reference period)
• Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) — Taxation of employment income and termination awards
• Directive 2003/88/EC (EU Working Time Directive) — Article 7 (Annual leave and payment in lieu principles)

Key Case Law

• Court of Appeal – Harpur Trust v Brazel [2022] UKSC 21 — Calculation of statutory annual leave and holiday pay for permanent part-year workers
• Court of Justice of the European Union – King v The Sash Window Workshop Ltd (Case C-214/16) — Entitlement to carry over and payment in lieu of leave where the employer failed to provide paid leave
• ECJ – Joined Cases C-569/16 and C-570/16 (Bauer and Willmeroth) — Financial compensation for accrued annual leave transfers to the worker's estate upon death
• ECJ – Kreuziger v Land Berlin (Case C-619/16) and Max-Planck-Gesellschaft v Shimizu (Case C-684/16) — Loss of leave requires clear evidence that the employer enabled the worker to take leave and informed them of forfeiture

Legal analysis as of August 2026. This article provides general operational and compliance guidance and does not constitute formal legal advice for specific employment disputes.