The salesperson hands in their notice on a Friday. By Monday, you want them off the premises, away from the clients, and unable to brief a competitor. A PILON payment looks like the obvious answer: pay them out, end the contract, move on. Hundreds of employers do exactly this every year. Some of them hand that departing employee a legal free pass to the customer list in the process.

Whether you are making your first PILON payment or reviewing how your contracts handle termination, this article covers what a PILON is, how it is taxed, what it must include, and the clause that makes the difference between a clean exit and an expensive one.

What is a PILON payment?

PILON stands for Payment in Lieu of Notice. Instead of requiring an employee to work their notice period, the employer pays the equivalent salary and, depending on the contract, other contractual benefits, in a lump sum and ends the employment immediately.

Every employee has a statutory minimum notice entitlement under the Employment Rights Act 1996: one week after one month of service, rising by one week for each year of employment up to a maximum of twelve weeks. Most employment contracts provide longer contractual notice, one month, three months, or more. The PILON replaces the pay the employee would have received during that period.

A PILON is not the same as redundancy pay. It is not a settlement payment. It is simply the monetary equivalent of the notice period the employee is not working. The two are often confused because they appear in the same conversation and sometimes in the same settlement agreement, but they are legally and taxably distinct. 

Is a PILON payment taxable?

Yes. Since 6 April 2018, all PILON payments, whether or not the employment contract contains a PILON clause, are fully subject to income tax and Class 1 National Insurance contributions. This is not optional and it is not discretionary. HMRC's position is clear.

Before 2018, the position was more nuanced. If a contract contained no express PILON clause, an employer paying in lieu was technically making a damages payment rather than a contractual one, and that payment could in some circumstances fall within the £30,000 termination payment exemption. That route closed with the Finance (No.2) Act 2017, which introduced the concept of Post-Employment Notice Pay, known as PENP.

The legislation works by requiring employers to calculate the PENP, the amount of basic pay attributable to the unworked notice period, and subject that figure to income tax and Class 1 NIC through payroll. There are no workaround and no exemption for the notice pay element.

How the PENP calculation works

The Post-Employment Notice Pay formula is straightforward in principle. HMRC defines it as:

PENP = (Basic Pay x Days in Unworked Notice Period) / Days in Last Pay Period

Basic pay for PENP purposes means salary only. It excludes commission, bonuses, overtime, benefits in kind, and pension contributions. If your departing salesperson earns a £60,000 base salary plus commission, the PENP calculation is based on the £60,000 alone, but any commission the contract requires you to pay during the notice period should be accounted for separately in the overall package.

Where the PILON payment exceeds the PENP figure, for example because the contract requires you to continue providing a car allowance or private medical cover during notice, the excess may qualify for the £30,000 exemption depending on its nature. The PENP itself does not.

What about the £30,000 tax-free exemption?

The £30,000 exemption for termination payments still exists. It applies to genuine ex-gratia payments, amounts the employer is not contractually obliged to pay, which compensate the employee for the loss of employment rather than for work done or notice owed. Enhanced redundancy pay above the statutory minimum is the most common example.

What the exemption does not cover is the PENP. The legislation separates the two explicitly: calculate the PENP first, tax it in full through payroll, and only then consider whether any remaining termination payment qualifies for the exemption.

This matters when structuring an exit package. An employer who conflates the PILON with a lumpsum exit payment and treats the whole sum as potentially exempt is making an error that HMRC will correct, with interest and penalties. The components must be identified and treated separately in the settlement agreement or payroll record.

Does a PILON payment include holiday pay?

No, not automatically. This is one of the most common assumptions employers make, and it leads to underpayment claims.

Under the Working Time Regulations 1998, employees accrue paid annual leave throughout their employment. When employment ends, including where it ends by way of a PILON payment, any accrued but untaken leave must be paid out. That payment is separate from the PILON itself.

If an employee has taken more leave than they have accrued by the termination date, the contract may permit the employer to make a deduction. If they have taken less, the employer must pay the balance. Failing to do so creates a potential claim for unlawful deduction from wages under the Employment Rights Act 1996.

When drafting a PILON payment letter or settlement agreement, itemise the PILON and the holiday pay separately. Both figures need to be correct; both need to be documented.

The risk some employers miss: what happens without a PILON clause

This is the part most employment law overviews skip past, and it is the part that costs employers money.

An employer cannot make a PILON payment simply because it wants to. Without an express PILON clause in the employment contract, paying an employee in lieu of notice instead of requiring them to work it is a breach of contract by the employer. The employer is failing to provide work and the opportunity to earn during the notice period.

Under the principle established in General Billposting Company v Atkinson [1909] AC 118, where an employer wrongfully repudiates a contract, the employee is released from their obligations under it. Those obligations include post-termination restrictions: the non-compete covenant that prevents them working for a direct competitor for six or twelve months, the non-solicitation covenant that stops them approaching your clients and candidates.

The scenario plays out like this. Your head of sales resigns. You want them off the floor. You pay them three months in lieu and send them home. Your contract contains no PILON clause. You have just breached the contract. Your former head of sales is now, at law, free to call every client on your list the following Monday morning, because the restrictions that would have prevented it no longer bind them.

This is not a theoretical risk. It is a well-established legal principle that employment tribunals and courts apply consistently. It catches employers who are in a hurry, which is almost always the situation when someone you want gone is handing over to a competitor.

The fix costs nothing. A properly drafted PILON clause in every employment contract, inserted before you ever need to use one, gives you the contractual right to elect to pay in lieu, preserves the employment contract as the legal basis for the exit, and keeps the post-termination restrictions enforceable. Without it, every PILON you make is a gamble on whether the other side will notice.

If you are already in this position, a PILON has been paid without a clause and the restrictions now look vulnerable, take legal advice immediately. There are arguments available depending on how the exit was documented, but the window closes quickly once the employee's new employer's solicitors get involved.

Garden leave vs a PILON payment: which should you use?

Garden leave and a PILON payment are often discussed as if they are alternatives. They are not the same thing and they do not carry the same legal consequences.

During garden leave, the employee remains employed. They continue to receive their salary and contractual benefits. They are required to stay away from the business, clients, and competitors. The employment contract remains live throughout. Post-termination restrictions continue to accrue against the garden leave period, and the employee cannot argue that the contract has been breached because the employer is honouring every obligation under it.

A PILON ends the employment on the date the payment is made. It is faster and often cleaner. But without a PILON clause it creates breach of contract risk, and even with one it shortens the clock on any restrictions timed from the end of employment rather than the end of notice.

For senior employees with access to client relationships, sensitive pricing information, or proprietary methodology, garden leave is generally the stronger protection. For lower-risk exits where the priority is speed, a properly documented PILON with an express contractual right is effective and proportionate. The best contracts include both clauses and give the employer the choice at the point of termination, depending on the individual and the circumstances.

PILON payments in settlement agreements

Settlement agreements are the mechanism through which employment claims are compromised in exchange for a payment. They appear in redundancy situations, performance-managed exits, and cases where the employer simply wants certainty that the employee will not bring a tribunal claim.

A settlement agreement involving a PILON must identify each payment element clearly: the PILON itself (subject to tax and NIC as PENP), any enhanced redundancy payment (potentially eligible for the £30,000 exemption above the statutory minimum), any contribution to legal fees (generally exempt up to £500 per HMRC guidance), and the accrued holiday pay. HMRC expects the tax treatment to be correct on the date of payment, it is not the employee's responsibility to resolve it after the event.

ACAS early conciliation is a mandatory step before most employment tribunal claims can proceed. Where a settlement is reached through ACAS using a COT3 agreement rather than a formal settlement agreement, the £30,000 exemption applies in the same way, and the tax treatment of the PENP element is unchanged.

Frequently asked questions about PILON payments

Is a PILON payment the same as redundancy pay?

No. A PILON replaces the salary an employee would have earned during their notice period. Redundancy pay compensates for the loss of the role itself. The two are calculated differently, taxed differently, and arise from different legal bases. They often appear together in an exit package but must be treated separately in the payroll record and in any settlement agreement.

Can an employer make a PILON payment without a clause in the contract?

Yes, but at significant risk. Without an express PILON clause, paying in lieu is a breach of contract by the employer. That breach may release the employee from post-termination restrictions, including non-compete and non-solicitation covenants. If the employee has access to client relationships or commercially sensitive information, this is not a theoretical concern.

Does a PILON payment affect pension contributions?

Usually not. The PILON represents pay for a period the employee does not work, and most pension schemes are structured around contributions on actual pay earned. However, this depends on the scheme rules and the contract terms. If the contract expressly requires pension contributions to continue during notice, the PILON calculation should reflect the employer's contribution. Take advice if the scheme is defined benefit or the contract is silent on the point.

How does the Employment Rights Act 2025 affect PILON payments?

The Employment Rights Act 2025 extended day-one unfair dismissal rights and changed the landscape around dismissal procedures more broadly. The tax treatment of PILON payments is set by the Finance (No.2) Act 2017 and remains unchanged by the 2025 legislation. However, the risk attached to a poorly managed exit, including one where a PILON is paid without a contractual right, increases as tribunal access improves and the number of eligible claimants grows.

Get your contracts right before you need to use them

Employment contracts drafted two or three years ago may contain no PILON clause at all. If that describes your business, the exposure is sitting in every senior employee's contract right now, waiting for the next resignation. The HR Doctor reviews and updates employment contracts as part of the Compliance Confidence Kit: identifying gaps, drafting the clauses that protect you, and keeping your documentation current as the law changes.

To find out where your contracts stand, book a free 30-minute discovery call with The HR Doctor.