Salary Sacrifice: Definition & How It Works

Salary sacrifice (also called salary exchange) is an arrangement where an employee agrees to give up a portion of their gross salary in exchange for non-cash benefits that have tax advantages. The sacrificed amount is deducted before income tax and National Insurance are calculated, reducing the employee’s taxable income and often resulting in lower overall tax.

Salary sacrifice is widely used in the UK for benefits such as pension contributions, cycle-to-work schemes, childcare vouchers, and electric vehicle leasing. Understanding how it works is essential for HR and payroll teams, particularly because it affects statutory payments like holiday pay.

Key Takeaways

• Salary sacrifice reduces an employee’s gross salary in exchange for non-cash benefits, lowering income tax and National Insurance contributions.
• Common UK salary sacrifice benefits include pension contributions, cycle-to-work schemes, childcare, and electric vehicles.
• Salary sacrifice affects statutory holiday pay — annual leave is paid on the reduced (post-sacrifice) salary, not the original gross.
• Employers also save on employer National Insurance contributions, which are 13.8% on earnings above the secondary threshold.
• Salary sacrifice arrangements must be documented in writing and comply with HMRC rules.

How Salary Sacrifice Works

The mechanics of salary sacrifice are straightforward:

1. Employee and employer agree on a sacrifice amount (e.g., £3,000 per year)
2. The employee’s gross salary is reduced by that amount (from £30,000 to £27,000)
3. The employer uses the £3,000 to provide a non-cash benefit (e.g., pension contribution, cycle scheme)
4. The employee pays income tax and National Insurance on £27,000 instead of £30,000
5. The employer pays employer National Insurance on £27,000 instead of £30,000

Worked Example: Pension Salary Sacrifice

Component	Before Sacrifice	After Sacrifice
Gross salary	£30,000	£27,000
Sacrifice amount	£0	£3,000
Pension contribution	Employee contributes £2,400	Employer contributes £5,400
Income tax (20% on amount above £12,570)	£3,486	£2,886
Employee NI (8% on amount above £12,570)	£1,394	£1,154
Employee takes home	£22,120 + £2,400 pension	£22,960 + £5,400 pension

The employee is £2,060 better off annually (higher pension contributions plus lower tax). The employer saves approximately £414 in NI contributions.

Common Salary Sacrifice Benefits in the UK

Benefit	How It Works	Tax Advantage
Pension contributions	Employer makes enhanced contributions from sacrificed salary	Income tax + NI saved; employer NI saved
Cycle to work scheme	Employer provides a bicycle and accessories	No income tax or NI on the benefit
Childcare vouchers	Employer provides vouchers for registered childcare	No income tax or NI (within limits)
Electric vehicles	Employer leases an EV for the employee	BIK tax is typically 2-5%, much lower than petrol/diesel
Technology equipment	Employer provides laptops, phones, tablets	Exempt from tax if work-related
Health screening	Employer provides health checks	Exempt benefit under HMRC rules

Pension Salary Sacrifice: The Most Common Use

Since the employer NI saving was reformed in 2025-26, pension salary sacrifice has become the most popular form. The employer saves 13.8% NI on the sacrificed amount, which often funds enhanced pension contributions at no net cost.

For higher-rate taxpayers, the savings are particularly significant because salary sacrifice reduces adjusted net income, potentially preserving personal allowance and child benefit entitlements.

Impact on Holiday Pay

This is a critical consideration that many employees and employers overlook. In the UK, statutory holiday pay is calculated based on gross pay — and salary sacrifice reduces gross pay.

How It Affects Annual Leave

Under the Employment Rights Act 1996, holiday pay should reflect what the employee would have earned if they had been working. For salary sacrifice employees, this means:

• Statutory holiday pay is based on the post-sacrifice salary, not the original gross
• Week’s pay calculation: If an employee’s pre-sacrifice salary is £30,000 and they sacrifice £3,000, their statutory holiday pay is calculated on £27,000
• Contractual holiday pay may differ — some employers pay full salary during leave regardless of sacrifice

Worked Example: Holiday Pay Impact

Factor	Value
Original gross salary	£30,000
Salary sacrifice	£3,000
Post-sacrifice gross salary	£27,000
Weekly statutory holiday pay	£27,000 ÷ 52 = £519.23

Without salary sacrifice, the statutory weekly holiday pay would have been £576.92. The difference is £57.69 per week.

Protections for Higher Earners

The Employment Rights Act 1996 provides that holiday pay should reflect “normal remuneration” — including regular salary sacrifice amounts where they form part of the employee’s normal pay. However, the legal position on whether salary sacrifice should be included in holiday pay calculations has been subject to case law developments.

The safest approach for employers is to pay contractual holiday pay that includes the sacrificed amount, or to clearly document in the salary sacrifice agreement how holiday pay will be treated.

Employer Obligations

HMRC Requirements

Salary sacrifice arrangements must meet HMRC criteria:

• The arrangement must be a genuine sacrifice — the employee must give up cash salary before it is earned
• The sacrifice must be documented in writing, ideally through a formal agreement
• The arrangement cannot reduce pay below the National Minimum Wage
• Benefits must be provided by the employer, not purchased directly by the employee with pre-tax money

National Minimum Wage

The sacrificed amount cannot reduce the employee’s pay below the National Minimum Wage. For 2025-26:

Age Group	NMW (per hour)
21 and over	£11.44
18-20	£8.60
Under 18	£6.40
Apprentice	£6.40

An employee earning just above the NMW may not be able to sacrifice any salary without falling below the threshold.

Employer NI Savings

One of the employer incentives for salary sacrifice is the NI saving. With employer NI at 13.8% (rising from 13.25% in 2025-26), an employer can save significant amounts:

Sacrificed Amount	Employer NI Saving (13.8%)
£1,000	£138
£3,000	£414
£5,000	£690
£10,000	£1,380

For a company with 100 employees each sacrificing £3,000 for pension, the annual NI saving is approximately £41,400.

Salary Sacrifice vs Other Arrangements

Feature	Salary Sacrifice	Additonal Voluntary Contribution	Direct Pension Contribution
How it works	Give up salary for benefit	Employee pays extra from net pay	Employer pays from employer funds
Tax treatment	Pre-tax deduction	Post-tax deduction	Pre-tax deduction
NI savings	Employee + employer	None	Employer only
Affects gross salary	Yes	No	No
Holiday pay impact	Potentially reduces statutory pay	No impact	No impact
Flexibility	Fixed at start of year	Employee can change monthly	Employer decides

Setting Up a Salary Sacrifice Arrangement

Step 1: Determine Eligibility

Check that the employee’s salary after sacrifice will not fall below the National Minimum Wage. Consider whether the employee is already in a pension scheme with auto-enrolment obligations.

Step 2: Draft the Agreement

The salary sacrifice agreement must include:

• The amount or percentage of salary being sacrificed
• The benefit to be provided in exchange
• The start and end dates of the arrangement
• How holiday pay will be treated
• What happens if the employee leaves employment
• The employee’s right to revoke the arrangement (typically at annual review)

Step 3: Communicate to Employees

Provide clear written information about the tax savings, the effect on gross pay, and how the arrangement affects holiday pay, pension contributions, and statutory payments.

Step 4: Update Payroll

Adjust the payroll system to reflect the reduced gross salary and ensure the benefit is correctly reported to HMRC.

Frequently Asked Questions

Does salary sacrifice reduce my pension contributions?

No, the opposite is true. Pension salary sacrifice increases your pension contributions. The employer makes enhanced contributions from the sacrificed salary, and the tax savings mean the employee often contributes less from net pay while receiving a larger total pension benefit.

Can I salary sacrifice if I earn minimum wage?

Generally, no. The sacrifice cannot reduce your gross pay below the National Minimum Wage. If your salary is close to the NMW threshold, you may be able to sacrifice only a very small amount, or the arrangement may not be viable.

How does salary sacrifice affect my mortgage application?

Mortgage lenders typically base affordability assessments on your gross salary. Since salary sacrifice reduces your stated gross salary, it could reduce the amount a lender is willing to offer. This is a significant consideration for employees planning to buy a property.

Is salary sacrifice worth it for higher-rate taxpayers?

Yes, salary sacrifice is particularly beneficial for higher-rate taxpayers because the income tax saving is 40% (compared to 20% for basic-rate taxpayers). Combined with the NI saving, higher-rate taxpayers can save significantly more than basic-rate taxpayers on the same sacrifice amount.

Can my employer change the salary sacrifice terms mid-year?

Salary sacrifice arrangements are generally fixed for the tax year and cannot be unilaterally changed by the employer. Any changes require the employee’s consent. Most agreements allow review at the start of each tax year, with either party able to give notice of termination.