National minimum wage: Avoid the pitfalls of pay averaging

Earlier this year it was reported that John Lewis set aside £36 million to compensate for a potential national minimum wage breach. As the Government releases its latest list of organisations owing wages, how can employers avoid the same trap? Fiona Rushforth and Katie Whitford of law firm Wedlake Bell explain.

The issue at John Lewis was the retailer’s policy of “pay averaging”, whereby workers’ annual pay is calculated and then paid in equal monthly installments regardless of variations in hours worked in particular months.

The reason for the policy is to provide the workers with certainty and stability, as well as more budgeting certainty for the company.

The error is likely to have affected thousands of workers and former workers, and was spotted when one employee queried her payslip. The error has prompted a review with HMRC, which is ongoing.

But why does pay averaging, which can benefit both employers and workers, potentially cause a breach of the NMW regulations?

The regulations differentiate between types of work, the key categories being:

• salaried hours work, where workers are paid for a fixed number of hours’ work in a year and paid on an annual salary in weekly/monthly instalments; and
• time work, where workers are paid by reference to time worked (e.g. at an hourly rate).

This difference is key to whether a policy of pay averaging will breach the regulations.

For salaried hours work, it does not matter for NMW purposes if the actual hours worked per month vary because the regulations do allow for pay averaging over the course of a year. Hours worked may vary month by month, but the employer does not need to worry if less than NMW is paid in one month, provided the NMW is paid on average for hours worked over the whole year.

However, for time work, under the regulations the average hourly rate is calculated based on a ‘pay reference period’ of between one week and one month depending on the worker’s normal pay period. The pay reference period cannot be longer than one month.

The worker’s pay for that period is divided by their hours worked during the same period, giving the average hourly rate.

If this is lower than the relevant national minimum wage, the worker’s employer (or the person responsible for pay in the case of agency workers) has breached the NMW legislation. This means that if the employee works more hours than normal in a particular pay period, the employer may be in breach.

Failure to pay the NMW can result in significant financial penalties and reputational damage. Where there is a breach of the NMW regulations, HMRC will require arrears to be repaid to employees and a financial penalty to be paid to the Secretary of State.

As we’ve seen, the Department for Business, Energy and Industrial Strategy (BEIS) can “name and shame” the employer, and civil proceedings and even criminal enforcement can follow if the non-compliance continues. Employees will have claims against their employer in the employment tribunal or county court.

This is particularly unfortunate for employers because they will be liable to make up the NMW deficit for those pay periods where the employee received less than NMW, even though (if the pay averaging has worked correctly) the same employee will have been overpaid for the time they worked in months where they worked shorter hours, and thus suffered no overall loss.

John Lewis has stated that this is the case for almost all of their affected employees.

How to avoid a national minimum wage breach

Employers who wish to use a policy of pay averaging should consider engaging workers on a salaried basis rather than on an hourly rate. However, if this is not practical, employers should consider how likely they are to fall foul of the regulations.

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If pay is close to minimum wage, and/or there is significant variation in hours from month to month, pay averaging may well be too risky. Employers should carefully audit their pay history to see whether they have paid less than NMW or come close to doing so.

If so, pay averaging is likely to be too risky. This is particularly true now, since the publicity John Lewis has suffered will have brought the issue to the attention of other pay-averaged employees.