What Is The Difference Between PAYG Withholding And Instalments

By Andrew Erkins | 13 March 2015

Pay As You Go (PAYG) is the system the Australian Taxation Office (ATO) uses to collect tax throughout the year, rather than leaving you with one massive bill at tax time. There are two types - PAYG withholding and PAYG instalments - and they work differently. Here's what Australian business owners need to know about both.

The two types of PAYG in Australia

The easiest way to think about it: one is tax you collect on behalf of your employees, and the other is tax you pay on behalf of your business.

• PAYG Withholding (PAYG-W) - you deduct income tax from your employees' wages and pay it to the ATO on their behalf. This ensures they don't face a large tax bill at the end of the financial year.
• PAYG Instalments (PAYG-I) - your business makes regular pre-payments towards its own expected income tax liability. This applies to companies, sole traders, and trusts earning business or investment income above the ATO's threshold.

Both are reported through your Business Activity Statement (BAS) or Instalment Activity Statement (IAS), and both are designed to smooth out tax obligations across the year rather than creating a cashflow shock in October.

PAYG withholding: what employers need to know

If you employ anyone in Australia - whether full-time, part-time, or casual - you're required to withhold tax from their wages and remit it to the ATO. This also applies to payments made to directors, contractors who haven't quoted an Australian Business Number (ABN), and workers under voluntary agreements.

How to register

You can register for PAYG withholding when you apply for your ABN, or later through your myGovID account. Once registered, you're required to:

• Withhold the correct amount from each pay based on the ATO's tax tables
• Report withheld amounts through Single Touch Payroll (STP) each pay cycle
• Lodge your BAS or IAS and pay the withheld amounts to the ATO by the due date

Getting the withholding amount right

The amount you withhold depends on your employee's earnings, their Tax File Number (TFN) declaration, and whether they've claimed the tax-free threshold. If an employee hasn't provided a TFN declaration, you must withhold at the top marginal rate - which nobody wants.

In Xero, PAYG withholding is calculated automatically based on the ATO's current tax tables. When you run a pay, Xero applies the correct withholding rate, generates your STP report, and pre-fills the PAYG-W amounts on your Activity Statement. The key is making sure your employee setup is correct - the right tax table, residency status, STSL (study loan) flags, and tax-free threshold claims all affect the calculation.

Reporting frequency

How often you lodge and pay PAYG-W depends on your annual withholding obligation:

• Quarterly - if your annual PAYG-W is less than $25,000 (most small businesses)
• Monthly - if your annual PAYG-W is $25,000 or more but less than $1 million

Regardless of your lodgement cycle, Single Touch Payroll means the ATO receives your withholding data every time you run a pay. The BAS/IAS is your payment mechanism.

PAYG instalments: pre-paying your business tax

PAYG instalments are the ATO's way of making sure businesses and investors pay tax progressively throughout the year, rather than facing a large bill after lodging their annual return.

The ATO will enter you into the PAYG instalment system automatically based on your most recent tax return. You'll be notified if your instalment rate is greater than 0% or if your notional tax exceeds $500. For the 2025-26 financial year, the ATO applies a GDP adjustment factor of 4% to instalment amounts, which adjusts your pre-payments upward to reflect expected income growth.

Two methods for calculating instalments

The ATO gives you two options:

• Option 1 - Instalment amount: The ATO calculates a fixed dollar amount based on your most recent tax return. You pay this amount each quarter (or monthly for larger businesses). Simple, but it may not reflect your actual income if things have changed.
• Option 2 - Instalment rate: You multiply your actual instalment income for the period by the ATO-provided instalment rate. This method adjusts automatically when income rises or falls, making it better for businesses with variable revenue.

If your gross business and investment income exceeds $2 million, you're generally required to use the instalment rate method. For everyone else, you can choose whichever method suits your cashflow better. Once you choose, your selection applies for the rest of the income year.

Can you vary your instalments?

Yes. If your business circumstances have changed significantly - revenue dropped, you sold an asset, or a major contract ended - you can vary your instalment amount or rate on your next Activity Statement. This avoids overpaying tax throughout the year and keeps your cashflow working for your business.

A word of caution: if you vary your instalments too aggressively and underpay, you could end up with a large tax bill at year end, plus the ATO's General Interest Charge (GIC) on the shortfall. Get it right by reviewing your position each quarter - or better yet, have your bookkeeper or BAS agent keep an eye on it.

How PAYG instalments work in Xero

Xero pre-fills your Activity Statement with PAYG instalment amounts at label T7 (instalment amount) or labels T2 and T8 (instalment rate and instalment income). If you're using the instalment amount method, Xero pulls the ATO-notified amount. If you're using the instalment rate method, you'll need to confirm your instalment income for the period and apply the rate.

The important thing is to review these figures before lodging - don't just accept the defaults if your business income has changed materially since your last tax return.

How PAYG appears on your BAS

Both types of PAYG are reported on your Business Activity Statement, but in different sections:

• PAYG-W (withholding) appears at labels W1 (total salary and wages) and W2 (amounts withheld from salary and wages), plus W3 and W4 for other withholding amounts like voluntary agreements or no-ABN payments
• PAYG-I (instalments) appears at label T7 (instalment amount method) or labels T2 and T8 (instalment rate method)

Both sections combine with your GST position to determine whether you owe the ATO money or are due a refund for the period. This is why accurate bookkeeping throughout the quarter matters - errors in either PAYG type flow directly into your BAS liability.

Common PAYG mistakes we see in Australian businesses

After working with hundreds of Australian businesses on Xero, these are the PAYG issues that come up most often:

• Not registering for PAYG-W before the first pay run - if you've hired your first employee and haven't registered, you're already behind on your obligations
• Wrong tax table applied - using the wrong residency status, missing a STSL debt flag, or not claiming the tax-free threshold correctly all produce incorrect withholding
• Ignoring the GDP adjustment on instalments - the 4% uplift for 2025-26 means your instalment amount is higher than last year, even if your income hasn't changed. Budget for it
• Never varying instalments when income drops - some business owners keep paying the ATO-notified amount even when revenue has fallen significantly, tying up cash unnecessarily
• Varying too aggressively when income rises - the opposite problem. Reducing instalments when income is actually growing creates an unpleasant surprise at tax time
• Confusing PAYG-W with PAYG-I - they're both "PAYG" but they're fundamentally different obligations. One is money you owe on behalf of your team, the other is money your business owes on its own income

The connection between PAYG and Single Touch Payroll

Since Single Touch Payroll (STP) Phase 2 rolled out across Australia, PAYG withholding data is reported to the ATO every time you process a pay run - not just at BAS time. This means the ATO has real-time visibility of your withholding obligations, and any discrepancies between your STP reports and your BAS will be flagged.

STP doesn't change when or how you pay PAYG-W to the ATO (that's still through your BAS), but it does mean the ATO knows what you owe before you lodge. Keeping your Xero payroll accurate and up to date isn't just good practice - it's the compliance baseline.

When should you get help?

PAYG is straightforward in principle but gets complex quickly - especially when you're managing multiple employees across different award rates, dealing with contractors, or trying to optimise your instalment payments for cashflow.

A registered BAS agent can lodge your Activity Statements, manage your PAYG obligations, and - importantly - you get an extra four weeks to lodge and pay when a registered agent handles it for you. That's a genuine cashflow benefit that many business owners don't realise they're missing.

If you'd like help getting your PAYG sorted - whether it's cleaning up withholding errors in Xero, setting up your first payroll, or reviewing whether your instalment amount still makes sense - our team is here to help.