TL;DR
- True cost of a £40k employee is £48k+ per year (1.2x salary) after employer NI, pension, and indirect costs1.2x salary
- Break-even vs a £300/day contractor: 160 days (73% utilisation). Below that, contractors are cheaper160 days
- April 2025 NI increase added ~£986/year per employee. Employment Allowance (£10,500) offsets this for small agencies+£986/yr
- At 65% utilisation (agency average), a £40k employee costs £336 per productive day£336/day
💡Quick reference summary. Continue reading for comprehensive analysis and context.
Contractor vs employee cost UK is one of the most searched questions by agency owners for good reason. Get it wrong and you either overspend on contractors you should have hired, or carry permanent staff through months of low utilisation.
This guide gives you the actual numbers. We have calculated the true employer cost at four salary bands, compared those against contractor day rates, and worked out the exact break-even point where permanent hires become cheaper. Every figure uses the current 2025/26 employer NI rate of 15% and the £5,000 secondary threshold.
The True Cost of a Permanent Employee in 2025/26
Most agency owners look at salary and think that is the cost. It is not. The true cost of an employee includes employer National Insurance, pension contributions, statutory benefits, equipment, and the indirect costs of recruitment and training.
Here is the full breakdown for a £40,000 employee using current 2025/26 rates:
| Cost Component | Calculation | Annual Cost |
|---|---|---|
| Gross Salary | £40,000 | |
| Employer NI (15%) | (£40,000 - £5,000) × 15% | £5,250 |
| Employer Pension (3%) | (£40,000 - £6,240) × 3% | £1,013 |
| Sick pay provision | Average 4.4 days/year | ~£700 |
| Equipment and software | Laptop, licences, desk (ongoing) | £500-£1,000 |
| Training and development | £500-£1,000 | |
| Employers' liability insurance | £100-£300 | |
| Total (ongoing year) | £48,063-£48,263 |
That is a 1.2x multiplier on the base salary. For every £1 you pay in salary, budget £1.20 in total employer cost.
In year one, add recruitment fees (15-20% of salary through an agency, amortised over 3 years) and the total rises to £50,000-£53,000. That is 1.25x-1.33x salary.
Do not forget holiday pay
Employees get 28 days paid leave (5.6 weeks including bank holidays). That means 28 out of 252 working days are unproductive but paid. The salary already covers this, but it means your employee only delivers about 196 billable days per year, not 252. Factor this into day-rate comparisons.
True Employer Cost at Four Salary Bands
The multiplier changes slightly at different salary levels because employer NI and pension scale while some fixed costs stay the same:
| Salary Band | Employer NI | Pension (3%) | Other Costs | Total Cost | Multiplier |
|---|---|---|---|---|---|
| £30,000 | £3,750 | £713 | £1,800 | £36,263 | 1.21x |
| £40,000 | £5,250 | £1,013 | £1,800 | £48,063 | 1.20x |
| £50,000 | £6,750 | £1,313 | £1,800 | £59,863 | 1.20x |
| £75,000 | £10,500 | £1,321 | £2,000 | £88,821 | 1.18x |
The pension contribution caps at the upper earnings limit (£50,270), so higher salary bands see a slightly lower multiplier. But the principle holds: budget 1.2x salary as your minimum true cost.
The True Cost of a Contractor
Contractors are simpler to calculate. You pay the day rate. That is it. No employer NI, no pension, no holiday pay, no sick pay, no equipment costs.
| Day Rate | Full Year (220 days) | 3 Days/Week (132 days) | 60% Utilisation |
|---|---|---|---|
| £250/day | £55,000 | £33,000 | £33,000 |
| £300/day | £66,000 | £39,600 | £39,600 |
| £350/day | £77,000 | £46,200 | £46,200 |
| £400/day | £88,000 | £52,800 | £52,800 |
The key advantage is flexibility. You only pay for the days you use. If a project finishes early or a client churns, you stop paying. With a permanent hire, the cost continues regardless.
The disadvantage is the premium. A £300/day contractor costs £66,000 for a full year versus £48,000 for an equivalent permanent hire. That is a 37.5% premium for flexibility and zero bench risk.
Break-Even: When Does a Permanent Hire Become Cheaper?
This is the question every agency owner should be asking. The break-even point is the number of days per year where the permanent hire costs the same as the contractor. Fewer days than this: hire a contractor. More days: hire permanently.
| Day Rate | vs £40k Employee (£48k total) | Break-Even Days | Utilisation % |
|---|---|---|---|
| £250/day | £48,063 | 192 days | 87% |
| £300/day | £48,063 | 160 days | 73% |
| £350/day | £48,063 | 137 days | 62% |
| £400/day | £48,063 | 120 days | 55% |
At £300/day, the break-even is 160 days per year (73% utilisation). If you need someone for more than 3.5 days per week consistently, a permanent hire saves money.
At £250/day, the break-even is 192 days. That is close to the 196 productive employee days (after holidays and sickness). At low day rates, contractors and employees cost nearly the same for full-time work, so the employee wins on knowledge retention and team integration.
The utilisation trap
These break-even numbers assume the employee is 100% utilised on productive work. The typical UK agency utilisation rate is only 65%. At 65% utilisation, a £40,000 employee effectively costs £48,000 / (220 × 0.65) = £336 per productive day. That makes a £300/day contractor look competitive even at high usage levels.
The April 2025 Employer NI Increase: What Changed
From April 2025, employer NI jumped from 13.8% to 15% and the secondary threshold dropped from £9,100 to £5,000. This hit agencies hard.
For a £40,000 employee:
| Regime | Calculation | Employer NI |
|---|---|---|
| Old (pre-April 2025) | (£40,000 - £9,100) × 13.8% | £4,264 |
| New (April 2025+) | (£40,000 - £5,000) × 15% | £5,250 |
| Increase per employee | +£986/year |
That is a 23% increase in employer NI cost per employee. For a 10-person agency all earning £40,000, that adds £9,860 per year to the wage bill.
The data supports what we are seeing: APSCo reported a 24% year-on-year uptick in contractor vacancies in January 2025, and the British Chambers of Commerce found that 82% of firms say the NI rise impacts their business. Agencies are actively shifting toward contractor models to avoid the additional cost.
Employment Allowance: The Offset
The Employment Allowance increased to £10,500 per year (up from £5,000) in April 2025, and the previous £100,000 NI liability cap was removed. This means most agencies can now claim it. For a 10-person agency on £40,000 salaries, the £10,500 allowance covers the entire NI increase (£9,860) and then some.
You cannot claim Employment Allowance if you are a sole director with no other employees, or for deemed employees under IR35.
Inside IR35 vs Outside IR35: The Cost Difference
IR35 status fundamentally changes the cost equation. If a contractor engagement falls inside IR35, the fee-payer (usually the agency) must deduct PAYE income tax, employee NI, and employer NI from the contractor's payments.
For a contractor earning £300/day (£66,000/year):
| Component | Outside IR35 | Inside IR35 |
|---|---|---|
| Gross payment | £66,000 | £66,000 |
| Employer NI (fee-payer bears) | £0 | ~£9,150 |
| Total cost to agency | £66,000 | ~£75,150 |
| Additional cost inside IR35 | +£9,150 (14%) |
Inside IR35 adds approximately 14% to the cost of engaging a contractor. At that point, the financial case for using a contractor instead of a permanent employee mostly disappears, and you lose the employee benefits of knowledge retention, team integration, and better valuation optics.
IR35 penalties can be severe
HMRC can investigate up to 6 years of payments. Penalties range from 30% (careless) to 100% (deliberate concealment) of the unpaid tax. For a £300/day contractor over 3 years, retrospective liability could exceed £50,000. Use HMRC's CEST tool for every engagement, and keep records showing you took "reasonable care".
Need help assessing IR35 status for your contractors? Try our free IR35 checker or talk to our team.
Bench Time: The Hidden Cost Agencies Forget
Bench time is the percentage of paid hours where your permanent staff are not working on billable client work. It is the single biggest reason the true cost of an employee is higher than the salary suggests.
According to The Wow Company's BenchPress report, the average UK agency utilisation rate is 65%. That means 35% of your permanent staff time is unbillable cost. For juniors, utilisation sits around 75%. For directors and founders, it drops to around 33%.
| Utilisation Rate | Bench Time | Wasted Cost/Year | Effective Day Rate |
|---|---|---|---|
| 75% (junior staff) | 25% | £12,000 | £291/day |
| 65% (agency average) | 35% | £16,800 | £336/day |
| 50% (downturn) | 50% | £24,000 | £436/day |
At 65% utilisation, your £40,000 employee with a total cost of £48,000 effectively costs £336 per productive day. That is more than a £300/day contractor who bills only for the days they work.
Contractors eliminate bench risk entirely. You pay for output, not attendance. This is why volatile, project-based agencies tend to lean heavily on contractors, while retainer-based agencies with predictable workloads benefit more from permanent staff.
When to Hire Permanently vs Use Contractors
Here is a decision framework based on the numbers above and what we see working for UK agencies:
| Scenario | Recommendation | Why |
|---|---|---|
| Need under 3 days/week | Contractor | Below break-even at all day rates |
| 3-4 days/week, uncertain duration | Contractor (review at 6 months) | Hedge against downturn risk |
| 4-5 days/week, 6+ month horizon | Employee | Cheaper at high utilisation; knowledge retention |
| Specialist niche skill, short project | Contractor | Access talent you cannot retain full-time |
| Building for agency sale | Employee | Higher EBITDA multiple (1-2x more) |
| Agency under 5 people, volatile revenue | Contractor-heavy | Minimise fixed costs; survive revenue dips |
| 10+ people, 60%+ retainer revenue | Hybrid | Employees for baseline; contractors for peaks |
The most successful agencies we work with run a hybrid model: permanent staff cover 60-70% of baseline capacity, with contractors handling overflow, specialist requirements, and seasonal peaks.
How Your Workforce Model Affects Agency Valuation
If you are planning to sell your agency in the next 3-5 years, your contractor-to-employee ratio matters more than most owners realise.
Agency valuations typically use EBITDA multiples of 4x-7x for mid-size agencies. Employee-heavy agencies with recurring retainer revenue command multiples 1-2x higher than contractor-dependent agencies. Here is why:
Employee-Heavy Agency
- Predictable recurring costs
- Team continuity for clients
- Retained IP and knowledge
- Enables retainer-based revenue
- 6-7x EBITDA multiple typical
Contractor-Heavy Agency
- Variable, unpredictable costs
- Key person risk (contractors leave)
- Limited IP ownership
- Project-based revenue dominates
- 4-5x EBITDA multiple typical
For a £1m revenue agency with 20% EBITDA margin, that 1-2x multiple difference means £200,000-£400,000 in valuation. Worth thinking about if an exit is on the horizon. Read more in our agency valuation guide.
What Changes in April 2026
Several regulatory changes landing in April 2026 affect the contractor vs employee decision:
IR35 small company thresholds increase
Turnover threshold rises from £10.2m to £15m and balance sheet from £5.1m to £7.5m. More end clients will now qualify as "small," shifting IR35 determination responsibility back to the contractor. This reduces compliance burden for agencies working with larger clients.
New umbrella company obligations
End clients must ensure umbrella companies correctly operate PAYE and NICs. This adds a compliance layer for agencies using umbrellas for inside-IR35 contractors.
SSP from day 1
Statutory Sick Pay becomes payable from day 1 of absence (previously day 4) and the Lower Earnings Limit is removed. This slightly increases the cost of permanent employees, particularly in roles with higher absence rates.
Dividend tax increase
Basic rate dividend tax rises from 8.75% to 10.75% and higher rate from 33.75% to 35.75%. This affects agency owners personally (how they extract profit) but does not directly change employee vs contractor costs. Read our full dividend tax guide.
Two Strategies to Reduce Employee Costs
1. Salary Sacrifice Pension
When an employee agrees to sacrifice part of their salary into a pension, the sacrificed amount is not subject to employer NI. At 15%, that saves £150 for every £1,000 sacrificed. For a £40,000 employee sacrificing £5,000 into a pension, the agency saves £750 per year in employer NI.
2. Employment Allowance (£10,500)
Claim the full £10,500 Employment Allowance through your payroll software. For a 10-person agency, this typically covers 2 full employees' worth of employer NI. Check eligibility: you cannot claim if you are a sole director with no other employees or a public body.
Between salary sacrifice and Employment Allowance, a 10-person agency can reduce total employer NI costs by £15,000-£18,000 per year. That meaningfully changes the contractor vs employee calculation.
Want help optimising your payroll costs? Book a free call5 Mistakes Agencies Make When Choosing Contractors vs Employees
Comparing day rate to salary directly
A £300/day contractor is not comparable to a £66,000 salary. The employee at £66,000 costs £79,000+ once you add NI, pension, and indirect costs. Compare contractor day rate to total employer cost divided by productive days.
Ignoring bench time in the calculation
An employee earning £40k costs £48k, but only delivers ~143 productive days at 65% utilisation. That is £336/productive day. The £300/day contractor suddenly looks cheaper.
Not budgeting for year-one recruitment costs
Recruitment fees of 15-20% add £6,000-£8,000 on a £40k hire. If the person leaves within 12 months (average agency staff turnover is 20-25%), you pay again.
Treating inside-IR35 contractors as cheap labour
Inside IR35 adds ~14% employer NI on top of the day rate. At that point, you are paying employee-level costs without employee-level commitment. Either restructure to be genuinely outside IR35 or hire permanently.
Not claiming Employment Allowance
Since April 2025, the allowance is £10,500 and the £100k NI cap has been removed. Many agencies are eligible but have not updated their payroll. Check with your accountant.
Frequently Asked Questions
Is it cheaper to hire a contractor or an employee in the UK?
It depends on utilisation. At a £300/day contractor rate versus a £40,000 salary (total cost £48,063), the employee becomes cheaper once you need them for more than 160 days per year (73% utilisation). Below that threshold, a contractor costs less because you only pay for days worked. For agencies, the critical variable is bench time: if your permanent staff utilisation is below 70%, contractors may be more cost-effective even at premium day rates. The hybrid model (employees for baseline capacity, contractors for peaks) works best for most agencies above 10 people.
What is the true cost of an employee in the UK?
Approximately 1.2x to 1.35x their gross salary. For a £40,000 employee, expect to pay around £48,063 per year including employer NI at 15% (£5,250), pension at 3% (£1,013), and indirect costs like equipment, training, and insurance. In year one with recruitment fees (15-20% of salary), the cost rises to £50,000-£53,000 (1.25x-1.33x salary). Remember that employees only deliver around 196 productive days after holidays and sickness, not the full 252 working days.
How much is employer National Insurance in 2025/26?
Employer NI is 15% on earnings above the secondary threshold of £5,000 per year (£96/week). This increased from 13.8% above £9,100 in April 2025. For a £40,000 employee, employer NI costs £5,250 per year. The Employment Allowance of £10,500 can offset this for eligible businesses. You cannot claim Employment Allowance if you are a sole director with no other employees. The combined effect of the rate increase and threshold drop means employers pay approximately £986 more per employee per year than before April 2025.
Do employers pay National Insurance on contractors?
Not if the contractor is genuinely outside IR35 and operates through their own limited company or as a sole trader. You pay the agreed day rate and that is it. However, if the engagement falls inside IR35, the fee-payer (often the agency) must deduct employer NI at 15% from the contractor's payments, plus employee NI and PAYE income tax. This adds approximately 14% to the cost of an inside-IR35 engagement. For medium and large clients, the end client determines IR35 status, but the agency as fee-payer bears the NI cost.
What happens if HMRC reclassifies my contractor as an employee?
HMRC can investigate up to 6 years of payments. You would owe the unpaid PAYE income tax, employer NI (15%), employee NI, plus interest from the date the tax should have been paid. Penalties range from 30% of unpaid tax for "careless" errors, to 70% for situations where you knew the status was wrong, up to 100% for deliberate concealment. For a contractor paid £300/day over 3 years, the total liability including penalties could exceed £50,000. Mitigation: use HMRC's CEST tool, maintain substitution clauses, and keep detailed records demonstrating "reasonable care."
How do you calculate a contractor day rate from a permanent salary?
Divide the total employer cost (not just salary) by productive working days. For a £40,000 salary with total employer cost of £48,063, divided by 196 productive days (220 working days minus 28 days holiday minus average sickness and training), the equivalent day rate is £245. Contractors typically charge a 20-40% premium above this for flexibility, lack of benefits, and their own business running costs (insurance, accountancy, unpaid holiday). So the equivalent contractor rate would be £295-£345/day.
What is inside IR35 vs outside IR35?
IR35 determines whether a contractor is genuinely self-employed (outside IR35) or a "disguised employee" (inside IR35) for tax purposes. Inside IR35: the fee-payer must deduct PAYE, employee NI, and employer NI from payments. The contractor takes home significantly less, and the cost to the hiring business is approximately 14% higher. Outside IR35: the contractor invoices for their services, pays Corporation Tax through their limited company, and the hiring business pays zero employer NI or pension. Key factors HMRC assesses: control over working methods, right to send a substitute, mutuality of obligation, and financial risk.
How much does bench time cost an agency?
For a £40,000 employee with total cost of £48,063: at 75% utilisation (good), bench time costs £12,000/year. At the industry average of 65%, bench time costs £16,800/year. During a downturn at 50% utilisation, bench time costs £24,000/year. This is the core financial risk of permanent hires. Contractors eliminate this risk entirely because you stop paying when the work ends. The optimal strategy for most agencies is to staff permanently at 60-70% of peak capacity and use contractors for the remainder.
What is the Employment Allowance and who can claim it?
The Employment Allowance is a £10,500 annual offset against your employer NI bill (increased from £5,000 in April 2025). Most businesses qualify, including agencies. The previous £100,000 NI liability cap was removed, opening it to larger businesses. You cannot claim if you are a sole director with no other employees, a public body, or for deemed employees under IR35. You claim it through your payroll software (Xero, QuickBooks, Sage). It applies per business, not per employee, so you get one allowance regardless of team size.
Should I hire contractors or employees for my agency?
Use permanent employees for consistent workload above 4 days/week with a 6+ month horizon, and when building for agency valuation (employee-heavy agencies command 1-2x higher EBITDA multiples). Use contractors for specialist skills, short projects, and when revenue is volatile. Agencies under 5 people with unpredictable revenue should lean contractor-heavy to minimise fixed costs. Agencies above 10 people with 60%+ retainer revenue should be employee-heavy with contractor flexibility for peaks. Review your utilisation data quarterly to get the balance right.
How does using contractors vs employees affect agency valuation?
Employee-heavy agencies with recurring retainer revenue command EBITDA multiples 1-2x higher than contractor-dependent agencies. Buyers value predictable costs, team stability, client relationship continuity, and retained IP. A £1m revenue agency with 20% EBITDA margins might achieve 6-7x with primarily employee delivery versus 4-5x with heavy contractor reliance. That is a £200,000-£400,000 difference in sale price. If an exit is 3-5 years away, gradually transitioning key contractor roles to permanent hires is one of the highest-ROI moves you can make.
What are the hidden costs of hiring an employee?
Beyond the obvious (salary, NI, pension): recruitment fees (15-20% of salary through an agency), onboarding and training time (typically 1-3 months before full productivity), management overhead, equipment and software licences (£1,500-£3,000 in year one), employers' liability insurance, and the opportunity cost of bench time. The biggest hidden cost for agencies is bench time: at 65% utilisation, 35% of your permanent staff cost is spent on non-billable time. For a 10-person agency, that is over £160,000 per year in unproductive cost.
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