PAYG Withholding vs Instalments: What's the Difference?

By Jen Bacquiano · 13 March 2015 · Updated 19 March 2026

Pay As You Go (PAYG) is the ATO's system for collecting income tax progressively throughout the year. It has two parts. PAYG withholding is tax you deduct from your employees' wages and send to the ATO on their behalf. PAYG instalments are pre-payments your business makes toward its own expected income tax. Both appear on your Business Activity Statement (BAS), but they're separate obligations with different rules, different thresholds, and different consequences when they go wrong

What is PAYG?

PAYG stands for Pay As You Go. It's the Australian Taxation Office's mechanism for collecting income tax in regular amounts across the financial year, rather than leaving taxpayers with one large bill after lodging their annual return. The system applies to both employers (who withhold tax from employee wages) and businesses or investors earning income that isn't subject to withholding

The confusion starts because the ATO uses the same acronym for two different things. A business with employees might have both PAYG withholding and PAYG instalment obligations running simultaneously, reported on the same BAS but in completely different sections

PAYG withholding: tax you collect on behalf of employees

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

PAYG withholding isn't a tax on your business. It's a collection mechanism. You're acting as the middleman between the ATO and your employees, making sure the right amount of tax reaches the ATO each pay cycle

Registration and requirements

You can register for PAYG withholding when you apply for your ABN, or later through your myGovID account. Once registered, you need 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, and lodge your BAS or IAS and pay the withheld amounts by the due date

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 47%, which is the top marginal rate plus Medicare levy. Nobody wants that on their payslip, so getting TFN declarations sorted before the first pay run matters

How PAYG withholding works in Xero

Xero calculates PAYG withholding 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 catch is that the calculation is only as good as your employee setup. The right tax table, residency status, Study and Training Support Loan (STSL) flags, and tax-free threshold claims all affect the final number. We see incorrect withholding in client files regularly, and it almost always traces back to a setup issue rather than a Xero bug

Reporting frequency

How often you lodge and pay PAYG withholding depends on your annual obligation. If your annual PAYG-W is $25,000 or less, you report quarterly. Most small businesses fall here. If your annual PAYG-W is more than $25,000 and up to $1 million, you report monthly

STP means the ATO receives your withholding data every time you process a pay run, regardless of your lodgement cycle. The BAS is the payment mechanism, not the reporting mechanism. The ATO already knows what you owe before you lodge

PAYG instalments: pre-paying your own business tax

PAYG instalments are the ATO's way of collecting expected income tax from businesses and investors throughout the year. Unlike withholding, where you're collecting someone else's tax, instalments are payments toward your own business's income tax liability

The ATO enters you into the system automatically based on your most recent tax return. You don't apply for it. A letter arrives telling you how much you need to pay and when

Entry thresholds

The ATO uses your latest tax return to determine whether you enter the PAYG instalment system. The thresholds differ by entity type

For individuals (including sole traders) and trusts, you'll automatically enter the system if you have all of the following: instalment income of $4,000 or more from your latest tax return, tax payable on your latest notice of assessment of $1,000 or more, and estimated notional tax of $500 or more. All three conditions must be met. Instalment income is gross business and investment income, excluding GST and capital gains

For companies and super funds, the threshold is different. You enter automatically if your instalment income from the latest tax return is $2 million or more, or if your estimated notional tax is $500 or more. The key word is "or" - you only need to meet one condition, not both

Two methods for calculating instalments

The ATO gives you two options, and you choose on your first Activity Statement for the income year. Once you choose, it applies for the rest of the year

Option 1 - Instalment amount. The ATO calculates a fixed dollar amount based on your most recent tax return, adjusted by the GDP adjustment factor. For 2025-26, that factor is 4%. You pay the same amount each quarter regardless of actual income. Simple, but it won't reflect reality if your business income has changed significantly

Option 2 - Instalment rate. You multiply your actual instalment income for the period by an ATO-provided percentage rate. This method adjusts automatically as income rises or falls, making it better for businesses with variable revenue

Business entities with an aggregated turnover of $50 million or more aren't eligible for the instalment amount option and must use the instalment rate method. Everyone under that threshold can choose whichever method suits their cashflow

Varying your instalments

If your business circumstances have changed materially, whether revenue dropped, a major contract ended, or you sold an asset, you can vary your instalment amount or rate on your next Activity Statement. This prevents you from overpaying tax and tying up cash your business needs

The risk goes both ways. Vary too aggressively downward when income is actually growing, and you'll face a larger-than-expected tax bill at year end plus the ATO's General Interest Charge (GIC) on any shortfall. The safe approach is reviewing your position each quarter against actual figures, not just accepting whatever the ATO calculated from last year's return

How PAYG instalments appear in Xero

Xero pre-fills your Activity Statement with PAYG instalment amounts at label T7 (instalment amount method) 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. Either way, review the figures before lodging, especially if your business income has changed since the return the ATO based its calculation on

How both PAYG types appear on your BAS

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

PAYG withholding appears at labels W1 (total salary and wages) and W2 (amounts withheld), plus W3 and W4 for other withholding amounts like voluntary agreements or payments where no ABN was quoted. PAYG instalments appear 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, and the ATO now has real-time visibility via STP to spot discrepancies

Common PAYG mistakes we flag in client files

These are the issues we see most often across Xero files

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. The ATO expects registration before you make your first payment
Wrong tax table applied in Xero - incorrect residency status, a missing STSL debt flag, or the tax-free threshold not claimed properly. Each one produces incorrect withholding that flows through to STP and your BAS. Our payroll errors article covers the full list
Ignoring the GDP adjustment on instalments - the 4% uplift for 2025-26 means your instalment amount is higher than last year even if income hasn't changed. Budget for it, or vary your instalments if it no longer reflects your actual position
Never varying when income drops - some business owners keep paying the ATO-notified amount even when revenue has fallen significantly, locking up cash they could be using in the business
Varying too aggressively when income rises - the opposite problem. Reducing instalments when income is actually growing creates an unpleasant surprise at tax time, plus potential GIC
Confusing PAYG-W with PAYG-I - one is money you owe on behalf of your team, the other is money your business owes on its own income. Mixing them up on the BAS creates reconciliation issues that compound each quarter

PAYG withholding and Single Touch Payroll

Since STP Phase 2 rolled out across Australia, PAYG withholding data goes to the ATO every time you process a pay run. Not at BAS time. Every pay run. This means the ATO has real-time visibility of your withholding obligations, and any gap between your STP reports and your BAS lodgement gets flagged automatically

STP doesn't change when or how you pay PAYG-W to the ATO. That's still through your BAS by the relevant due date. But it does mean the ATO knows what you owe before you lodge. Keeping your Xero payroll accurate and up to date is the compliance baseline, not a nice-to-have

When to get help with PAYG

PAYG is straightforward in principle. Two types of tax, both reported on your BAS, both designed to smooth out obligations across the year. But it gets complicated once you're managing multiple employees across different award rates, dealing with contractors, or trying to work out whether varying your instalments is worth the risk. That's where a dedicated bookkeeping and compliance team earns its keep

A registered BAS agent can lodge your Activity Statements, manage both types of PAYG, and give you an extra four weeks to lodge and pay. That's a genuine cashflow benefit most business owners don't realise they're leaving on the table

If you need help cleaning up withholding errors in Xero, setting up your first payroll, or reviewing whether your instalment amount still makes sense for the current financial year, reach out to our team

Want help with your business bookkeeping?

We can keep your accounts up to date, accurately, so you can focus on what you do best

Learn more

Jen Bacquiano

Jen has twelve years of Australian bookkeeping experience, a CPA, and a BAS Agent registration. She's also a Swiftie who speaks three Filipino dialects

Meet Jen

Common questions

PAYG withholding and instalments are both credited against your actual tax liability when you lodge your annual return. If the total PAYG amounts paid during the year exceed your actual tax, the ATO issues a refund for the difference. If they fall short, you pay the balance owing.

PAYG withholding is tax deducted from employee wages by the employer and sent to the ATO on the employee's behalf. PAYG instalments are regular pre-payments a business or investor makes toward its own expected income tax liability. Both are reported on the BAS but in different sections - withholding at W1/W2, instalments at T7 or T2/T8.

You can apply to the ATO to exit the PAYG instalment system if your circumstances have changed - for example, if your instalment income drops below $4,000 (individuals and trusts) or your notional tax falls below $500 (companies). You can also reduce instalments to zero by lodging a variation, though the ATO may review this if the variation appears unreasonable.

If you miss a PAYG instalment payment, the ATO applies the General Interest Charge (GIC) on the outstanding amount from the due date until payment. Repeated non-lodgement of Activity Statements can also trigger Failure to Lodge penalties. The instalment amount is still credited against your annual tax, but penalties and interest accumulate in the meantime.

Individuals and trusts enter the PAYG instalment system when their latest tax return shows instalment income of $4,000 or more, tax payable of $1,000 or more, and estimated notional tax of $500 or more. Companies and super funds enter when instalment income reaches $2 million or more, or when estimated notional tax is $500 or more.

Insights