Xero Payroll Setup and Single Touch Payroll (STP2) Compliance
A practical guide to mapping Xero pay items to STP2 income types, itemizing allowances correctly, setting employment basis and cessation codes, and completing the annual finalisation declaration — so every pay run lodges cleanly with the ATO.
Quick Summary
- STP2: an expanded ATO reporting standard requiring income-type disaggregation, itemized allowances, employment basis, and cessation reason codes on every pay run.
- Income Types: Xero pay items must be mapped to ATO income types (e.g., salary and wages, working holiday maker) before the first STP2-compliant pay run is lodged.
- Allowances: travel, meals, laundry, and other allowances must be itemized separately using ATO allowance categories rather than bundled into ordinary gross pay.
- Reporting cadence: STP information is reported to the ATO on or before each pay day — there is no separate monthly or quarterly payroll lodgement.
- Finalisation: employers must lodge an STP finalisation declaration by 14 July each year confirming that the financial year’s figures are complete and accurate.
Scope & Objective
This guide covers the setup work that determines whether a Xero payroll file reports cleanly under STP2: mapping existing pay items to the correct ATO income types, itemizing allowances and deductions the way the ATO expects, recording the employment basis and cessation details STP2 requires, and completing the year-end finalisation declaration on time.
- Applies to: any Australian business running payroll through Xero, and any business still using default or Phase 1 pay item settings that haven’t been reviewed for STP2.
- Not covered: state-based payroll tax obligations, superannuation guarantee rate calculations, or awards and enterprise agreement interpretation — these depend on the employer’s specific circumstances and industry.
- Core STP2 principle: every dollar reported must be attributed to the correct income type and, where relevant, allowance or deduction category — a single undifferentiated gross figure is no longer sufficient.
- Also useful for: bookkeepers and payroll officers auditing an existing Xero payroll file that was set up before STP2 became mandatory.
Mapping Pay Items to STP2 Income Types
Every pay item in Xero — ordinary hours, overtime, bonuses, director’s fees — must be mapped to one of the ATO’s STP2 income types before it can be reported correctly. Getting this mapping right the first time avoids lodgement rejections and prevents an employee’s income from appearing in the wrong category on their prefilled tax return.
- Salary and Wages (SAW): the default income type for ordinary employment income, covering most standard pay items.
- Closely Held Payees (CHP): a separate income type for payees closely related to the employer, such as family members of a family business, which follows different reporting timing rules.
- Working Holiday Maker (WHM): required for employees on a working holiday visa, since they are taxed under a different schedule.
- Directors’ Fees: reported separately from ordinary salary and wages even when paid to the same person in another role.
Configuring Allowances and Deductions Separately
STP Phase 1 allowed many employers to bundle allowances into ordinary gross pay. STP2 does not: allowances now need their own pay items, each linked to the matching ATO allowance category, so the ATO can see exactly what was paid and why.
Income type disaggregation means STP2 reports break a single pay run into its component parts — ordinary hours, overtime, allowances, leave, bonuses — instead of a single lump gross figure. This is the core structural change from STP Phase 1, and almost every setup mistake traces back to a pay item that was never disaggregated correctly.
Creating occurs when no matching transaction exists yet — the user codes the bank line directly to an account (e.g., “Bank Fees,” “Office Supplies”), which both reconciles the line and creates the underlying accounting entry in a single step.
Getting the balance between these two right — matching wherever a transaction already exists, and creating (correctly coded) wherever it doesn’t — is what keeps the bank account balance in Xero equal to the real bank balance at all times.
Getting allowance categories right also protects employees, since some allowances affect an individual’s eligibility for certain tax offsets or government benefits and need to appear separately on their income statement.
- Travel allowances: for work-related travel costs, reported under a dedicated travel allowance category rather than as part of wages.
- Meal and overtime meal allowances: itemized separately so they don’t inflate an employee’s reported ordinary earnings.
- Laundry and uniform allowances: mapped to their own ATO category rather than absorbed into a general allowance line.
- Tool and equipment allowances: kept distinct from wages so any tax-free component is reported correctly.
Deductions need the same care. Union fees, workplace giving, and salary sacrifice arrangements each have a specific STP2 treatment, and a deduction mapped to the wrong type can misstate an employee’s reportable income.
- Union or professional association fees: reported as a standard deduction type.
- Workplace giving: reported separately so it can be reflected correctly on the employee’s income statement.
- Salary sacrifice (superannuation): must reduce ordinary reportable income correctly rather than appearing as a straight deduction.
Setting Employment Basis and Cessation Reason Codes
STP2 requires every employee record to carry an employment basis — full-time, part-time, casual, labour hire, or other — and, when someone leaves, a cessation reason code explaining why. Both fields feed directly into the ATO’s reporting and are easy to overlook on records that were set up before STP2 became mandatory.
- Employment basis: reviewed and confirmed for every active employee, since a default or blank value can cause a pay run to fail STP2 validation.
- Voluntary cessation: used when an employee resigns or retires of their own accord.
- Employer-initiated cessation: used for redundancy, dismissal, or the end of a contract at the employer’s initiative.
- Transfer or death: separate reason codes exist for internal transfers between related entities and, where applicable, an employee’s death.
Reviewing Pay Run Reports Before Lodgement
Because STP information lodges on or before every pay day, there’s no monthly buffer to catch mapping errors after the fact. Reviewing the pay run summary report before finalising each pay run — checking income types, allowance totals, and superannuation figures against what’s expected — catches most STP2 errors before the ATO ever sees them.
- Compare the pay run summary against the previous period for unexpected jumps in any income type or allowance category.
- Confirm every new starter has an income type, employment basis, and tax file number declaration on file before their first pay run.
- Check that terminated employees from the period carry the correct cessation reason code before the pay run locks.
Completing the Year-End STP Finalisation Declaration
The finalisation declaration is the formal confirmation to the ATO that a financial year’s STP data is complete and correct, and it’s what allows employees’ income statements to move to “Tax ready” status so they can lodge their own returns. It’s due by 14 July for most employers, with an earlier deadline applying to closely held payees in some circumstances.
- Reconcile total payments reported through STP for the year against the general ledger payroll accounts before finalising.
- Correct any known errors using an update event rather than waiting until finalisation to fix them.
- Lodge the finalisation declaration on time — a late or missing declaration delays employees’ prefilled tax returns and can attract ATO follow-up.
Common Xero Payroll and STP2 Mistakes
- Leaving legacy pay items unmapped to an STP2 income type, causing pay run lodgements to fail validation.
- Bundling allowances into ordinary gross pay instead of itemizing them under their own ATO allowance category.
- Missing the employment basis field on new starters, leaving it blank or defaulted incorrectly.
- Forgetting to record the cessation reason code when finalising a terminated employee’s last pay run.
- Missing the 14 July finalisation deadline, delaying employees’ access to their prefilled tax return information.
Need Help With Xero Payroll and STP2 Compliance?
Need expert help mapping pay items, configuring allowances, or completing your STP finalisation declaration in Xero? Contact our Accounting & Bookkeeping team today.