How to Calculate VAT on an Invoice

VAT-Exclusive vs VAT-Inclusive Pricing

Before calculating VAT, you need to understand whether you're working with VAT-exclusive or VAT-inclusive figures. This distinction is crucial and causes frequent confusion.

VAT-exclusive (net) prices:
This is the price before VAT is added. When you quote a day rate of £500, that's typically a VAT-exclusive figure. You'll add VAT on top to reach the total the client pays.

VAT-inclusive (gross) prices:
This is the total amount including VAT. Consumer prices in shops are usually displayed VAT-inclusive. If someone quotes £600 "including VAT," you need to work backwards to find the net amount and VAT component.

Freelancers typically quote VAT-exclusive rates and add VAT on invoices. However, some contracts specify VAT-inclusive totals, and you need to calculate what portion is VAT correctly.

The Calculation Formulas

Here are the essential formulas for calculating VAT at the standard 20% rate:

Adding VAT to a net amount (VAT-exclusive → gross):

• VAT Amount = Net Amount × 0.20
• Gross Amount = Net Amount × 1.20

Extracting VAT from a gross amount (VAT-inclusive → net):

• Net Amount = Gross Amount ÷ 1.20
• VAT Amount = Gross Amount ÷ 6 (or: Gross Amount - Net Amount)

Why divide by 6?
At 20% VAT, the gross amount is 120% of the net amount. VAT is 20% of net, which equals 20/120 = 1/6 of gross. So dividing the gross by 6 gives you the VAT directly.

For reduced rate (5%):

• Adding VAT: Gross = Net × 1.05
• Extracting VAT: Net = Gross ÷ 1.05; VAT = Gross ÷ 21

Step-by-Step Examples

Let's work through realistic invoicing scenarios:

Example 1: Simple invoice with one service
You've completed a web development project for £3,500 (net).

1. Calculate VAT: £3,500 × 0.20 = £700
2. Calculate gross total: £3,500 + £700 = £4,200
3. Or in one step: £3,500 × 1.20 = £4,200

Invoice shows: Subtotal £3,500 | VAT (20%) £700 | Total £4,200

Example 2: Multiple line items
You're invoicing for design (£1,200) and consulting (£800), both at 20% VAT.

1. Calculate subtotal: £1,200 + £800 = £2,000
2. Calculate VAT: £2,000 × 0.20 = £400
3. Calculate total: £2,000 + £400 = £2,400

For multiple items at the same VAT rate, it's simpler to calculate VAT on the subtotal rather than per item.

Example 3: Extracting VAT from an agreed price
A client agrees to pay £5,400 "all in" for a project. You need to find your actual fee and the VAT portion.

1. Calculate net: £5,400 ÷ 1.20 = £4,500
2. Calculate VAT: £5,400 - £4,500 = £900
3. Or: £5,400 ÷ 6 = £900

Your actual fee is £4,500. The £900 VAT goes to HMRC.

Handling Mixed VAT Rates

While uncommon for most freelancers, some invoices may include items at different VAT rates. This requires calculating VAT separately for each rate.

Example: Invoice with standard and zero-rated items
You're invoicing for consultancy services (£2,000 at 20%) and digital publications (£500 at 0%).

1. Consultancy VAT: £2,000 × 0.20 = £400
2. Publications VAT: £500 × 0 = £0
3. Net subtotal: £2,000 + £500 = £2,500
4. Total VAT: £400 + £0 = £400
5. Grand total: £2,500 + £400 = £2,900

Invoice presentation for mixed rates:
HMRC requires you to show the VAT amount for each different rate applied. Your invoice should clearly display:

• Items at 20%: Net £2,000, VAT £400
• Items at 0%: Net £500, VAT £0
• Totals: Net £2,500, VAT £400, Gross £2,900

Most invoicing software handles mixed rates automatically, but verify the calculations if you create invoices manually.

Common Calculation Errors

These mistakes cause problems with clients, HMRC, and your own accounts:

Error 1: Calculating 20% of the gross amount
Wrong: £1,200 (gross) × 0.20 = £240 VAT
Right: £1,200 ÷ 6 = £200 VAT
Taking 20% of a VAT-inclusive figure overstates the VAT. The gross already includes VAT, so you must extract it, not add more.

Error 2: Charging VAT on VAT
If you're recharging expenses, ensure you're calculating VAT correctly. If you paid £120 (gross) for an item and recharge it:
Wrong: Net £120 + VAT £24 = £144 (charging VAT on a VAT-inclusive amount)
Right: Net £100 + VAT £20 = £120 (recharging the net, adding VAT once)

Error 3: Using the wrong rate
Most services are 20%, but check if any of your supplies qualify for reduced or zero rates. Conversely, don't apply zero rate to services that should be standard rated.

Error 4: Forgetting the VAT fraction
When working backwards from gross to net, many people mistakenly subtract 20% from the gross. This gives the wrong answer:
Wrong: £1,200 - (£1,200 × 0.20) = £1,200 - £240 = £960
Right: £1,200 ÷ 1.20 = £1,000
The difference is £40 — a material error on every invoice.

Decimal Rounding Rules

VAT calculations often produce amounts with more than two decimal places. HMRC permits rounding, but you must be consistent.

HMRC's acceptable methods:

• Round down: Always round VAT amounts down to the nearest penny
• Standard rounding: Round to the nearest penny (0.5p rounds up)

You must apply the same method consistently across all invoices. Most businesses use standard rounding, and most accounting software does this automatically.

Example of rounding:
Net amount: £127.50
VAT at 20%: £127.50 × 0.20 = £25.50 (no rounding needed)

Net amount: £127.33
VAT at 20%: £127.33 × 0.20 = £25.466
Rounded VAT: £25.47 (standard rounding) or £25.46 (rounding down)

Per-line vs total rounding:
You can calculate VAT per line item and round each, or calculate VAT on the total and round once. The results may differ by a few pence. Either approach is acceptable, but be consistent.

Currency and international invoices:
If invoicing in foreign currency, calculate VAT in that currency. For your VAT return, convert to GBP using HMRC's official rates or consistent commercial rates. Keep records of the exchange rates used.

Accurate VAT calculations build trust with clients and keep you compliant with HMRC. When in doubt, verify with the formulas above, and consider using invoicing software that automates these calculations.