This month European judges ruled that a construction firm that awarded "rolled-up" holiday pay to workers in lieu of paid leave acted unlawfully. Here's why

A ruling on 16 March by the European Court of Justice in Luxembourg has made "rolled-up" holiday pay unlawful. This is the practice of adding pay for annual leave to workers' hourly or daily rate instead of paying it in respect of a period of leave taken. In construction, where irregular working patterns and short-term contracts are common, employers often find it convenient to roll up holiday pay, although the employee must agree.

Rolling-up holiday pay is convenient for employers as they do not have to calculate holiday pay every time a worker takes leave. This is especially beneficial where hours of work and amounts of pay fluctuate. However, it has been criticised as discouraging workers from taking holiday, particularly as the more work the person does, the more pay he or she can earn.

In the case Caulfield vs Hanson Clay Products, the court decided the practice of rolling-up holiday pay was not lawful under the Working Time Directive, which guarantees a minimum of four weeks' holiday a year. Holiday pay must be paid in respect of a specific period during which the worker took leave. The judgment said: "The entitlement of every worker to paid annual leave is an important principle of European community social law from which there can be no derogation." Unusually, the court has taken a harder line than the advocate-general in her advisory opinion to the court last year. There, it was suggested that rolled-up holiday pay could be lawful if the employer put in place safeguards to ensure that workers could take the four weeks' leave to which they are entitled.

The workers in the Hanson case were employed at a brick factory in Accrington, Lancashire. Under the terms of a collective agreement with trade unions recognised by the employer, it was agreed that they would be paid 13.36% of their hourly rate as holiday pay at the same time as their weekly pay. On this basis, the workers were not paid when they actually took leave because their holiday pay was rolled-up with their hourly rate. Three workers took a period of annual leave and then pursued a claim in the Manchester employment tribunal seeking pay in respect of the leave taken. The workers succeeded in the tribunal. The employer appealed to the employment appeals tribunal where the tribunal's decision was overturned and the workers then appealed to the Court of Appeal.

The judgment is significant because of the conflicting case law in the UK. In the Hanson case, the tribunal and the Court of Appeal were inclined to allow employers to use rolled-up hourly rates of pay, but a Scottish court of session case (MPB Structures Ltd vs Munro) ruled that these practices were unlawful.

Because rolled-up holiday pay has been found to be unlawful by the European Court of Justice, employers are likely to face administrative inconvenience. But it's not all bad news. They could also have had to face the problem of not being given credit for the holiday element of the rolled-up rate so as to set this off against the entitlement to holiday pay under the directive, thereby having to pay twice. It is good news for employers that the judgment allows for off-setting where the rolled-up holiday pay system has been operated in a transparent and comprehensible manner.

It had been thought that there would also be the potential for large claims for backdated holiday pay going back as far as 1 October 1998

However, this potential for set-off does not mean employers will be able to continue with rolled-up holiday pay arrangements. The judgment says that EU member states are required to take the steps to make sure "practices contrary to the directive are not continued".

It had been thought that there would also be the potential for large claims for backdated holiday pay going back as far as 1 October 1998 when the working time directive was implemented in to domestic law. However, in a 2005 case the Court of Appeal held that claims to enforce entitlement to holiday pay can only be brought under the working time regulations and not as a claim for unauthorised deductions from wages. The effect of this is to limit a claim for backdated holiday entitlement to the most recent holiday year.

In practical terms it would seem that the practice of paying rolled-up holiday pay is going to have to stop because the court has decided that it can lead to workers not taking their leave entitlement under the working time regulations. There is only likely to be a financial exposure as a result of the judgment for those employers that have paid rolled-up holiday pay in a way that lacked transparency.

Employers who use systems of rolled-up holiday pay would be best advised to change to a system that ensures that workers are paid in respect of specific periods of leave.