As employers, we are facing a year of workforce disruption and ever-increasing employment cost. Even without the shock of energy price increases and geopolitical uncertainty, 2026 is going to be a tricky year.

Rising employment costs are forcing employers to rethink their workforces, with changes to working patterns, tighter hiring and difficult trade-offs that directly impact our employees.

These changes unfold against a backdrop of expanding worker rights, increasing exposure to employment litigation and intensifying regulation and enforcement.

As the labour market continues to weaken, how will cautious recruitment and lower mobility shape the UK economy – and what does this mean for our workforces?

The UK labour market: workforce challenges and economic impact

The Iran crisis has sent energy prices soaring and shockwaves through supply chains. The UK economy and labour market will feel the effects of these jolts for the next 12 months at least.

At the start of the year, conditions appeared to be stabilising: unemployment was close to 5%, and headline data showed tentative improvement. However, as our latest UK Economic Outlook update shows a weaker picture, we expect the unemployment rate to reach 5.5% in 2026 in the wake of the Middle East conflict. The latest Purchasing Managers' Index (PMI) indicators reflect this caution among employers and UK labour market weakness. April’s snapshot shows the employment balance stands at 46.9 – anything below 50 signals contraction from the previous month.

If energy prices go even higher, or if there is a return to conflict in the Middle East after April’s ceasefire, the unemployment rate could shift towards 6%. In this scenario, ‘stagflation’ – low growth and high inflation – returns. For now, we’re forecasting around 0.5% for growth, with impacts on discretionary spending and demand.

On inflation – an important factor when considering pay rises – we anticipate a peak of 3.5–4% later this year, and an average of around 3.5% for 2026. Overall, this means the UK labour market will remain fragile in 2026 as economic growth slows.

How are employers responding to economic conditions?

We can see in our survey how employers are already responding to a subdued economic outlook and weaker labour market. The biggest challenge respondents reported in the last 12 months was rising employment costs (62%). Of those, 37% report cutting back on hiring or reducing workers’ hours. One in three has offered fewer opportunities for workers to earn more through overtime.

During this period, employers were feeling the impact of two Autumn Budgets. This included the first round of National Minimum Wage hikes and employers’ National Insurance Contributions, which came into effect in April 2025. Since November 2025, firms have also been looking ahead to further uplifts in minimum wages set out in the 2025 Budget. At the same time, they have been preparing for the compliance costs of the new Employment Rights Act.

Before the Iran crisis, we expected real-wage growth to average less than 1% over the next two years. This reflects a ‘lower and slower’ outlook for inflation, growth and interest rates. However, we now expect real wage growth to be negative in the second half of 2026. This increases the likelihood of workers bargaining for higher wages so real incomes keep pace with the cost of living.

We saw in the last energy price crisis how workers were able to negotiate higher wages to cover the impact of inflation on household bills, including food and fuel. However, this time there are two differences that could dictate whether workers’ negotiations will be as successful as they were in 2022/23.

The first is the change in the balance of vacancies-to-unemployed workers. In 2022/23, this measure of job market tightness was 1:1. Today, the ratio of unemployed workers is at its highest since 2014, making a balance of around 1:2.5. Competition for jobs – not workers – is therefore higher, potentially reducing workers’ leverage in negotiations.

The second difference is the Employment Rights Act’s enhanced trade union recognition rights and how this will have an impact on pay bargaining. Almost 38% of survey respondents said they would recognise a trade union if their employees requested it. A further 25% said they were already seeking to improve collaboration without formal recognition.

A complex picture for skills gaps and productivity

Ensuring the right people are in the right roles at the right time remains essential to UK economic growth, particularly in high growth sectors and industries facing persistent skills shortages.

However, more than half of respondents (51%) identified recruiting new employees as one of their biggest challenges for the year ahead. One reason for this is that weaker pay competitiveness appears to be discouraging job moves, limiting labour market mobility. Only 10% had frozen hiring outright over the past 12 months.

Where recruitment is continuing, firms are prioritising roles with clearer returns on salary investment. Survey results suggest stronger demand for skilled and technical roles over the next 12 months. Of the 70% recruiting here, 66% plan for this to be at higher levels compared with previous years. Demand for graduate hires is also stronger. Over half (53%) of respondents plan to increase graduate headcount, with 58% saying this will be at higher levels than before. Across all levels, AI skills are crucial with 63% of employers expecting candidates to have experience of working with AI.

Against this backdrop, decisions around pay, investment in skills and recruitment strategies will play a critical role in determining whether any economic recovery is sustainable.

The cost of employment: rising pressures and workforce trade offs

Rising employment costs remain the dominant force shaping workforce decisions. Employers are making trade-offs to manage these pressures while preparing for a more complex regulatory environment.

When asked to identify their key workforce challenges over the last 12 months, 62% of employers cited rising employment costs, with 57% pointing to higher salary expectations.

More than half expect these pressures to continue over the next year, suggesting cost and pay pressures are now perennial rather than short term.

Regulatory obligations are increasing too. The Employment Rights Act introduces new employment rights alongside the creation of the Fair Work Agency (FWA), marking a shift towards proactive enforcement. This adds to administrative demands for employers, increases scrutiny and places greater pressure on people teams. Many of these decisions are now being taken at board level, where affordability, risk and long-term workforce needs are being weighed together.

These factors signal a new era of enforcement and a complex mix of rising costs and difficult workforce decisions.

How employers are responding: workforce cost management and behavioural change

Rather than turning to redundancies, employers are offsetting costs in flexible ways. Around 3 in 10 are taking action across working hours, benefits and the use of agency and off-payroll workers, highlighting a shift towards cost control.

National Minimum Wage (NMW) increases are also a major factor in these workforce trade-offs. Our survey shows 50% of employers are prioritising experienced hires, while 29% are reducing entry-level roles.

Wage increases are influencing not just pay costs but also workforce composition and working patterns.

While affordability remains a priority, careful implementation is a must. New worker rights and stronger enforcement add complexity, increasing the need to ensure workforce decisions align with legal requirements and fair working practices. Cost management cannot come at the expense of compliance.

Where cost pressures are creating new and unintended risks

A range of unintended consequences is emerging as employers respond to rising costs and regulatory change.

Enforcement pressure and the FWA

Alongside cost pressures, around two-thirds of employers anticipate compliance demands will intensify, adding further pressure to people teams. The FWA is expected to take a central role in enforcement, using proactive monitoring similar to HMRC’s NMW reviews.

Despite this change, awareness of the FWA remains relatively low. Only 16% of employers identify the agency’s introduction as a concern, leaving many exposed to increased scrutiny and future claims as enforcement activity increases.

Minimum wage changes and their impact on the workforce

Employers are taking widespread action to manage minimum wage increases, with only 12% report taking no action at all.

As a result, a concertina effect is beginning to emerge. Pressure at the bottom of the pay scale is feeding through into higher pay expectations elsewhere in the workforce. This is widening the cost impact beyond the initial wage uplift and reshaping workforce composition over time.

These changes risk further unintended consequences, including reduced entry-level opportunities and greater reliance on variable labour to manage rising fixed costs.

Holiday pay emerging as the new compliance risk

Holiday pay is becoming a significant compliance flashpoint. 56% of employers reported paying holiday at a single rate, masking underlying risk where pay varies across the workforce. A further 11% of employers still calculate holiday pay manually, increasing the likelihood of errors, including under- or over-payment.

The FWA is expected to scrutinise holiday pay closely, leaving employers with complex workforce arrangements more exposed to claims.

Salary sacrifice changes drive reward model reviews

Planned changes to pension salary sacrifice, including the removal of National Insurance savings in 2029, are already prompting employers to review reward models. Our survey shows 51% are exploring flexible benefits, 44% are reallocating budgets and 38% are reviewing employer pension contributions.

For many organisations, pension salary sacrifice is one of a range of reward options. As reward costs are scrutinised more closely, reviews may focus more on productivity, performance and long-term affordability, even where employee mobility is easing.

What employers need to do right now

Employers face higher employment costs, increased regulation, and stronger enforcement with less tolerance for technical error. As enforcement becomes more proactive, pressure on payroll accuracy, and compliance around reward is intensifying. There is a new tension between policy intent and employer behaviour. While reforms aim to protect workers, many employers are responding with more cautious recruitment, a tightening of performance management and changes to workforce models.

As enforcement tightens, cost reduction is only safe when the technical detail is right. Organisations that take a considered, informed approach will be best placed to build compliant, resilient workforce structures.

Author: Chris Robson, Partner, Employment Tax – Fair Pay lead

Beyond compliance: the real-world impact of employment law reform

The Employment Rights Act is one of the most significant shifts in UK employment law in decades.

Businesses have not been waiting passively for the rules to take effect. Instead, many are reassessing risk, revising workforce models and shoring up their HR and legal capacity to prepare for a more complex and litigious employment landscape.

While much of the debate has been politically ideological, the reality for employers is far more immediate. The reforms are already changing behaviour, which may result in unintended consequences.

What is the Employment Rights Act and when does it take effect?

From April 2026 onwards, the Employment Rights Act introduces a package of reforms designed to strengthen worker protections and expand employer obligations. Described as “a modern framework for workers’ rights” (Sir Keir Starmer) and “job destroying, anti-business” (Kemi Badenoch), the Act introduces changes affecting unfair dismissal, trade unions and workplace sexual harassment.

Alongside these ground-breaking changes to employment legislation comes the new Fair Work Agency (FWA). Its remit? To create a level playing field for employers while “ensuring workers get the rights and protections they are entitled to”. For most of our respondents, the introduction of the FWA was the least of their worries, surprisingly at the bottom of areas of upcoming regulatory change which concerned them.

How prepared are employers?

The landscape of worker rights is set to shift dramatically over a relatively short period, and the pace of change is testing employer readiness. While most businesses recognise the scale of change, preparedness varies significantly.

Just over half of employers (55%) say they have reviewed their risks and started implementing changes. A further quarter (24%) have reviewed risks but not yet acted, while a minority (15%) optimistically believe they are already compliant. Among those who have taken no action, the most common reason, understandably, is uncertainty – businesses are waiting for further government guidance as consultations are still ongoing.

For many, preparation is translating into practical action. Employers are not relying solely on policy updates. Instead, they are investing in capacity:

- 81% have already increased, or plan to increase, their HR team.

- Over half have created a specific compliance role for employment rights.

- Many have updated handbooks, rolled out training or engaged external advisers.

These actions reflect a recognition that the impact of the Act will be felt every day – in recruitment, performance management, grievances and day-to-day line management. Most employers see that this exercise is not a one-off review and are spending accordingly.

From compliance to consequence: how behaviour is changing

Unfair dismissal and ‘job-hugging’ caution

Changes to unfair dismissal rights are already influencing hiring and people management decisions. Over half of employers report reviewing probation and performance management processes. Large numbers say they are being more cautious with recruitment or pausing hiring altogether, signalling that tougher probation conditions could be a threat to UK job mobility. Workers may choose to stay-put (‘job-hugging’) rather than risk the insecurity of a new contract. The resulting employee disengagement has an inevitable knock-on effect on productivity.

Preparing for the new unfair dismissal regime should be a priority for employers. The six-month service requirement and removal of the cap on unfair dismissal compensation are likely to have the biggest impact on employment strategies. The clock is ticking for employers that have long-ignored performance issues.

Zero-hours reform and workforce redesign

Reforms affecting zero-hours workers are prompting structural change, particularly in the retail sector. Of those employers using zero-hours workers, almost all plan to reduce or eliminate zero-hours contracts altogether, offer guaranteed hours to mitigate risk, or shift flexibility into agency labour instead. This goes well beyond contract compliance and represents a fundamental redesign of workforce models.

The next 12 months: pressure on people teams intensifies

These reforms are landing at a time when employers are already under strain. Rising employment costs, higher salary expectations and skills shortages are all significant workforce challenges today and will continue to be in 2027.

Against this backdrop, employers expect a marked increase in complaints, grievances and employment tribunal claims. Some anticipated lengthy, AI-generated grievances would contribute to that growth. Around two thirds anticipate higher volumes of disputes, disrupting businesses and putting further pressure on HR teams, ACAS and an over-stretched employment tribunal system. A new right of access for trade unions and enhanced flexible working rights will add to HR workloads.

Balancing stronger rights with business resilience

The Employment Rights Act is reshaping how employers hire, manage, reward and resource their workforces.

The challenge over the next 12 months will be ensuring that necessary risk management does not translate into damaging and unintended consequences. We may see stalled recruitment, an over-reliance on off-payroll workers or unsustainable pressure on people teams become the unhappy outcomes of trying to do the right thing.

The real test of employment law reform will not be whether policies are updated, but whether workers’ rights can be fundamentally enhanced without risking the resilience, sustainability and growth of their employers.

Author: Charlie Barnes, Head of Employment Legal

Research was conducted by 3Gem on behalf of RSM UK. Data was collected between 9 and 18 March from 300 UK businesses ranging between £50m-over £500m turnover.

3Gem is a global insights business, powered by a proprietary panel of more than 10 million people representing voices across 55 countries.