diff --git a/lnbits/core/views/payment_api.py b/lnbits/core/views/payment_api.py
index f9bcb4de2..648237ffc 100644
--- a/lnbits/core/views/payment_api.py
+++ b/lnbits/core/views/payment_api.py
@@ -1,5 +1,6 @@
 from hashlib import sha256
 from http import HTTPStatus
+from secrets import token_hex
 
 from fastapi import (
     APIRouter,
@@ -37,8 +38,9 @@ from lnbits.core.models import (
     UpdatePaymentExtra,
 )
 from lnbits.core.models.payments import UpdatePaymentLabels
-from lnbits.core.models.users import AccountId
+from lnbits.core.models.users import AccountId, UserLabel
 from lnbits.core.models.wallets import BaseWalletTypeInfo
+from lnbits.core.services.users import update_user_account
 from lnbits.db import Filters, Page
 from lnbits.decorators import (
     WalletTypeInfo,
@@ -51,6 +53,7 @@ from lnbits.decorators import (
 from lnbits.helpers import (
     filter_dict_keys,
     generate_filter_params_openapi,
+    is_valid_label,
 )
 from lnbits.wallets.base import InvoiceResponse
 
@@ -291,9 +294,24 @@ async def api_update_payment_labels(
     if not account:
         raise HTTPException(HTTPStatus.NOT_FOUND, "Account does not exist.")
 
-    # only keep labels that belong to the user
     user_label_names = [label.name for label in account.extra.labels]
-    payment.labels = [label for label in data.labels if label in user_label_names]
+    updated_account = False
+    for label_name in data.labels:
+        if label_name not in user_label_names:
+            if not is_valid_label(label_name):
+                raise HTTPException(
+                    HTTPStatus.BAD_REQUEST, f"Invalid label name: '{label_name}'."
+                )
+            account.extra.labels.append(
+                UserLabel(name=label_name, color=f"#{token_hex(3)}")
+            )
+            user_label_names.append(label_name)
+            updated_account = True
+
+    if updated_account:
+        await update_user_account(account)
+
+    payment.labels = data.labels
     await update_payment(payment)
     return SimpleStatus(success=True, message="Payment labels updated.")
 
diff --git a/tests/api/test_payment_api.py b/tests/api/test_payment_api.py
index 95339b2d0..447feaffb 100644
--- a/tests/api/test_payment_api.py
+++ b/tests/api/test_payment_api.py
@@ -376,6 +376,62 @@ async def test_payment_extra_update_requires_successful_payment(
     )
 
 
+@pytest.mark.anyio
+async def test_api_update_payment_labels(
+    client,
+    to_wallet,
+    adminkey_headers_to,
+):
+    payment_hash = uuid4().hex
+    checking_id = await _create_payment(
+        to_wallet.id,
+        amount_msat=1_000,
+        payment_hash=payment_hash,
+        status=PaymentState.SUCCESS,
+    )
+
+    # 1. Update labels with new valid labels
+    response = await client.put(
+        f"/api/v1/payments/{payment_hash}/labels",
+        headers=adminkey_headers_to,
+        json={"labels": ["income", "restaurant"]},
+    )
+    assert response.status_code == 200
+    assert response.json()["success"] is True
+
+    # 2. Check that the labels were updated on the payment
+    payment = await get_payment(checking_id)
+    assert payment.labels == ["income", "restaurant"]
+
+    # 3. Check that the new labels were auto-created in the user's account config
+    from lnbits.core.crud.users import get_account
+
+    account = await get_account(to_wallet.user)
+    assert account is not None
+    user_labels = {label.name: label.color for label in account.extra.labels}
+    assert "income" in user_labels
+    assert "restaurant" in user_labels
+    assert (
+        user_labels["income"] is not None
+        and user_labels["income"].startswith("#")
+        and len(user_labels["income"]) == 7
+    )
+    assert (
+        user_labels["restaurant"] is not None
+        and user_labels["restaurant"].startswith("#")
+        and len(user_labels["restaurant"]) == 7
+    )
+
+    # 4. Check that invalid labels are rejected
+    response = await client.put(
+        f"/api/v1/payments/{payment_hash}/labels",
+        headers=adminkey_headers_to,
+        json={"labels": ["invalid!label"]},
+    )
+    assert response.status_code == 400
+    assert "Invalid label name" in response.json()["detail"]
+
+
 async def _create_payment(
     wallet_id: str,
     *,