My employee switched to regular insurance in April making him ineligible for HSA contributions. Payroll neglected to stop taking his contributions out and it was recently discovered and has since been corrected. What is the penalty for the employee since he has already used the money for medical bills?
First, your employee needs to work out his contribution limit for the year. Because he was eligible for a few months, his limit will be prorated. See this post for details on how to calculate the prorated limit.
Once he determines his contribution limit, you'll know how much needs to be taken out. You (or he) can do an excess contribution withdrawal to remove the extra contribution without penalty. See this post for more details.
If he has already spent some or all of the extra contribution, talk to the HSA custodian. They may be able to reclassify some of his distributions as excess contribution withdrawals. You won't get the money back, but it will avoid the penalty. Your employee would then need to add the extra as "other income" on his tax return so he can pay tax on it.
You have until April 15 to remove the excess HSA contributions. If you are unable to do it by then, the penalty to your employee is 6% (Source: Pub 969) on the excess that is not removed, in addition to the income tax.