For an Installation to be IFR certified the GPS has to be connected to an altitude encoder. The GARMIN 430/530 will use the encoder data as the primary altitude indication.
If the encoder failed it would flag up that it has no altitude data and you can then enter the settings menu and switch it back to GPS derived data. The unit is then no longer certified for IFR flight.
You don't need to set QNH or otherwise as the encoder encodes at 1013mb.