There are three answers to this.
Firstly, some transponders have their own encoder built in (Filser for example).
Secondly, a "blind encoder" can be used and can be thought of as an external add-on box for the transponder which is hidden away and has no controls.
Lastly you can have an encoding altimeter. This looks like a normal altimeter but has a seperate (electronic) output for the transponder.
In all cases they are connected into the static system and transmit the height relative to 1013. The controller can input the QNH into the radar system which can then convert your transponder output to Altitude.
If you had been at edinburgh or Glasgow yesterday you could have made an even bigger error as the QNH went down to 966mb which would give an error of around 1400ft!