Payroll Audit: A Complete Guide For Businesses

It goes without saying that payroll is one of the most critical business functions and therefore should be closely monitored and appraised.

Use this guide to learn everything you need to know about payroll audits so you can ensure your payroll process is efficient, accurate, and compliant.

What Is A Payroll Audit?

A payroll audit is a systematic review of an organization's payroll processes, records, and systems to ensure accuracy, compliance, and efficiency.

The purpose of a payroll audit is to verify that employees are being paid correctly, payroll taxes are properly calculated and remitted, and that the organization is adhering to relevant laws and regulations.

Payroll auditing ensures compliance by identifying discrepancies, such as errors in wage garnishment calculations, protecting both employees and employers from legal risks.

A thorough payroll audit typically includes:

1. Verifying employee data: Names, job titles, pay rates, tax withholdings, and classifications (employee vs contractor).
2. Checking hours and pay: Ensuring time records match payments and overtime is correctly calculated.
3. Reviewing benefits and deductions: Confirming that insurance, 401(k), and other deductions are accurate and authorized.
4. Validating tax payments and filings: Ensuring correct amounts are withheld, paid, and reported to the IRS and other agencies.
5. Matching reports to financial records: Cross-checking payroll expenses with accounting and bank records.
6. Spotting unusual activity: Looking for red flags like duplicate payments, ghost employees, or unexpected bonuses.

Why Conduct A Payroll Audit?

Conducing periodical payroll audits is important for the following reasons:

• Accuracy: Helps ensure that employees are paid the correct amounts, including wages, overtime, bonuses, and deductions. This prevents underpayments or overpayments, which can lead to employee dissatisfaction and financial discrepancies.
• Compliance: Verifies adherence to federal, state, and local labor laws and tax regulations. Ensures accuracy of special considerations, like payroll garnishment calculations.
• Fraud Prevention: Detects and mitigates payroll fraud, such as ghost employees, unauthorized pay rate changes, or improper expense reimbursements. Strong internal controls identified through audits help in preventing such activities.
• Financial Accuracy: Ensures accurate financial reporting, which is crucial for budgeting, financial planning, and reporting to stakeholders. Accurate payroll records contribute to the overall financial health and transparency of the organization.
• Operational Efficiency: Identifies inefficiencies in the payroll process, enabling the organization to streamline operations, reduce processing time, and lower administrative costs.
• Risk Management: Identifies and addresses potential risks related to payroll, such as data breaches, unauthorized access, and system errors. This helps protect sensitive employee information and maintain the integrity of the payroll system.
• Improved Decision Making: Provides accurate and reliable payroll data, which is essential for informed decision-making by management. It supports strategic planning and human resource management.

In summary, regular audits help catch and fix small errors before they snowball, ensure compliance with tax and labor laws, reduce the risk of employee disputes or audits from authorities, and maintain accurate financial records for strategic planning.

Pro Tip

The timing of audits matters more than most realize. I run comprehensive audits quarterly for most clients, but certain high-risk areas need monthly attention. Benefits reconciliation, for instance—I check this monthly because errors compound fast and create major headaches with providers.—Andrew Lokenauth, Fractional CFO and financial advisor

How To Audit Payroll

So, now you’re aware of why auditing payroll is important, how can you actually do it yourself? Follow this detailed step-by-step guide to perform a comprehensive payroll audit.

1.  Define the scope and objectives

As Kimberly DeCarrera, Fractional CFO at Springboard Legal, suggests “The first thing is to figure out regarding payroll audits is what the goal is.

Some common reasons that we do these audits is for 401k compliance, workers compensation compliance, EEOC compliance, or lawsuits. Starting with the purpose in mind will help guide what data is collected and analyzed.”

Pro Tip

Document the audit process comprehensively, as findings may become evidence in regulatory proceedings or litigation. Legal considerations include maintaining attorney-client privilege when possible by involving counsel in audit planning, ensuring compliance with record retention requirements, and understanding that audit discoveries can trigger mandatory reporting obligations under certain circumstances.—Seann Malloy, Founder and Managing Partner of Malloy Law Offices

2. Gather payroll documentation

Collect all relevant records for the audit period, such as:

• Employee profiles (hire date, classification, wage rate)
• Time and attendance records
• Pay stubs and payroll reports
• Tax forms (W-2s, 1099s, 941s, 940s)
• Direct deposit authorizations
• Benefits and deductions summaries

As Lee Baldwin, Head of Managed Services at Pay Check Limited, highlights:

“When auditing payroll, the most important first step is to have your employee data accurate and consistent in your payroll and HR systems.

To do this, you review employment status (full-time, part-time, contractor), job titles, pay rates, scheduled hours, and tax information.

As a specific example, I review W-4 forms against the tax withholding information in the payroll system to ensure no errors.

If the marital status or number of dependents of a person shifted and the record was not updated, it can result in withholdings being incorrectly done—and that will cost penalties to the business from the IRS.”

Tip: Ensure you also have system logs or audit trails for any manual adjustments made during the payroll period.

3. Conduct the audit

Now you have everything in place, it’s time to conduct the actual audit. Here are some examples of what you could be looking out for:

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1. Employee classification

• What to check: Ensure employees are correctly classified as exempt/non-exempt under the FLSA and as employees vs. independent contractors.
• Why it matters: Misclassification can lead to costly penalties, back wages, and tax issues.

2. Wage and hour compliance

• Hours Worked: Validate timesheets and punch records against pay received.
• Overtime: Confirm that overtime is paid accurately and consistently, especially for non-exempt employees.
• Minimum Wage: Cross-reference pay rates against federal, state, and local minimum wage laws.

3. Deductions and benefits

• Authorized Deductions: Ensure all deductions (benefits, garnishments, taxes) are legally compliant and properly authorized.
• Benefit Contributions: Verify employer and employee contributions to health plans, retirement, etc. are correct and timely.

4. Tax withholdings and reporting

• Federal, State, and Local Taxes: Check correct withholding amounts and that deposits were made on time.
• FICA & FUTA/SUTA: Ensure Social Security, Medicare, and unemployment taxes are accurately calculated and remitted.
• Tax Filings: Confirm that W-2s, 1099s, and quarterly payroll tax returns (like Form 941) match internal records.

5. Pay frequency and accuracy

• Pay Periods: Verify consistent and timely payroll runs as per the company’s pay schedule.
• Gross-to-Net Calculations: Recalculate sample payslips to ensure deductions are correct.

6. Leave and PTO tracking

• Accrual Accuracy: Audit leave balances and accruals (vacation, sick leave, etc.) to ensure compliance with company policy and legal mandates.
• Usage Recording: Ensure leave used has been deducted appropriately and reflected on payroll.

7. Recordkeeping requirements

• Retention: Check that payroll records are being kept for the legally required period (typically 3–4 years).
• Accessibility: Ensure records are securely stored but accessible for audits or employee inquiries.

8. Review payroll policies and procedures

Examine your organization's payroll policy and procedures and ensure they're up-to-date and comply with relevant laws and regulations.

Remember that there is a mix of federal and state payroll regulations to comply with.

Pro Tip

The project manager needs to have the critical thinking skills to determine if in the course of the audit, it requires immediate remedy (and doesn’t look like you’re trying to cover anything up to avoid perceptions of impropriety) or if it can wait until after the summary report is provided.—Eric Mochnacz, Director of Operations, Red Clover HR

Sample audit techniques

• Spot Checks: Randomly select employees from different departments for detailed review.
• Trend Analysis: Compare payroll reports over multiple periods to identify spikes, anomalies, or recurring issues.
• Cross-Referencing: Match payroll records against HR files (hiring documents, contracts) and time-tracking systems.
• Reconciliation: Ensure that payroll journal entries in the general ledger align with actual payroll bank transfers.

Pro Tip

Finding discrepancies is often a matter of following patterns. If there is a persistent issue in a given department—e.g., not deducting 401(k) contributions or misclassifying employees—it usually reflects an area of training or process shortcoming. We once found that several employees were improperly classified as exempt, making them ineligible for overtime pay when they should have been receiving it. That audit led to a complete review of classifications, and we updated job descriptions and retrained managers on FLSA guidelines.—Lee Baldwin, Head of Managed Services, Pay Check Limited

4) Creating a summary report

The next step is to present your findings in a summary report. While yours might vary, it will likely look something like this:

• Title Page
  • Report title: Payroll Audit Report
  • Company name
  • Audit period (e.g., Jan 1 – Mar 31, 2025)
  • Date of report
  • Name and role of the auditor
• Executive summary—A 1-page summary that provides:
  • Purpose of the audit
  • Scope (which departments, pay periods, or systems were reviewed)
  • Methodology (e.g., random sampling, cross-verification)
  • Key findings (e.g., number of discrepancies, classification issues)
  • High-level recommendations
• Scope and Objectives—Clearly define:
  • Scope: What was reviewed (e.g., 3 months of payroll records, 5 departments, 2 payroll systems)
  • Objectives e.g. Ensure compliance with labor laws and tax regulations, confirm accuracy of payments, deductions, and classifications.
• Methodology—Explain how the audit was conducted:
  • Types of data reviewed (payroll records, timesheets, HR files, tax filings)
  • Sampling approach (e.g., 10% of employee population)
  • Tools used (e.g., spreadsheets, payroll software reports)
• Detailed findings—This is the heart of the report. Structure it by audit category for clarity e.g. employee classification, wage and hour issues, etc. Include:
  • Issue
  • Impact (e.g., financial, compliance, employee morale)
  • Root cause (e.g., system error, policy gap)
  • Suggested action
• Recommendations—Make actionable suggestions e.g. update employee classification checks, automate overtime calculation.
  • Prioritize them (e.g., Critical, High, Medium, Low) to help decision-makers focus.
• Appendices: Sample payslips reviewed, recalculated pay vs. actual pay, screenshots or logs of findings, relevant policies or legal references.

Presentation tips:

• Know your audience—Tailor the presentation to:
  • Executives: Focus on risks, compliance, costs, and strategic fixes.
  • HR/Payroll Teams: Emphasize process flaws, tools, and tactical recommendations.
  • Finance: Highlight financial impacts and control weaknesses.
• Use visual aids—Create a short slide deck or dashboard with:
  • Charts: Misclassification or deduction errors by type or department
  • Tables: Summary of findings with severity
  • Diagrams: Workflow issues or process gaps

5) Make an action plan

Following the identification of payroll discrepancies and improvement opportunities outlined in this report, the next step is to implement a structured action plan to address these findings. 

The goal is to correct issues, strengthen compliance, and improve payroll accuracy and efficiency going forward.

To do this effectively, the audit findings should be reviewed and grouped by theme—such as employee classification, tax compliance, wage calculations, and benefits administration.

Each issue should be prioritized based on its level of risk or impact, with urgent items (e.g. potential legal or financial exposure) addressed first.

For each area of concern, the team should define clear objectives and translate them into specific, trackable actions. 

For example, reclassifying misidentified contractors, setting up automated overtime calculations, or introducing regular reconciliation of benefits deductions. Each task should have:

• A clearly designated owner
• A target completion date
• Status updates
• Any tools, support, or approvals needed

This information should be captured in a centralized tracker—whether a spreadsheet or project management tool—so progress can be easily monitored. 

Regular check-ins (e.g. biweekly) will help ensure accountability, remove roadblocks, and keep the plan on schedule.

As fixes are implemented, it's important to revise any associated policies or documentation (e.g. SOPs, payroll procedures, employee handbook) to reflect the updated processes.

Where feasible, controls should also be introduced to prevent recurrence—such as automated audit checks or approval workflows.

Lastly, scheduling a follow-up audit in the coming months will help confirm the changes are working as intended and reinforce long-term compliance.

Primary Payroll Issues

As mentioned above, during payroll audits, several common errors tend to emerge—some stemming from manual mistakes, others from system limitations or outdated policies. 

Here's some of the most frequently observed payroll audit issues:

• Misclassification of employees as independent contractors or incorrect exempt/non-exempt status
• Outdated or incorrect pay rates leading to under- or overpayment
• Overtime not calculated or paid accurately
• Incorrect federal, state, or local tax withholdings
• Paystub compliance
• Discrimination patterns
• Missing or unauthorized payroll deductions (e.g., benefits, garnishments)
• Inaccurate tracking or application of PTO and leave balances
• Failure to comply with wage laws (e.g., minimum wage, final pay timing)
• Late, missing, or incorrect tax filings and reports (e.g., W-2s, 941s)
• Incomplete or missing payroll documentation and time records
• Garnishments
• Errors caused by poor integration between timekeeping, HR, and payroll systems.
• Terminated still getting paid or even fake employees 

Pro Tip

Several states or local jurisdictions require certain information to be displayed on the paystubs. We want to make sure that the proper information is displayed according to the laws. This is where you may need to have legal counsel help with the audit.—Kimberly DeCarrera, Fractional CFO, Springboard Legal

Payroll Audit Best Practices

Auditing payroll is an important task that may involve multiple departments. Here are some best practices so that, when it comes to auditing time, the auditing process is as effective and efficient as possible.

Here are some payroll auditing best practices to ensure a thorough and effective audit:

Regular audits

Conducting regular payroll audits, such as quarterly or annually, helps to identify and address issues promptly.

“I suggest you perform a mini-audit at least quarterly and a complete audit at the end of the year,” says Baldwin. “In quarterly audits, I focus on those high-risk areas like overtime pay, time-off accruals, and benefit deductions.

I once discovered during a Q2 audit that our company was paying overtime for a 38-hour workweek instead of 40, costing us a few hundred dollars. Finding it early prevented a huge year-end financial anomaly.”

Make use of automated systems

Utilize automated payroll systems to centralize data, generate detailed reports, and maintain accurate records of pay, taxes, and deductions.

It also provides audit trails and automated logs, making it easier to track changes, verify compliance, and spot discrepancies quickly.

Pro tip: Leverage the data analytics functionality built into new payroll systems. These systems can raise red flags on their own—such as duplicate payments, oversized bonus payments, or negative net pay.—Lee Baldwin, Head of Managed, Pay Check Limited

Work in cross-functional groups

Bringing multiple perspectives into the audit will help identify issues. As Baldwin highlights “Technology only goes so far. I always bring cross-functional groups, like HR, finance, and legal, together to review the numbers.

Each department brings a different point of view—finance may be able to confirm accuracy of payment, HR may be able to confirm policy consistency, and legal may be able to confirm compliance with labor regulations.

To illustrate, during a recent audit, our attorney noted that we were unknowingly breaking a local labor regulation on frequency of pay in one of our satellite locations.”

Maintain detailed audit documentation

As Seann Malloy, Founder and Managing Partner of Malloy Law Offices, suggests, “Maintain detailed audit documentation under attorney-client privilege when possible, as audit findings frequently become central evidence in wage and hour litigation or regulatory enforcement actions.

Implement ongoing monitoring procedures to prevent recurring violations while training management on proper payroll practices and documentation requirements.”

How Payroll Software Can Help Employers Improve Audits

Payroll software can significantly aid you in conducting a payroll audit by automating processes, ensuring accuracy, and providing comprehensive data and reports.

Here are several ways payroll software can help with your payroll audit:

• Centralized data. All payroll information is stored in a single, centralized system, making it easier to access and review data during an audit.
• Error detection tools: Built-in tools to flag potential errors and fraudulent activities.
• Detailed reporting: Generate detailed payroll reports that provide insights into payroll transactions, tax filings, and employee earnings, facilitating thorough reviews.
• Audit trails: Maintains an audit trail of all payroll-related changes and transactions, including who made changes and when aiding in tracking and verifying activities.
• Data accuracy: Minimizes the risk of errors by validating data entry and performing consistent calculations across all payroll periods.
• Customizable checklists and alerts: Allows you to create customizable checklists and set up alerts for important payroll tasks and deadlines, ensuring nothing is overlooked during the audit.
• Historical data access: Easily access historical payroll data for comparison and trend analysis, which can help identify anomalies or discrepancies.
• Backup and recovery. Ensures data is regularly backed up and can be recovered in case of system failures, protecting against data loss.

For more information, check out our pick of the best payroll software.

Auditing Payroll FAQs

Why is a payroll audit necessary?

To ensure employees are paid accurately and on time, verify legal compliance (wage laws, tax regulations), identify process gaps, and prevent costly errors or fraud.

Is auditing payroll a legal requirement?

Although it’s not a legal requirement, auditing payroll demonstrates accountability and operational maturity, and may become functionally necessary in industries subject to government contracts, union agreements, or nonprofit reporting standards.

How often should payroll audits be conducted?

Best practice is at least annually, with quarterly mini-audits or spot checks depending on organizational size, complexity, or risk exposure.

Who should perform the payroll audit?

Ideally, someone independent of the payroll process, such as an internal audit team, HR business partner, or external auditor, to ensure objectivity.

What laws or regulations must payroll comply with?

Payroll must comply with:

• • Recordkeeping regulations

• • Federal laws (e.g., FLSA, IRS code)

• • State/local wage laws

• • Tax deadlines and reporting requirements

• • Recordkeeping regulations

What systems or tools support payroll auditing?

Common tools include:

• • Audit checklists and payroll compliance logs.

• • Payroll software (e.g., Gusto, ADP, Paychex)

• • Time tracking integrations

• • Spreadsheets and reconciliation templates

• • Audit checklists and payroll compliance logs.