Payroll processing is a critical function in any business.
If you’re a small business opting to process payroll manually, you’ll likely want to automate much of the process using payroll software.
To help, this guide will provide you with a comprehensive understanding of how payroll works and how to manage it.
What Is Payroll Processing?
Payroll processing is an essential business function that involves managing the payment of salaries to employees at the end of the pay period. This process includes several key tasks:
- Employee information management: Keeping accurate records of each employee's personal and employment information, such as name, address, social security number, and details of the job position.
- Time tracking: Recording the time worked by each employee. This can be done through time tracking software to track hours worked, overtime, and leave time.
- Calculating pay: Determining the correct amount to pay for each employee. This involves calculating total compensation including gross wages (based on hourly rates or salaries), adding any bonuses or commissions, and accounting for overtime payments.
- Deducting payroll taxes and other withholdings: Calculating and deducting federal, state, and local taxes, as well as other deductions like social security, Medicare, retirement plan contributions, health insurance premiums, and any other garnishments or deductions.
- Issuing payments: Paying employees either through direct deposit to their bank accounts, paper checks, or pay cards.
- Reporting and record-keeping: Maintaining records of payroll transactions and ensuring compliance with employment and tax laws. This includes reporting to government agencies and providing employees with payroll-related documents such as pay stubs and year-end tax forms (e.g., W-2 forms in the United States).
- Compliance with laws and regulations: Ensuring that the payroll process complies with all relevant laws and regulations, including tax laws, minimum wage requirements, overtime rules, and record-keeping laws.
Payroll processing can be handled in-house by your accounting or human resources department, or it can be outsourced to specialized payroll service providers.
Payroll software is commonly used to automate many aspects of the payroll process and help ensure accuracy and compliance.
Typical Payroll Cycles
Common payroll cycles refer to the frequency with which a business calculates and distributes wages to its employees. The choice of payroll cycle can impact both the employer's cash flow and the employees' budgeting. Here are the most common types:
- Weekly payroll: Employees are paid once a week, often on a specific day like Friday. This results in 52 pay periods per year.
- Bi-weekly payroll: In this cycle, employees are paid every two weeks, typically resulting in 26 pay periods per year.
- Semi-monthly payroll: Employees are paid twice a month, usually on the 1st and 15th or the 15th and last day of the month. This results in 24 pay periods per year.
- Monthly payroll: This cycle involves paying employees once a month, resulting in 12 pay periods per year.
The choice of payroll cycle can depend on various factors, including the nature of the workforce (salaried vs. hourly employees), administrative capacity, cash flow considerations, and employee preferences.
Additionally, some regions or countries may have legal requirements or customary practices that influence the choice of payroll cycle.
What’s Needed To Process Payroll
To run an accurate, compliant payroll process, you’re going to need:
- An employer identification number (EIN) and state/local tax IDs.
- Employee information: Accurate and up-to-date records of all employees, including their full names, addresses, social security numbers or equivalent identification, employment start dates, and other relevant personal details.
- Employment contracts: Detailed records of employment terms, including salary or hourly rates, overtime rates, bonus or commission structures, and any other compensation agreements.
- Timekeeping system: For hourly employees, a reliable system to track hours worked, including regular hours, overtime, and any leave taken, such as vacation or sick leave.
- Payroll schedule: A clear payroll schedule (weekly, bi-weekly, semi-monthly, or monthly) that complies with local labor laws.
- Tax information: Understanding of applicable local, state, and federal tax laws to accurately withhold and remit payroll taxes. This includes federal income tax, Social Security, Medicare, and any state or local taxes.
- Benefits information: Details of any benefits provided to employees, such as health insurance, retirement plans, and other perks, and how these impact payroll calculations.
- Bank account information: For organizations offering direct deposit, current bank account information for each employee is necessary.
How To Process Payroll
Imagining that you’re starting from scratch, here’s how to set up and run an efficient, compliant payroll process.
Step 1: Gain your EIN and state/local tax IDs
- Follow this guide from the IRS to do so.
Step 2: Establish your payroll policy
- Define payroll schedule: Decide on a regular payroll cycle (weekly, bi-weekly, semi-monthly, or monthly).
- Set up payroll policies: Establish clear policies for overtime, leave, benefits, deductions, and other payroll-related aspects.
Step 3: Collect and verify employee information
- Check employee data: Check you have accurate employee information including:
- Tax forms (W-4, W-9, I-9)
- Identification numbers (like Social Security numbers)
- Deductions: benefits such as health insurance and retirement plans
- Bank account details
- Employment contracts with correct salary or hourly rates.
Step 4: Track time and attendance
- Tally work hours: For hourly employees, track the number of hours worked, including regular hours and overtime.
- Manage leave and absences: Take note of any vacation, sick leave, or other absences as it pertains to worker pay.
Step 5: Calculate gross pay
- Determine gross pay for hourly employees: Multiply the number of regular hours worked by the hourly rate, and add any overtime pay.
- Calculate gross pay for salaried employees: Divide annual salary by the number of pay periods to get the gross pay for each cycle.
Step 6: Calculate deductions
- Withhold taxes: Calculate and withhold federal, state, and local taxes based on employee tax information.
- Deduct benefits and other contributions: Deduct contributions for benefits like health insurance, retirement plans, etc.
- Account for other deductions: Include any other garnishments, deductions legally required or agreed upon such as from on-demand pay.
Step 7: Determine net pay
- Subtract deductions from gross pay: The result after all deductions is the net pay for each employee.
Step 8: Process payments
- Issue payments: Pay employees via the chosen method (direct deposit, check, cash, etc.).
- Provide pay stubs: Distribute pay stubs to employees, detailing gross pay, deductions, and net pay.
Step 9: Record and report payroll
- Maintain records: Keep detailed records of each payroll cycle for internal and legal purposes.
- Report to government agencies: File required reports with tax authorities and other government agencies.
Step 10: Prepare for year-end processing
- Year-end reports: Prepare and distribute year-end tax documents to employees (like W-2s in the U.S.).
- Reconcile yearly data: Ensure all payroll data for the year is accurate and complete.
Step 11: Review and update payroll information
- Regular audits: Periodically audit the payroll process for accuracy and compliance.
- Update policies and records: Make adjustments as needed for changes in tax laws, employee information, or company policies.
Payroll Process Best Practices
Follow these best practices to help ensure you run an efficient and accurate process.
- Stay updated on regulations: Regularly update your knowledge of local, state, and federal tax laws and employment regulations. This includes understanding changes in tax rates, minimum wage laws, overtime rules, and benefits regulations. Resources like the US government’s compliance assistance will help here.
- Maintain accurate employee records: Keep accurate and up-to-date records of all employees, including their details, tax information, benefits, and any changes in their employment status or pay rate.
- Regular audits and reconciliation: Periodically audit your payroll process to ensure accuracy and reconcile payroll records with bank statements and general ledger accounts regularly.
- Open communication with managers. Communicate your payroll process with managers highlighting what’s required of them and when.
- Clear communication with employees: Maintain open lines of communication regarding payroll policies and changes, provide clear, detailed pay stubs, and be available to answer employee queries about their pay.
- Timely and accurate tax filings: Ensure that all payroll-related tax filings are accurate and submitted on time. This includes withholding the correct tax amounts and timely remittance to tax authorities.
- Data security and privacy: Implement strong security measures to protect sensitive payroll data. This includes safeguarding digital records and ensuring privacy in handling employee information.
- Make efficient use of technology:
- Invest in payroll software that can automate calculations, manage data, and stay updated with the latest tax rates and regulatory changes. To help, here are some key payroll software features.
- Use a reliable system for tracking employee hours, especially for hourly workers. Ensure that the system accurately captures regular hours, overtime, and leave.
- Prepare for year-end processing early: Start the year-end payroll process well in advance. This includes verifying employee information, updating payroll records, and preparing for tax document distribution.
- Seek professional advice: When in doubt, consult with payroll experts or legal advisors, especially for complex issues or major changes in payroll laws and practices.
- Document payroll procedures: Maintain a written record of all payroll procedures. This helps in maintaining consistency and serves as a training tool for new staff.
- Plan for contingencies: Have a backup plan for payroll processing in case of emergencies or unexpected disruptions (like technological issues or natural disasters).
- Seek employee input. As Malcolm Ferrante, senior accountant at CBS Group, highlights “Seeking employee input can also shed light on pain points and highlight opportunities for improvement.”
- Double and triple-check EVERYTHING before submitting.
For your payroll process to remain compliant, you have to deduct the appropriate payroll taxes from the employee’s paycheck:
- Social security: Known collectively as FICA taxes, both you and your employees contribute to these. The Social Security tax is 6.2%, paid by both the employee and the employer, for a total of 12.4%.
- Medicare taxes: The tax for Medicare is 1.45% for the employer and 1.45% for the employee, for a total Medicare tax of 2.9%.
- State and local taxes: Some states and local authorities might impose additional taxes.
Here’s a more comprehensive breakdown of payroll taxes.
A mix of federal and state laws govern the payroll process. Here’s what to look out for:
- Minimum wage: The Wages and the Fair Labor Standards Act (FLSA) sets the minimum wage as $7.25 per hour although some state minimum wages are higher.
- Overtime pay: Unless exempt, the FLSA states that any hours worked over 40 hours must be paid to employees as overtime pay.
- Pay frequency: Monthly payday requirements “must be consistent” at a federal level, but state laws vary
- Payment methods: While no federal law exists, some states have laws determining which payment method(s) you can use e.g. direct deposit or pay cards. To help, use this resource of wage payment laws.
- Payroll taxes: Must calculate all payroll taxes correctly and pay them on time
- Tax forms: Must file payroll tax forms on time
- Recordkeeping requirements: The FSLA requires employers to keep payroll records for non-exempt employees for at least three years.
- Paid sick leave: Federal law doesn’t require sick leave but, at the time of writing, there are 14 states with their own paid sick time laws.
- Paid family leave: While no federal law exists, at the time of writing, 13 states have mandatory paid family leave systems.
Required Payroll Documents
Here’s a list of the documents you need for processing payroll:
- Form 940: An annual federal tax form that employers must file if they’ve paid wages of $1,500 or more in a calendar quarter. It's used to report the employer's annual Federal Unemployment Tax Act (FUTA) tax liability.
- Form 941L: A form that employers must file quarterly to indicate how much they withheld in payroll taxes across all their employees per quarter. It's necessary for most small businesses that withhold federal income taxes and FICA taxes from their employees' paychecks.
- Form 944: A form that businesses must file if their annual liability for Social Security tax, Medicare Tax, and federal income tax is $1,000 or less.
- Form W-4: Also known as the Employee's Withholding Certificate, this form is filled out by employees upon being hired to let their employers know how much tax the employers should withhold from their paychecks.
- Form 1095-C: An employer-provided health insurance offer and coverage form that applicable large employers must file. It includes information about the health coverage for the employee, including the cost and covered months.
- Form 1096: A form used by the payers to summarize 1099-INT Forms being filed with the IRS. It's only required when 1099-INT Forms are filed by paper.
- Form 1099: A tax document that details any earnings received outside of the salary paid by an employer. It's required for self-employed people or those who run a side hustle.
- Form WH-347. As part of the David-Bacon Act, businesses working on government construction contracts worth over $2000 must submit certified payroll using this form.
Toward Error-Free Payroll Processing
Payroll is a business function that necessitates perfection (or as close as you can get to it).
If any errors occur then adapt your process and create procedures to avoid them in the future.
Remember to carry out regular audits double and triple-check everything before submitting!
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