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Payroll Processing: A Comprehensive Guide For Modern Businesses

Finn Bartram

QUICK SUMMARY

Does payroll processing give you the heebie jeebies? Use this comprehensive guide to help make your payroll process as efficient and accurate as possible.

TABLE OF CONTENTS What Is Payroll Processing? Payroll Cycles What’s Needed To Process Payrolls How To Process Payroll Payroll Processing Best Practices Payroll Taxes Payroll Regulations Required Payroll Documents Classifying Workers Payroll Policy Using Payroll Software Using Payroll Services

Payroll processing is a critical function in any business and one it *coughs* pays to get right.

There’s quite a lot of fiddly admin and regulation to navigate, so I’ve put together this guide to provide you with a comprehensive understanding of how payroll works and how to process 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.
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 through either 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 you can outsource payroll to specialized payroll service providers.

Payroll software is commonly used to automate many aspects of the payroll process and help ensure accuracy and compliance (payroll software explained later).

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.

Payroll cycle type	Number of cycles per year	Common for
Weekly	52	Hourly
Bi-weekly	26	Hourly/salaried
Semi-monthly	24	Salaried
Monthly	12	Salaried

Payroll cycles for different employee types.

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. Here's a checklist for running a successful payroll:

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 (more on this further down).

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

Setting up payroll requires collecting employee tax information and calculating deductions. Integrating top tax management solutions ensures accurate and efficient processing.

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 wage garnishments or deductions legally required or agreed upon.

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 Processing 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 and 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, payroll services specifically for small businesses, 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 maintain 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.

Payroll Taxes

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.

Payroll Regulations

A mix of federal and state laws govern the payroll process. Here’s what to look out for:

Fair Labor Standards Act (FLSA)

The Fair Labor Standards Act (FLSA) is a U.S. federal law enacted in 1938 that establishes minimum wage, overtime pay, recordkeeping, and youth employment standards affecting full-time and part-time workers in the private sector and in federal, state, and local governments. Key provisions of the FLSA include:

Minimum Wage: The FLSA sets the federal minimum wage, which as of 2023 is $7.25 per hour. Some states and cities have established higher minimum wages.
Overtime Pay: Employees covered by the FLSA must receive overtime pay for hours worked over 40 in a workweek at a rate not less than time and one-half their regular rates of pay.
Recordkeeping: Employers must keep employee time and pay records.
Child Labor: The FLSA restricts the employment of minors, particularly those under the age of 18, in certain jobs and during certain hours to ensure their health, well-being, and educational opportunities.

Certain employees are exempt from some of the FLSA’s requirements, such as those in executive, administrative, professional, and outside sales positions, as well as some computer employees, who meet specific criteria regarding their job duties and compensation.

The Federal Insurance Contributions Act (FICA)

The Federal Insurance Contributions Act (FICA) is a U.S. federal law that requires employers and employees to contribute to Social Security and Medicare, which are programs providing benefits for retirees, disabled individuals, and children of deceased workers. Key aspects of FICA include:

Social Security: FICA taxes fund the Social Security program, which provides retirement, disability, and survivor benefits. As of 2023, the Social Security tax rate is 6.2% for both employers and employees, on earnings up to a certain annual limit ($160,200 in 2023).
Medicare: FICA taxes also fund the Medicare program, which provides health insurance for people aged 65 and older and certain younger individuals with disabilities. The Medicare tax rate is 1.45% for both employers and employees, with no income limit. Additionally, an extra 0.9% Medicare tax applies to high earners (income above $200,000 for single filers and $250,000 for married couples filing jointly).
Employer Contributions: Employers match the contributions made by employees, paying an equal amount for both Social Security and Medicare taxes.
Self-Employed Individuals: Self-employed individuals are responsible for the entire FICA contribution, paying a combined rate of 15.3% (12.4% for Social Security and 2.9% for Medicare). They can, however, deduct the employer-equivalent portion of the Social Security tax when calculating their income tax.

The Federal Unemployment Tax Act (FUTA)

The Federal Unemployment Tax Act (FUTA) is a U.S. federal law that imposes a payroll tax on employers to fund unemployment compensation programs.

Only employers pay the FUTA tax; employees do not. The FUTA tax rate is 6.0% on the first $7,000 of each employee's annual wages.

However, employers can receive a tax credit of up to 5.4% for timely payment of state unemployment taxes, effectively reducing the FUTA tax rate to 0.6% in most cases.

The FUTA tax applies to the first $7,000 of an employee's wages each year. Wages beyond this amount are not subject to FUTA tax.

State laws

Payroll rules and regulations can vary significantly from state to state in the United States. Here are some key aspects and examples of state-specific payroll requirements:

Minimum wage: Many states have minimum wage rates higher than the federal minimum wage. For example, California has a minimum wage of $15.50 per hour (as of 2023) for employers with 26 or more employees.
Overtime: Some states have specific overtime rules that differ from federal regulations. For instance, California requires overtime pay for any hours worked over 8 in a day and over 40 in a week, as well as for the first 8 hours on the seventh consecutive day of work in a workweek.
Pay frequency: States may dictate how often employees must be paid. In New York, for example, manual workers must be paid weekly, while clerical and other workers can be paid semimonthly or monthly.
State income tax withholding: Employers must withhold state income tax according to each state's rules. For instance, in Massachusetts, the state income tax withholding rate is a flat 5% on most wages.
Paid leave: Some states mandate paid leave policies. For example, New Jersey requires employers to provide paid sick leave, accruing at a rate of 1 hour for every 30 hours worked, up to 40 hours per year.
Unemployment insurance: States administer their own unemployment insurance programs with varying tax rates and wage bases. For instance, in Texas, the unemployment tax rate for new employers is 2.7% on the first $9,000 of each employee’s wages.

Payroll specialists and software can help you keep track of all the above labor laws and state variations. Some useful resources:

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 W-9: Used to request a taxpayer identification number (TIN) and certification from U.S. persons (including resident aliens). It is typically used by individuals and businesses that are not subject to withholding taxes. For example, independent contractors, freelancers, and other self-employed individuals often complete a W-9 form for clients who need to report payments made to them.
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.

How To Classify Workers

In general, workers can be classified into two main categories: employees and independent contractors. Here’s how to classify them:

Full-time employees

Employees typically work under the control and direction of the employer. The employer determines what work will be done and how it will be performed. Key characteristics of employees include:

Behavioral control: The employer directs and controls how the work is done, including when and where to work, what tools or equipment to use, what assistants to hire, where to purchase supplies, and what work must be performed by a specified individual.
Financial control: The employer has the right to control the business aspects of the worker’s job, including:
- Significant investment in tools or equipment.
- Unreimbursed expenses.
- Opportunity for profit or loss.
- Services available to the market.
- Method of payment (hourly, weekly, or salary).
Relationship type:
- Written contracts describing the relationship.
- Employee benefits such as insurance, pension plans, paid leave, etc.
- The relationship is expected to continue indefinitely.
- The work performed is a key aspect of the business.

Independent contractors

Independent contractors operate under a different set of criteria. They are self-employed and often run their own businesses. Key characteristics of independent contractors include:

Behavioral control: Independent contractors have control over how they perform their work. They decide when, where, and how to do their tasks without the employer’s instruction.
Financial control: Independent contractors have a significant degree of control over the business aspects of their work. They often:
- Have significant investment in their tools and equipment.
- Pay their own business expenses.
- Have the opportunity to make a profit or incur a loss.
- Offer their services to other clients or customers.
- Are typically paid per job or on a project basis.
Relationship type:
- Contracts outlining the work and relationship specifics.
- No employee benefits provided.
- Often a project-specific or fixed-term relationship.
- The work performed may not be central to the employer’s core business.

Factors to consider

To classify workers accurately, consider the following factors:

Control: How much control does the employer have over the worker’s activities? More control suggests an employee relationship.
Financial investment: Does the worker have a significant investment in their work and the opportunity for profit or loss? Independent contractors often have more financial investment.
Relationship nature: Is there an ongoing relationship with benefits, or is the relationship project-based without benefits?

How To Establish A Payroll Policy

We touched on this earlier, but here’s a more detailed explanation of how to write your payroll policy.

1. Introduction

Purpose: Explain the objective of the payroll policy.
Scope: Identify who the policy applies to (e.g., all employees, specific departments).

2. Pay periods and pay dates

Pay frequency: Specify how often employees are paid (e.g., weekly, bi-weekly, semi-monthly, monthly).
Pay dates: List the specific dates when employees will receive their paychecks.

3. Wages and salaries

Base pay rates: Describe how base pay rates are determined.
Overtime pay: Outline the conditions for overtime pay and the rates applicable.
Bonuses and incentives: Provide guidelines for any bonus or incentive programs.

4. Payroll deductions

Mandatory deductions: Detail required deductions such as federal and state taxes, Social Security, and Medicare.
Voluntary deductions: Include information on voluntary deductions like retirement contributions, health insurance premiums, and charitable donations.

5. Timekeeping and attendance

Time tracking methods: Describe the methods for tracking employee hours (e.g., time clocks, timesheets, electronic systems).
Submission deadlines: Specify deadlines for submitting and approving time records.

6. Payroll processing

Processing Schedule: Outline the timeline for payroll processing, including when data needs to be submitted and approved.
Verification Procedures: Include steps for reviewing and verifying payroll data before processing payments.

7. Payment methods

Direct deposit: Encourage or require direct deposit and explain the setup process.
Paper checks: If paper checks are used, describe the distribution process and any associated deadlines.

8. Handling payroll errors

Error reporting: Define the procedure for employees to report payroll errors.
Correction process: Establish the process and timeline for correcting payroll errors and making adjustments.

9. Final paychecks

Termination pay: Specify when and how final paychecks will be issued for terminated employees.
Resignation pay: Outline the process for issuing final paychecks to employees who resign.

10. Compliance and recordkeeping

Legal Compliance: Ensure the policy complies with all relevant federal, state, and local laws.
Record Retention: Specify the types of records that need to be maintained and the retention period.

11. Employee classification

Classification guidelines: Provide criteria for classifying employees (e.g., full-time, part-time, temporary, independent contractors).
Exempt vs. Non-Exempt: Define the differences between exempt and non-exempt employees under the Fair Labor Standards Act (FLSA).

12. Paid time off (PTO) and leaves of absence

PTO accrual: Explain how paid time off is accrued and used.
Leave policies: Outline policies for different types of leave (e.g., sick leave, vacation leave, family leave).

13. Payroll changes

Change requests: Describe how employees can request changes to their payroll information (e.g., changes in tax withholding, direct deposit details).
Notification requirements: Specify the notice period required for processing changes.

14. Confidentiality and security

Data protection: Outline measures to protect the confidentiality and security of payroll information.
Access controls: Describe who has access to payroll information and under what circumstances.

15. Policy review and updates

Regular review: Schedule regular reviews of the payroll policy to ensure it remains up-to-date.
Update procedures: Explain the process for updating the policy and how updates will be communicated to employees.

Using Payroll Software

You could process payroll manually, including calculating wages and tax deductions, but this can be time-consuming and prone to errors if you do payroll yourself.

Payroll software automates much of the time-consuming and potentially error-prone tasks related to payroll management including calculating wages, withholding taxes, direct deposits, submitting reports, and generating paychecks. So the value gained greatly outweighs any costs associated with payroll solutions.

Benefits of using payroll software include:

Quickly and accurately calculating employee pay
Ensuring federal tax compliance with the IRS (or CRA for Canadian payroll solutions), avoiding breaking tax laws by accident.
Accounting for local tax compliance in the areas where your employees do their work.
A self-service portal where employees can access pay stubs and tax forms, update their bank account information, use time tracking tools, and more.
Access to expense management software functionality for on-the-job costs.

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

Featured Software

Using Payroll Services

The functionality of a payroll service—as provided by an external company—includes handling all aspects of payroll processing on your behalf.

These services take on the responsibility of managing payroll including calculating wages, deducting taxes, and ensuring compliance with legal and tax requirements.

The goal of payroll services is to streamline payroll operations, reduce the administrative burden on internal staff, and mitigate compliance risks. These services are particularly useful for managing global payroll.

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

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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