How to Do Payroll

How to Do Payroll
Article by Zarah AriolaZarah Ariola
Last Updated: August 26, 2023

Payroll management involves essential components like wages, hours, benefits, taxes, deductions, garnishments, and regulatory compliance. All these aspects require equal attention to establish an effective and sustainable process.

Mistakes in payroll taxes lead to costly penalties; that’s why this article explains how to do payroll for any business, either independently or with the help of a professional payroll company.

How Does Payroll Work?

Payroll involves detailed documentation of your employees' work, including their hours, wages, and allocation of your budget for their compensation. It includes several steps, such as gathering employee information, calculating taxes and deductions, administering benefits, and sending paychecks. The process can be automated or performed manually.

Whether you’re an employer or hire an employer of record (EOR), you’ll need the following information to process payroll:

  • Employer Identification Number
  • Local tax ID
  • Employees’ Form W-4
  • Payroll frequency
  • Established payroll system
  • Employee banking details
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How to Do Payroll In-House

Managing payroll internally can be cost-effective for companies with few employees and dedicated payroll specialists or an HR department. Follow these five essential steps to learn how to do payroll yourself:

Step #1: Calculate Hours and Gross Pay

When manually processing your employees' payrolls, follow these steps:

  • Calculate working hours. Do it for every employee during the payment period (usually a month).
  • Calculate gross pay. Multiply the total hours by the employee's pay rate to get their gross pay.
  • Calculate overtime. According to the Fair Labor Standards Act, if an employee works overtime (more than 40 hours weekly), multiply each overtime hour by at least 1.5 times the regular pay rate. The US states have varying overtime pay requirements, so be sure to know the regulations applicable in your state.
  • Define workweeks. Ensure workweeks consist of seven consecutive 24-hour periods.

Step #2: Process Payroll Deductions

After determining the gross pay, the next step is processing payroll deductions:

  • Pre-tax deductions. Deduct contributions for benefits like health insurance, 401(k) retirement plans, and life insurance from the gross pay.
  • Statutory deductions. Calculate and withhold federal and state income taxes and Federal Insurance Contributions Act (FICA) taxes for social security and Medicare. As an employer, you must match the FICA tax portion.
  • Post-tax deductions. Subtract post-tax deductions, including court-ordered wage garnishments, IRA retirement plans, and other applicable deductions.

Some states and jurisdictions may have additional taxes that require withholding from employees' pay and payment by the employer. Be sure to know your state’s tax regulations.

Step #3: Define Your Net Pay and Pay Your Employees

The net pay is the amount remaining after subtracting all pre-tax and post-tax deductions from an employee's paycheck. This is the actual money that employees receive and take home.

Regarding processing and distributing paychecks, various methods are available if you comply with salary payment laws. You must be familiar with the specific electronic delivery requirements in the jurisdictions where you have employees.

Employers prioritize flexibility, cost-effectiveness, and compliance when choosing payment processing options, as traditional paper checks and postage can increase payroll operating expenses. Direct deposits, pay cards, eWallets, and similar payment methods are more convenient and cost-effective alternatives.

Step #4: File Tax Report

Taxes deducted from your employee's wages must be filed with the federal government. Form 941, or the Employer's Quarterly Federal Tax Return, is used to report and pay FICA taxes, income tax, Social Security tax, and other withheld taxes quarterly.

Employers pay the Federal Unemployment Tax Act (FUTA) and state unemployment taxes. These taxes should not be deducted from employee wages. You should file these in compliance with the local guidelines specified by your local jurisdiction.

Step #5: Document Your Payroll Records

Taking recordkeeping seriously is crucial to ensuring everything is accounted for, avoiding compliance issues, and providing accurate monthly payrolls.

Payroll records for each employee should include the following:

  • Name and occupation
  • Address
  • Social Security number
  • Day and time when an employee's workweek began
  • Number of hours worked each day and workweek
  • The basis on which the employee’s wages were paid
  • Regular hourly pay rate
  • Total daily or weekly straight-time earnings
  • Overtime earnings for each workweek
  • Gross wages
  • Payroll deductions
  • Allowances claimed
  • Net wages
  • Date of each payment and the pay period that it covered
  • Taxes withheld
  • Form W-4

You should keep the tax purposes record on file for at least four years, in compliance with federal or jurisdictional requirements.

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Best Payroll Methods for Businesses

The preferred payroll method depends on the business size, the number of employees, the budget, the complexity of payroll tasks, desired level of control, compliance requirements, and scalability for future growth. Some often-used payroll methods include:

Manual payroll involves calculating employee wages, deductions, and taxes using spreadsheets, pen and paper, or basic accounting software. It is suitable for businesses with very few employees or if you’re calculating your own payroll.

Payroll software refers to using dedicated payroll software that automates the payroll process, making it more efficient and accurate. Depending on business size and requirements, payroll software can range from basic to complex systems. These software solutions handle calculations, tax withholdings, and deductions.

Outsourcing payroll refers to delegating the payroll process to specialized payroll service providers. They handle all payroll-related tasks, including calculating wages, deductions, taxes, and issuing paychecks. This method saves time, ensures compliance, and reduces payroll administration burden.

Common Payroll Mistakes and How To Avoid Them

Some of the most common payroll mistakes include the following:

  • Mistakes in pay calculations. Sometimes, employees are paid too much or too little due to errors in calculating their pay. This can happen with salaried and hourly workers, due to making incorrect retroactive payments, missing the first paycheck for new hires, or deducting the wrong amount for benefits or other deductions.
  • Misclassifying employees and contractors. Some employers mistakenly classify contracted workers as independent contractors. This can deprive them of important rights and protections like minimum wage, overtime pay, social security contributions, etc.
  • Overtime calculation errors. Incorrectly logging overtime hours can lead to mistakes in pay. This can happen when employees work during breaks, travel between worksites, or participate in activities outside regular working hours.
  • Failing to report all taxable compensation. Employee pay includes more than regular wages. It also has bonuses, equity compensation, private medical insurance, and other rewards, which must be reported for tax purposes.
  • Entering poor or wrong data. The accuracy of the payroll process depends on the accuracy of the data entered into the system and the skills of the people handling it. It's important to ensure that the data entered into the system is correct and trustworthy.
  • Using the wrong tax code. Keep track of tax codes to pay employees correctly and ensure that tax authorities collect the right amount of tax. Tax codes can change based on new employees, company benefits, furloughed employees, remote work, and hybrid work.
  • Insufficient payroll resources. If you’re managing payroll in-house, you must have more than one person who knows how to handle payroll tasks and understands the rules and regulations related to taxes and legal requirements. You should also have a backup plan if the computer system fails or is unavailable.
  • Failing to meet reporting deadlines. Not submitting required reports on time can lead to penalties for late tax filing.

To avoid payroll mistakes, follow these practices:

  • Double-check your data and ensure the information entered into the payroll system is accurate.
  • Train your payroll team so they understand how to do their job correctly. Have more than one person trained in payroll tasks to have a backup plan.
  • Stay aware of important deadlines for submitting payroll reports. Set reminders and make sure you complete and submit the reports on time.
  • Stay updated on changes in tax codes. Adjust your payroll system accordingly to calculate taxes accurately. Seek advice from tax experts or authorities if needed.
  • Develop a system to keep payroll records organized. Ensure you have accurate employee information, time and attendance records, and relevant documents. Regularly review and fix any errors you find.

Following these steps will ensure accurate and compliant payroll processing. If needed, consider seeking help from payroll experts or using professional payroll services to make the process easier.

How To Set Up Payroll Using a Payroll Service Provider

Outsourcing payroll processing is reliable and cost-effective if you find an adequate payroll provider. Payroll companies allow decision-makers and managers to focus on their core business processes and goals while ensuring employees get paid timely and adequately.

These companies calculate compensation and taxes automatically and file them directly to IRS and state tax departments on your behalf. They keep track of total hours worked and pay employees via direct deposit methods.

Step #1: Choose Your Payroll Provider

Many specialized companies have the necessary expertise and resources, including payroll software, to process payments accurately and minimize the risk of penalties. When selecting a payroll provider, consider the size of your company and industry-specific requirements.

Look for a provider with a proven track record of delivering satisfactory services and being timely and responsible regarding tax filing. You can ensure smooth payroll operations and compliance with regulatory obligations by conducting thorough research and selecting a reputable and well-suited payroll company.

Step #2: Add Your Employees

Before processing payrolls, submit your employees’ info to the payroll service provider. If you are switching to a new payroll provider, add the current employees’ payroll information, such as names, addresses, social security numbers, tax withholding info, etc.

Step #3: Track Working Hours and Import Them

Employers must keep track of wage records for up to two years, as required by the US Department of Labor, and make sure they know your state’s specific requirements. Track your employees’ work hours and provide their timecards to your payroll service provider.

Step #4: Have Your Payroll Provider Keep Track of Your Tax Payments

The IRS requires tax forms to be kept for three years. Certain states may have longer retention requirements; be sure to check the specific requirements in your state.

What You Need To Run Payroll

As mentioned earlier, you should know the entire process and the prerequisites you must meet before starting payroll. Once you set up the payroll processing system, information and documentation will easily flow, which will greatly help your reporting.

The essential steps in the payroll processing system include:

  • Gathering the preliminary information needed to process payroll
  • Finding your EIN through the IRS.
  • Establishing state and local tax ID numbers.
  • Collecting employee financial information like W-4 and 1099 forms.
  • Setting up a payroll schedule
  • Choosing a weekly, biweekly, semiweekly, or monthly payroll system.
  • Establishing payroll tax payment dates.
  • Calculating and issuing payment
  • Calculating hourly employee schedules and overtime pay.
  • Calculating gross pay for each employee.
  • Determining deductions and subtract them from gross pay.
  • Calculating net pay and issue payment.
  • Completing follow-up tasks after each pay period:
  • Keeping and documenting payroll records.
  • Reporting new hires to the IRS.
  • Staying up to date on any miscalculations or mistakes, which should be documented and eventually reported to the IRS.

Final Thoughts on How to Do Payroll

You can process employee payments in-house or outsource them to a specialized payroll company or accountant. Either way, setting up a sound payroll management system is crucial. It ensures timely and accurate employee payment while mitigating the risks of pitfalls and improving business operations. If you outsource the payroll process, establish it and ensure that tax payments and other administrative obligations remain intact.

How to Do Payroll FAQs

1. What are the steps to process payroll?

The essential 5-step process of doing payroll consists of the following:

  • Calculating working hours and gross pay
  • Processing payroll deductions
  • Defining net pay and paying employees
  • Filing tax reports
  • Documenting payroll records

2. How do you calculate payroll?

To calculate or do your own payroll, you should follow several steps:

  • Determine gross pay for each employee. This includes regular wages, overtime pay, commissions, bonuses, and other compensation forms.
  • Subtract pre-tax deductions from the gross pay. These may include contributions to retirement plans (e.g., 401(k)), health insurance premiums, and other pre-tax benefits.
  • Calculate and withhold federal, state, and local income taxes. Additionally, withhold Social Security and Medicare taxes (FICA taxes) as the law requires.
  • Subtract post-tax deductions from the remaining amount after taxes.
  • The net pay is the final amount that the employee will receive. Subtract all deductions (pre-tax and post-tax) from the gross pay to get the net pay.
  • Once the net pay is determined, distribute the payment to the employee via the chosen payment method (e.g., direct deposit, physical paycheck).

3. How do I create a simple payroll?

You can simplify the payroll process by following these steps:

  • Choose the payroll software that suits your needs.
  • Gather employee information — social security numbers, contributions, deductions, and tax filing status. Set up payroll and obtain necessary IDs and bank details.
  • Calculate gross pay. Subtract deductions such as pre-tax deductions (health insurance, retirement plans), tax withholdings (federal, local, state taxes), and post-tax deductions (insurance, 401(k), garnishments) to get net pay.
  • Pay employer taxes like FUTA, SUTA, and local taxes based on employee compensation.
  • Integrate payroll software with accounting software for journal entries.
  • Check and pay state taxes for employees in different states. Obtain state tax IDs and make required payments manually or through software.
  • Annually send earning reports (W2, W1, W4, 1099) to employees and IRS.
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