Gross pay is the amount of money your employees make before anything is taken out for taxes, health insurance, and retirement. Net pay is what’s left over.
When it comes to budgeting, which one should you use?
It all depends on whether you’re budgeting for your company or for yourself.
We’ll get into all that and more.
How to Calculate Gross Pay vs. Net Pay
Gross pay is the total amount your employees are earning before deductions are taken out. But it doesn’t just include the salary or wages you pay employees. Here are some of the common elements of gross pay:
- Base Pay: This is the annual salary ($80,000 a year, for example) or the hourly wages (like $50/hour) you pay an employee.
- Overtime Pay: Hourly employees are usually entitled to overtime pay if they work more than 40 hours a week.
- Paid Time Off (PTO): Salary or wages employees earn during PTO is part of gross pay.
- Bonuses: Do you give out performance and holiday bonuses? These count as gross pay.
- Commissions: If you pay employees a base wage plus commissions, the commissions count as gross pay.
- Tips: If employees regularly receive tips, they may be included in gross pay.
- Allowances: Do you give employees money to cover gas, mileage, and upkeep when they use their vehicle for work reasons? This counts as gross pay.
- Retroactive Pay: If you pay employees additional wages one pay period to make up for a mistake in an earlier one, this is gross pay.
So here’s an example. During Pay Period 1, you pay Employee A $5,000 in total hourly pay, $200 in performance bonuses, and $400 in overtime pay. These payments are all considered gross pay. Employee A won’t be able to take all of it home.
You still have to deduct things like taxes, retirement contributions, and health insurance premiums from the gross pay. Once you do that, you’ll have Employee A’s net pay—the amount that actually goes into their bank account.
Here’s a comprehensive list of payroll line items that get deducted from gross pay to make net pay:
- Federal Income Tax: Most workers are subject to federal income tax. The amount they pay is based on things like their income, family size, and any tax credits they claim.
- Social Security and Medicare Tax: Many employees pay these federal taxes in addition to income tax. They help fund Medicare and Social Security services in the United States.
- State and Local Taxes: States and cities may have their own taxes that must be deducted from an employee’s gross pay. These may include state and local income tax, disability insurance, paid family leave contributions, and education taxes.
- Insurance Premiums: While some employers fully fund their employees’ health, vision, dental, and life insurance premiums, many split the cost with employees. The employee portion of any premiums is deducted from gross pay.
- Retirement Contributions: Employees often choose to contribute to a 401(k), and many employers match those contributions up to a certain amount. The employee contribution is deducted from gross pay.
- Garnishments: Some employees you work with will have court-ordered garnishments you must deduct from their gross pay. Common garnishments include unpaid back-taxes, child support, and alimony.
- Union Dues: If employees are part of a union, their union dues are usually deducted from their gross pay and deposited straight into the union’s bank account.
- Charitable Donations: Some employees elect to reserve a portion of their gross pay for charitable donations. These are often taken out of each paycheck and forwarded to the chosen organization.
- Health Savings Account (HSA) Contributions: Employees who have high-deductible health insurance may be eligible to open an HSA. The contributions to this account may be deducted from an employee’s paycheck.
- Flexible Spending Account (FSA) Contributions: Employees who don’t qualify for an HSA may choose to participate in an FSA, if you set one up. Contributions typically come out of an employee’s gross pay.
After these types of deductions are taken out of gross pay, everything left over is net pay.
Let’s return to the example of Employee A. This employee earned $5,000 in hourly pay, a $200 performance bonus, and $400 in overtime pay during Pay Period 1.
But Employee A has the following deductions:
Federal Income Tax: -$672 for a 12% tax bracket
State Income Tax: -$280 for a 5% state tax rate
Social Security Tax: -$347.20 for a rate of 6.2% on the gross pay of $5,600
Medicare Tax: -$81.20 for a rate of 1.45% on the gross pay of $5,600
Health Insurance Premium: -$200 premium
401(k) Retirement Plan Contribution: -$280 for a 5% contribution
HSA Contribution: -$100 in contributions for the pay period
So what’s left?
$3,639.60 in net pay for that pay period.
To sum it up, Employee A’s gross pay is $5,600, and their net pay is $3,639.60 after all the necessary deductions.
Now let’s figure out who should use which type of pay when it comes to budgeting income.
Using Gross Pay vs. Net Pay for Budgets
Whether you should use gross or net pay for your budget depends on one thing: whether you’re budgeting as an employer or as an individual.
Your net pay is the only figure you should use for a personal budget.
Your employees’ gross pay is the figure you should use for your company budget—mostly. You actually need to account for a bit more than just gross pay for your company budget.
We’ll talk more about that below.
First, we’ll break down why net pay is the only number to use for a personal budget. Then we’ll talk about the number you need for your company budget.
Use Net Pay for Personal Budgets
When you’re an employee receiving a paycheck, you are not bringing home the full amount represented in your gross pay.
Instead, you’re getting what’s left after all the deductions. If you budget with gross pay, you’ll have a lot less take-home income each month than you budget for.
Let’s say it’s Employee A’s first pay period at their new job. They expect $5,000 in hourly pay, a $200 performance/sign-on bonus, and $400 in overtime pay for a total of $5,600. They get excited at making that much money in one two-week pay period and create the following personal budget:
- Mortgage payment: -$2,200
- Childcare: -$1,000
- Groceries: -$800
- Gas: -$400
- Utility bills: -$600
- Medical bills: -$200
- Savings: -$400
Then their first paycheck arrives, and it’s only $3,639.60 in net pay. That’s a full $1,960.40 less than what they budgeted for. Suddenly Employee A must scramble to figure out which bills need to be paid right now and which ones can wait for the next pay period.
So remember: when it comes to your personal life, always use your take-home pay—the money left over after taxes, premiums, and other deductions.
Use 125% of Gross Pay for Business Budgets
You might think that if you budget for gross pay, you’ll have what you need to cover your employees’ salaries. But the truth is that employees cost businesses more than just the direct compensation you offer—aka their gross pay.
For instance, remember that $200 health insurance premium Employee A is paying out of their paycheck? The full premium is $1,200 per person. You, the employer, are paying the $1,000 that your employee isn’t paying.
And even though some federal and state taxes are deducted from your employees’ paychecks, the full percentage of taxes owed is higher than what they pay. The federal payroll tax rate, for instance, is 15.3%. This is the employer-employee contribution to things like Social Security, Medicare, and unemployment insurance.
The employee pays half of those taxes. You—the employer—pay the other half.
On top of these bigger deductions, there are things like retirement contribution matches, gym memberships, and other types of compensation you offer to attract top talent.
You could spend days trying to calculate how much every single item will cost you.
Don’t do that.
Instead, simply add 25% on top of employee gross pay.
Let’s say you’re Employee A’s employer. You know that for this pay period—and maybe future ones as well—you’ll pay $5,600 in gross pay. But budgeting with gross pay alone won’t cover all your costs. So you add $1,400—which is 25% of $5,600—to your budget. Now you’ve got a budget of $7,000 each pay period for Employee A.
This should cover all your costs.
For most employers, anyway. If you find that the 25% rule routinely comes up just short of your actual budgetary needs, increase it to 30%. If you always have money left over, decrease it to 20%.
It’s not a hard-and-fast rule, but it’s a highly useful and time-saving one. In most cases, it will save you from the panic of not having enough money budgeted to cover your employee salary costs. Our guide to creating a payroll budget can help you get started.
The final secret to acing payroll? Using high-quality payroll software that helps you budget and does all the calculations and payments for you.
