To calculate payroll correctly, you need to have accurate time sheets from employees, know how to calculate wages based on the amount of time your employees work, properly handle all payroll withholdings for taxes, benefits, and garnishments, and prevent silly mistakes that can get you into legal trouble.
Then comes your final review and cutting checks to pay your employees. It’s a much more in-depth process than it seems, even if you only have a few employees.
Because it’s one of the most important things you’ll need to do for your business, I’m focusing this guide entirely on calculating payroll.
As with most things you’ll do as a business owner, there’s an easy way and a hard way to do it. I’m going to talk about both, and trust me, you’ll want to opt for the easy way.
The Easy Way to Calculate Payroll
The easy way to calculate payroll is to get someone else to do it for you.
Yep, that’s the hack.
Except it’s not a hack; it’s a must. We strongly recommend going in this direction, even if you only have one employee.
When you’re starting out, use payroll software. I can’t even tell you how many hours the right payroll tool can save you every pay period, even in the smallest of companies.
Payroll software helps you set up and report all your employees to the state(s) you’re required to report to. Then, it calculates wages and deductions, manages and pays your federal, state, and local withholding taxes, and runs payroll every period.
All you need to do is make a few clicks here and there.
Your payroll software stores records for everything, too, so you can always refer back to something if necessary or print off a wage report for an employee upon request.
Now, as your business grows, your payroll software might need a little help to manage your employees and payroll. That’s where a payroll specialist or team can help.
Your payroll team can still save dozens of hours by using your software, but the team can also complete regular compliance checks, help you maintain your payroll budget, and complete other payroll-related tasks outside the scope of a payroll tool.
The Hard Way to Calculate Payroll
If the easy way to calculate payroll is to hand it off to someone else, then the hard way is obviously doing it yourself.
Sometimes, this is necessary if your business is super small and you don’t have the money to invest in payroll software or a payroll specialist or team. So, I’m going to detail how to calculate payroll the hard way, step-by-step.
But only if you promise one thing: you’ll hand over the payroll reins as soon as possible.
1. Calculate the Total Time Worked
Calculating payroll always starts by calculating the total time each employee works. This includes all regular hours, overtime hours, and shift differential time an employee is on the clock.
This process looks different for hourly, exempt salary, and non-exempt salary workers, which is where things can get complicated.
An hourly worker is the most straightforward. Hourly workers get paid based on the actual number of hours they work in a pay period.
If an hourly employee worked exactly eight hours a day, five days a week for the two weeks in your biweekly pay period, they’ve worked 40 hours per week or 80 hours total for that pay period.
Now, let’s say an hourly employee works a variable schedule each week. In that case, you’d need to add up their hours each day during that pay period.
Example for hourly workers: Valerie works 8 a.m. to 2 p.m. Monday to Wednesday and 4 p.m. to 8 p.m. Friday the first week of the pay period. The following week, she worked from 7 a.m. to 5 p.m. on Monday, Wednesday, and Friday. Her total hours would be 52 hours for that pay period.
However, suppose Valerie lives in a state with daily overtime after 8 hours, like California. In that case, she’d have 46 hours of regular time and 6 hours of overtime, as all three days during the second week have two hours of overtime each.
Be sure to separate regular and overtime hours to make wage calculations easier in the next step.
Exempt salaried workers are a bit different because you don’t calculate their hours worked based on their actual clocked time. Instead, you’ll calculate their paychecks with a daily salary that’s based on their annual salary.
Example for exempt salary workers: Charlie earns $80,000 a year and gets paid biweekly. His biweekly salary is $3,076.92 ($80,000/26 pay periods), making his daily salary $307.69 ($3,076.92/10 days per pay period). You’ll use the daily rate of $307.69 instead of the actual hours worked to calculate Charlie’s paychecks.
Take note that you can dock pay for missed days of work for specific reasons, like taking a full day off for an illness or personal reason, unless the employee uses paid time off days.
A non-exempt salary worker is eligible for overtime, just like an hourly worker. So, you’ll need to have their actual hours worked to calculate gross pay.
Employers and non-exempt employees must agree on the number of weekly hours their salary covers, which is usually 40 hours a week. That means any hours worked over 40 would qualify for overtime pay.
Example for non-exempt salary workers: Anne’s salary covers 40 hours per week. She gets paid biweekly. The first week of this pay period, Anne worked 42 hours; she worked 50 the second week. Anne’s total hours for this pay period are 80 regular (40+40) and 12 overtime (2+10) hours.
2. Calculate Payroll Deductions
Payroll deductions include wage garnishments, health insurance dues, retirement plan contributions, and anything else that comes out of an employee’s paycheck.
Deductions like health insurance dues and 401(k) contributions are known as pre-tax deductions, so you’ll remove whatever an employee owes before calculating their taxes. So, if an employee is subject to any pre-tax deductions, you’ll technically use an adjusted gross wage to calculate their taxes.
Wage garnishments, like child support payments or back taxes due, are known as post-tax deductions. These get removed after you calculate taxes. Union dues and Roth IRA retirement plans are also examples.
Consider both of these as you calculate gross pay in the next step.
3. Calculate Gross Pay
Now, you’ll use the hours you calculated—or, in the case of exempt salary workers, the daily rate—to calculate gross pay. Remember to remove any pre-tax deductions from an employee’s gross pay before calculating taxes in the next step.
For an hourly worker, this is pretty straightforward: Multiply hours worked by their rate of pay. So, a person working 40 hours a week at a rate of $20 per hour makes $800 per week. If they get paid biweekly, they’ll have $1,600 as their gross pay.
If that same person worked 45 hours each week, they’ll earn $800 per week in regular pay and $150 per week in overtime pay, for a total of $1,900 in gross pay on their paycheck.
Non-exempt salary workers’ pay is calculated similarly, but you need to calculate the worker’s hourly rate based on their salary.
Let’s use Anne from our previous example. Say she makes $60,000 a year, and salary covers 40 hours per week with biweekly pay. That’s 2,080 hours per year and an hourly rate of $28.85 ($60,000/2,080).
In our example, Anne worked 80 regular hours and 12 overtime hours this pay period. Her regular gross pay would be $28.85 x 80, or $2,308, and her overtime pay would be her overtime rate of $43.28 ($28.85 x 1.5) x 12, or $519. Her gross pay comes to $2,827 for this pay period.
For exempt salary workers, use the daily rate, which we calculated previously for Charlie. Charlie’s daily rate is $307.69, and his employment agreement states that his salary covers 10 days of work every two weeks. For this two-week pay period, Charlie works nine days and doesn’t use any PTO.
His gross pay would equal $2,769.21 ($307.69 x 9).
4. Calculate Federal Taxes
To calculate federal taxes correctly, you need the information your employees fill out on Form W-4, which shows how many tax allowances they have.
Then, use the IRS’s wage bracket tables and instructions to find out how much federal tax to withhold. Here’s a rundown of what you’ll do:
- Write down the employee’s gross pay for this pay period.
- Write down how many pay periods you have each year (for example, 26 if you pay biweekly).
- Divide the amount from Step 4a of the employee’s W-4, if any, by the number of pay periods and add that amount to the employee’s gross pay.
- Divide the amount from Step 4b of the employee’s W-4, if any, by the number of pay periods and subtract that amount from the gross pay you calculated in step 3 to get the employee’s adjusted wage.
- Use the wage brackets to find the tentative withholding amount based on the figure you calculated in step 4 and the employee’s pay frequency and tax status. To illustrate, we’ll use an adjusted wage of $775 biweekly for a single employee. Their tentative withholding using the wage brackets is $22.
- Divide the amount from Step 3 of the employee’s W-4, if applicable, by the number of pay periods. We’ll say this employee’s amount on Step 3 is $2,000, making the total for this step $2,000/26, or $76.92.
- Subtract the total from step 6 by the tentative withholding amount in step 5. Example: $22 – $76.92 = -$54.92 for this employee. If the number is less than 0, make this total 0.
- Add any additional withholding amount from Step 4c of the employee’s W-4, if applicable, to the amount calculated in step 7.
In our example, this employee has no federal withholding tax due to their gross wage amount and tax credits. Employees with higher wages and/or fewer tax credits will have higher tax withholdings per pay period.
Don’t forget to also calculate Medicare and Social Security taxes, better known as FICA, or Federal Insurance Contributions Act, taxes. These are relatively simple, as you don’t need to know an employee’s tax allowances to calculate them; you just need to know gross income.
The employee and employer each pay 6.2% for Social Security and 1.45% for Medicare. Medicare is taxed on all earnings, but Social Security is only taxed up to $168,600 in earnings for 2024.
For an employee making $2,000 in gross pay during this biweekly pay period, you’ll withhold $124 for Social Security ($2,000 x 6.2%) and $29 for Medicare tax ($2,000 x 1.45%). You, as an employer, would match those amounts for your portion of those taxes.
Finally, employers must also pay FUTA tax, short for Federal Unemployment Tax Act, of 6% on the first $7,000 paid to an employee each year. This is only paid by the employer and not withheld from taxes. The highest amount you’ll pay per employee is $420 per year ($7,000 x 6%).
5. Calculate State and Local Taxes
State and local taxes also are based on an employee’s withholding allowances and income. Many states have their own version of a W-4 that new hires need to fill out, but some don’t. All employees must fill out a W-4, regardless of the state they live in.
To calculate state and local tax, you’ll need to know the state and locality’s tax rates. States also publish helpful tax withholding tables, similar to those published by the IRS for federal taxes, to help you determine an employee’s tax withholding.
Localities usually have a set tax percentage based on gross income, but some fluctuate, like New York’s local taxes for New York City and Yonkers. In this case, you’ll also need to use associated tax rate tables to calculate the correct withholding amount.
All states and localities are a bit different, so be sure to reference the state’s overseeing tax department for specific calculation instructions. Generally, though, you can expect to calculate state and local payroll taxes similarly to federal taxes using an employee’s gross wages and allowances.
Remember that you’ll also need to pay state unemployment tax. This doesn’t come out of employee paychecks except for employees in Alaska, New Jersey, and Pennsylvania. Look up your state’s unemployment services department to learn its tax rate and wage base for accurate calculations.
6. Determine and Process the Final Paycheck
After calculating gross pay, deductions, and taxes, you should review your calculations before cutting checks. One small mistake could lead to incorrect calculations that have a significant impact on an employee’s final paycheck or your tax filings.
Here’s a rundown of everything to look for:
- Are the employee’s regular, overtime, and shift differential hours calculated correctly?
- Did you account for pre-tax and post-tax deductions correctly?
- Did you use the correct tax tables for your company’s pay frequency to calculate federal, state, and local taxes?
- Did you remember to withhold FICA taxes and pay the employer portion?
- Have you paid state and federal unemployment tax according to employee pay?
See what I mean about this being the hard way to calculate payroll? There’s a lot to remember and, unfortunately, a lot that can go wrong.
To reduce your risk of messing up your payroll and employees’ paychecks, do it the easy way by incorporating a payroll tool.
