There’s a lot that goes into payroll processing to get it right. And your employees deserve for you to get it right every time.
From federal, state, and local taxes to withhold plus payroll deductions and accurate time tracking and calculations, payroll processing has several factors that could go wrong. And if you don’t have an HR team to handle it all, you probably use payroll software and services.
There’s nothing wrong with that; in fact, payroll software and services can help you manage the entire process. But you’ll still hold the responsibility of verifying and reporting all payroll information properly.
I’m covering payroll processing here, from start to finish, to help you learn which parts you can outsource and which pieces of the process you’ll need to tackle yourself.
Setting Up Payroll Processing
Payroll processing is so much more than just handing employees a paycheck. Several calculations and considerations go into each employee’s pay, as no two employees get paid exactly alike.
Additionally, each state has different taxation and withholding regulations, which can further complicate things for businesses with employees working from different states.
But your employees work to get paid, and they expect to get paid correctly. You can achieve pay accuracy by being diligent in your payroll processing.
To be successful in payroll processing, you need to get your business and employees set up properly from the start:
- Set up an Employer Identification Number (EIN): An EIN identifies a business for tax purposes. Employers should have an EIN to keep business finances separate, and it’s actually required for most businesses to use when paying and filing taxes. You can apply for an EIN for free through the IRS website.
- Register new hires with the state: Each state has different rules and processes for businesses to register their new hires with that state. Generally, businesses must report the employee’s name, address, hire date, and Social Security number. Employers can find forms or online registrations via their state’s Department of Labor website.
- Collect completed W-4 forms: All employees should fill out a W-4 upon their hiring. This form, known as the Employee’s Withholding Certificate, ensures that employers withhold the right amount of taxes from the employee’s paychecks.
- Choose a pay frequency: Pay frequency is usually biweekly or semimonthly but can also be weekly or monthly. Choose the right pay frequency before processing payroll for the first time. Consider the type of employees you have and the pay period that makes the most sense for your company.
- Get a payroll bank account: Having a bank account specifically for payroll can assist your payroll accounting, keeping all payroll funds and transactions separate from your regular business banking account.
- Determine benefits: Set up optional benefits within your organization, like healthcare benefits or retirement plans. You’ll deduct employee contributions from their paychecks, so it’s necessary to have your benefits in place and know which employees are opting in before processing payroll.
Once all employees are entered into the system, have opted in or out of the company’s benefit plans, and have completed all required tax forms, you’re on the way to processing payroll. Review all entered information thoroughly at least a couple of times to avoid inaccuracies later.
Payroll Processing Step-by-Step
A step-by-step process is crucial when it comes to payroll processing to ensure that you don’t leave anything out. Here is the layout I’ve followed to keep payroll processing on track.
1. Review Employee Hours
Employee timesheets provide the foundation for which you pay hourly employees. The more hours they work, the more they get paid, making reviewing their hours a pivotal part of payroll processing to ensure that they get the amount they earned for the time they worked.
Reviewing hours is straightforward when you don’t have any employees who earn anything other than straight hourly pay. However, some employees work overtime or receive shift differentials, which leads to more complicated calculations.
When reviewing employee hours, verify that each employee’s regular hours, overtime hours, and shift differentials are included in their timesheets.
Time tracking software can make this process much easier, but if your company doesn’t currently use it, you’ll need to manually check for 40+ hours and work periods that fall under shift differential pay.
Also, check that employees are categorized properly as exempt or non-exempt. Some salaried employees, for example, may still fall under the Fair Labor Standards Act’s (FLSA) definition of non-exempt and, therefore, be allowed to receive overtime.
If possible, have supervisors review and approve their employees’ timesheets before sending them off to the person or people in charge of processing payroll for a second review.
2. Calculate Gross Pay
Gross pay is all wages earned from regular hours worked, overtime hours, and shift differentials.
For example, say an employee earns $25 an hour and worked 84 hours for the past biweekly pay period. The employee had 80 hours of regular time, totaling $2,000, and 4 hours of overtime paid at 1.5 times their regular pay ($37.50), totaling $150.
The employee earned a gross wage of $2,150 for the pay period.
Gross pay can also include other forms of direct compensation, like retention bonuses or commissions, that you’ll need to remember to add to your payroll.
For example, if the same employee earned a $500 performance bonus during this pay period, you’d add the bonus to their pay, bringing their new gross pay to $2,650.
Salaried employees have an annual salary rather than an hourly wage, so their gross pay calculation works differently. For these employees, you’ll divide their annual salary by the number of pay periods your company has.
So, an employee earning $78,000 on a biweekly pay schedule would have $3,000 in gross pay each pay period ($78,000/26 pay periods). From that number, you’ll add in any commissions, bonuses, or applicable shift differentials and overtime from that pay period.
An accountant can sometimes handle these calculations if you’d rather not do it yourself. Just make sure they have specific experience with payroll, especially working with tricky payroll situations involving shift differentials and overtime pay.
3. Figure In Deductions
Deductions get withheld from employee paychecks. Deductions can be things like:
- Employee contributions to a retirement plan
- An employee’s financial responsibility for their health insurance plan
- Court-ordered withholdings
- Charitable donations
- Employee gym membership fee
Each employee’s deductions and deduction amounts will probably differ, so you’ll need to manually check employee records to ensure accuracy if you don’t have software that automates this for you.
Also, be aware that some deductions come out of a paycheck before taxes are withheld. These are known as pre-tax deductions and include things like health insurance benefits and 401(k) plans.
Others are post-tax, meaning that you’ll deduct them after you withhold taxes. Charitable donations and court-ordered garnishments fit into this category.
Using the wrong type of deduction can affect tax withholdings, so be sure to get this part right. Without an HR team to manage benefits, this responsibility falls solely on your shoulders unless you have room to hire a payroll specialist.
4. Calculate Payroll Taxes
Figuring out payroll taxes can be one of the more complicated aspects of payroll processing. It’s not really the calculations that get tricky, but more so knowing the taxes you’re responsible for withholding and their amounts.
Absolutely consider hiring a payroll tax expert here if you don’t have much experience in this area. Or, opt for reliable payroll software that accounts for your employees’ tax forms to calculate the correct withholding.
You’ll need first to calculate Federal Insurance Contributions Act (FICA) tax, which includes Medicare and Social Security taxes. Social Security gets taxed at 6.2% and Medicare at 1.45% of gross wages.
Then, calculate federal, state, and local taxes. Federal and state withholdings vary by federal and state tax brackets and employee tax information—you’ll need updated W-4 forms to calculate these properly—while local taxes vary by jurisdiction. They’re all based on an employee’s gross pay.
Companies with workers in multiple states, like remote companies, have the responsibility of abiding by each state’s and locality’s unique tax laws. Each time you hire a new employee who lives in a different state, review their state and local income tax laws, which are often available on their respective taxation department websites.
Finally, calculate your tax responsibility as an employer. For example, employers are responsible for also paying 6.2% for Social Security and 1.45% for Medicare, based on the employee’s gross pay.
Employers also pay federal unemployment tax, known as FUTA, which is 6% of an employee’s first $7,000 earned in a year.
Some states have their own unemployment tax obligations, too, with varying rates for different employers. Most states have separate rates for new employers that fall on the lower end of their unemployment tax ranges.
5. Approve Payroll and Release Payments
With taxes and deductions withheld, you’ll end up with each employee’s net pay, which is the amount they’ll actually get paid.
After double and triple-checking everything you’ve done thus far, it’s time to approve payroll. This is the final step before issuing payments, so it’s a good time to make sure all employee records and withholding information are correct.
If everything looks good, you’re set to approve payroll and pay employees via direct deposit, check, or another method you prefer.
Sometimes, an employee catches an error after receiving their check. In this case, you’ll need to cancel their payroll, correct the error, and reissue a fixed paycheck.
It’s also best practice to give the employee a letter explaining the error to keep with their records. Keep a copy with your records, too, and account for any corrections in your payroll register and general business ledger. You may also need to correct tax deposits if your tax payments were affected.
6. Organize Payroll Records
Payroll records include all information about employee pay, including what you paid employees each pay period, how much each employee gets withheld for taxes, and what deductions each employee has.
The IRS requires payroll tax records to be kept for at least four years. Each state has its own requirements for the retention of full payroll records. For instance, Connecticut requires businesses to save records for seven years, while many states, like Utah, Nebraska, and Wisconsin, only require three.
Best scenario: Save them for at least seven years to be safe.
Every time you process payroll, organize and update your records to keep all information fresh for your next payroll run.
What Does a Payroll Processing Service Take Over?
Payroll processing services can handle several aspects of payroll processing, including calculating taxes and deductions for proper withholding, calculating gross pay, and finalizing payroll to pay employees.
Basically, anything that involves pay calculations can be handled by a payroll service, making them super valuable for small business owners without an HR team or payroll specialist on board.
You’ll still need to verify that employee hours are correct, that W-4 forms get processed immediately to update employee withholdings, and that anything leading to employee deductions is updated in your system.
But other than reviewing the accuracy of your payroll information, your payroll service can manage most payroll processing tasks.
If you can fit it into your budget, look for a payroll service offering HR outsourcing, which lets you hand the reins over to HR professionals for a lower cost than hiring them yourself.