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What Is Payroll?
Payroll is the process of paying all employees and independent contractors. It involves different procedures for hourly employees, salaried employees, and independent contractors. How many times you run payroll depends on whether your company pays employees monthly, twice per month, bi-weekly, or otherwise.
Payroll is a relatively complex and sometimes frustrating process if you’re running payroll manually. At the same time, paying your employees is one of the most important functions HR has. Understanding how payroll works will help you decide whether to run it yourself or invest in another method.
Payroll Processing Methods
There are three ways you can process payroll. You can do it manually, outsource it to another company, or use payroll software.
Manual Payroll Processing
To run payroll manually, you’ll need to make several calculations to determine the employee’s net pay and the company’s quarterly reports and taxes (see below for more detail). To do it right, you need to calculate gross pay, make the correct deductions, and create a system to keep track of all withholdings in order to report and pay taxes on behalf of employees.
You can also outsource your payroll function to a payroll company or an accountant. For a fee, these resources will run your payroll and make sure all deductions are made correctly. They’ll also make sure your company taxes are paid correctly. Using a payroll company or an accountant can be extremely helpful, but it’s often expensive.
Payroll software automates payroll by calculating deductions, tax withholdings, reimbursements, and direct deposit. It also helps you consider the various regulations that might impact tax withholdings and deductions. Payroll software can have its own pitfalls, however. For example, some software doesn’t integrate with some types of HR software, which can force you to make manual calculations.
Interested in payroll software? Check out Eddy’s payroll suite.
How to Calculate Payroll
Are you calculating payroll manually? Below is step-by-step guidance for how to process payroll and keep the right records:
If You’re Paying an Independent Contractor, Read This First
Independent contractors pay their own taxes and are not eligible for any benefits. Simply pay them their wages. Keep track of how much you pay them throughout the year; you’ll need this information to fill out and send a 1099-NEC to all contractors you paid more than $600 that year.
To run payroll for employees, follow the steps listed below.
Step 1: Make Sure You Have the Information You Need
Before getting started, make sure you have the following information for each employee:
- Most recent W-4
- Wage rate or salary
- How many hours they worked each week of the pay period (if applicable)
- Retirement and benefits information
- Reimbursement records from the employee
- Any post-tax deduction information, like a court order for wage garnishments
Step 2: Calculate Gross Pay
An employee’s gross pay is the total amount of money earned by the employee, including incentive pay, before any deductions are made. How you calculate an employee’s gross pay depends on whether they’re paid by the hour or on a salary.
Calculating Gross Pay for Salary Employees
To calculate the gross pay for a salaried employee, divide their yearly salary by how many times you will run payroll during the year. For example, if you run payroll on the first day of every month, then divide their salary by 12. Then, add in any additional pay earned during the pay period you’re running payroll for.
Calculating Gross Pay for Hourly Employees
To calculate gross pay for hourly employees, add the number of hours the employee worked each week separately. This is so that you can calculate overtime. In most states, overtime is calculated by counting how many hours above 40 an employee worked in each week. (In some states, overtime is calculated by counting how many hours exceeding eight hours an employee worked in a day.)
Once you’ve calculated how many regular hours and overtime hours an employee worked in a week, you can do the same for every other week included in the pay period. Then you can add in any additional pay earned during the pay period.
Learn more about calculating gross pay in our entry on gross pay.
Step 3: Calculate Taxable Income
Now that you have the gross pay, you can calculate the employee’s total taxable income, which is also called the adjusted gross income (AGI). To do this, you need to make all available pre-tax deductions. These might include:
- 401(k) plan contributions (in some states)
- Dental insurance
- Health insurance
- Flexible spending account (FSA)
- Health savings account (HAS)
The total amount of pre-tax deductions made depends in part on what elections the employee makes. It also depends on which maximum contribution limits apply, and variations in state income tax rules.
Step 4: Make Necessary Deductions and Reimbursements
Now that you have the employee’s total taxable income, you can make tax withholdings. To calculate this, you’ll need to see which withholding elections the employee made on their Form W-4, and whether they’re married. Then, you can use the IRS Publication 15-T to calculate necessary federal income tax withholdings. You’ll also have to calculate tax deductions for Social Security and Medicare, 50% of which must be paid by the company.
To calculate state income tax withholdings, you’ll need to know what your state income tax brackets are. If you’re not sure where to find these, contact your state’s Department of Revenue.
Lastly, to determine whether local income taxes apply to your employee, contact your local department of revenue or browse the Tax Foundation’s local income taxes list.
You may need to make post-tax deductions. Some, like union fees or 401K contributions (if your state does not allow pre-tax deductions for 401K plans), are voluntary. However, others are not. This may include wage garnishments to pay creditors, or child support payments.
Make sure to add any non-taxable reimbursements due to the employee for that pay period. Reimbursements are non-taxable only if they’re part of an accountable plan.
Step 5: Calculate Company Contributions and Taxes
Once you’re done calculating all deductions and contributions you withhold from the employee’s paycheck, calculate what taxes the company will have to pay and what contributions to match. Some payments you’ll make right away, while others should be made on a quarterly basis.
Questions You’ve Asked Us About Payroll
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