How to Do Payroll: A Step-by-Step Process

Payroll is the process by which employers pay their employees, encompassing the calculation of wages, withholding of taxes and deductions, and distribution of net pay. It is a fundamental operation for any business, crucial for ensuring compliance with federal, state, and local tax and labor laws. Understanding payroll helps businesses avoid penalties and maintain proper financial records.

Setting Up for Payroll

Before processing any payments, businesses must establish the necessary infrastructure for payroll. This involves obtaining identification numbers, gathering employee information, defining pay structures, and selecting a payroll processing method.

Businesses must obtain a Federal Employer Identification Number (EIN) from the Internal Revenue Service (IRS). An EIN is required for hiring employees, filing federal tax returns, and opening business bank accounts. Applying for an EIN is free and can be done online through the IRS website, typically resulting in immediate issuance. Businesses also need state tax identification numbers, such as those for state unemployment insurance and state income tax withholding, by registering with relevant state agencies.

Collecting comprehensive employee information is another prerequisite. For each employee, businesses need personal details like name, address, and Social Security Number. Employers must also obtain a completed Form W-4, Employee’s Withholding Certificate, from each employee for calculating federal income tax withholding. Additionally, employers are required to complete Form I-9, Employment Eligibility Verification, to confirm an employee’s legal authorization to work in the United States.

Defining pay structures and cycles is essential for consistent payroll processing. Businesses determine how often employees are paid, with common frequencies including weekly, bi-weekly, semi-monthly, or monthly. This decision impacts how gross pay is calculated, whether based on hourly wages, fixed salaries, commissions, or bonuses.

Finally, businesses choose a payroll processing method. Manual calculation involves handling all computations and record-keeping internally, offering full control but demanding significant time. Payroll software automates many tasks, reducing calculation errors and streamlining processes. Outsourcing payroll to a third-party service can save time and reduce the burden of compliance, providing expertise and enhancing data security.

Calculating and Processing Employee Pay

Once the payroll setup is complete, the ongoing process involves calculating gross pay, applying deductions, determining net pay, and distributing funds.

The first step is calculating gross wages. For hourly employees, this involves multiplying their hourly rate by regular hours worked, and calculating overtime pay for hours exceeding 40 in a workweek at one and a half times their regular rate. For salaried employees, gross pay is typically a fixed amount per pay period. Additional compensation, such as commissions or bonuses, is also added to determine total gross earnings.

From the gross pay, certain pre-tax deductions are subtracted. Common examples include health insurance premiums and contributions to a 401(k) plan. These deductions are taken before taxes are calculated, which reduces the employee’s taxable income.

Next, tax withholdings are calculated. Federal income tax withholding is determined using the employee’s Form W-4 and IRS tax tables. FICA taxes (Social Security and Medicare) are also withheld. The Social Security tax rate is 6.2% on wages up to an annual limit of $176,100, while the Medicare tax rate is 1.45% on all wages. An additional Medicare Tax of 0.9% applies to wages exceeding $200,000 in a calendar year. State and local income tax withholdings are calculated based on applicable regulations.

After pre-tax deductions and tax withholdings, post-tax deductions are applied. These deductions are taken from an employee’s pay after all applicable taxes have been calculated and withheld. Examples include wage garnishments, such as for child support, and certain post-tax insurance premiums.

Finally, net pay is determined by subtracting all pre-tax deductions, tax withholdings, and post-tax deductions from the gross pay. This is the amount the employee actually receives. Payment distribution then occurs, with common methods including direct deposit or issuing physical checks.

Managing Payroll Taxes and Filings

After processing employee pay, employers must manage their payroll tax obligations and ensure timely filings with government agencies. This includes calculating and depositing employer-specific taxes and submitting required quarterly and annual reports.

Employers have distinct payroll tax responsibilities beyond employee withholdings. They are required to match the FICA taxes (Social Security and Medicare) withheld from employee wages. Additionally, employers are responsible for Federal Unemployment Tax Act (FUTA) taxes and State Unemployment Tax Act (SUTA) taxes. FUTA tax is typically 6% on the first $7,000 of an employee’s wages, though employers often receive a credit for SUTA taxes paid. SUTA rates and wage bases vary by state and fund state unemployment benefits.

Depositing withheld federal income taxes and FICA taxes is a critical obligation. Employers must use the Electronic Federal Tax Payment System (EFTPS) for these deposits. The frequency of deposits, either monthly or semi-weekly, depends on the total tax liability reported during a lookback period. State and local payroll taxes also have specific deposit requirements and schedules.

Quarterly reporting is a regular requirement for most employers. Businesses generally file Form 941, Employer’s Quarterly Federal Tax Return, which reports wages paid, tips, federal income tax withheld, and both the employer and employee shares of Social Security and Medicare taxes. Form 941 is due by the last day of the month following the end of each quarter: April 30, July 31, October 31, and January 31.

Annual reporting obligations include filing Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. Additionally, employers must issue Form W-2, Wage and Tax Statement, to each employee by January 31 of the following year, reporting their annual wages and taxes withheld. A copy of each W-2, along with Form W-3, Transmittal of Wage and Tax Statements, must be submitted to the Social Security Administration (SSA) by the same deadline. State and local reporting requirements also exist.

Ongoing Payroll Responsibilities

Beyond routine processing and tax filings, ongoing payroll management involves continuous responsibilities to ensure compliance, accuracy, and responsiveness to changes.

Maintaining accurate and organized payroll records is essential for compliance and future reference. Businesses must retain employment tax records, including Form 941s, W-2s, and W-4s, for at least four years after the tax due date or payment date, whichever is later. Records supporting wage computations, such as time cards, should be kept for at least two years.

Handling new hires and terminations requires specific payroll-related actions. For new employees, all necessary forms, including the W-4 and I-9, must be completed promptly. When an employee is terminated, businesses must ensure final paychecks are issued in accordance with state laws, which may include payment of accrued unused vacation time.

Regular adjustments and updates to payroll are often necessary. This includes processing changes to an employee’s tax withholding information based on a new Form W-4, adjusting pay rates for raises, or modifying deductions for changes in benefits. Businesses must also stay informed about changes in federal, state, and local tax laws and rates, implementing these updates into their payroll system.

Finally, ongoing payroll management involves continuous compliance with labor and tax laws and preparing for potential audits. Should a payroll audit occur, businesses must have readily accessible and accurate records to demonstrate compliance.