How to Pay an Employee: Payroll Setup and Obligations

Paying employees accurately and on time involves navigating various legal and financial obligations. Businesses must understand the intricate process of payroll management to ensure compliance with federal and common state regulations. This includes calculating wages, withholding taxes, and adhering to reporting requirements. Proper payroll setup and ongoing management protect a business from penalties and foster positive employee relations by ensuring consistent and correct compensation.

Setting Up Your Payroll System

Establishing a payroll system begins with obtaining an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). This nine-digit number serves as your federal tax identification and is required for reporting taxes and other documents. You can apply for an EIN online directly through the IRS website, which typically yields the number immediately.

A foundational step before any payment occurs is correctly classifying workers as either employees or independent contractors. Misclassification can lead to significant penalties, including back taxes, interest, and fines. The IRS and state labor departments use specific criteria to determine proper classification, focusing on the degree of control and independence in the working relationship.

Once worker classification is determined, specific employee information and forms must be collected. The Form W-4, Employee’s Withholding Certificate, is mandatory for federal income tax withholding. This form allows employees to indicate their tax situation, influencing federal income tax withheld from their paychecks. Employers retain this form for their records, using the information to calculate federal tax withholdings.

Another essential document is Form I-9, Employment Eligibility Verification, which confirms an employee’s legal eligibility to work. Employers must complete and retain this form for each new hire, verifying identity and employment authorization documents. Employers must complete it within three business days of the employee’s first day of employment.

Establishing a consistent payroll schedule is a necessary preparatory step. Common payroll frequencies include weekly, bi-weekly, semi-monthly, or monthly. The chosen schedule dictates how often employees receive their pay and impacts the timing of tax deposits and reporting.

Businesses can manage payroll through various methods. Manual processing involves calculating wages and deductions by hand. Payroll software automates many calculations and reporting tasks. Alternatively, outsourcing payroll to a third-party service provider can offload the entire process, including tax calculations, filings, and direct deposits.

Calculating Employee Pay and Withholdings

Calculating an employee’s gross pay is the first step. For hourly employees, gross pay is calculated by multiplying the hourly wage by the number of regular hours worked. The Fair Labor Standards Act (FLSA) mandates overtime pay at 1.5 times the regular rate for hours exceeding 40 in a workweek for non-exempt employees.

Salaried employees typically receive a fixed amount per pay period, regardless of the hours worked. Additional compensation, such as bonuses or commissions, is added to an employee’s regular earnings to determine their total gross pay for the period. These payments are subject to the same taxes and withholdings as regular wages.

Mandatory withholdings include federal income tax, withheld from an employee’s gross pay based on their Form W-4 and applicable IRS tax tables. The amount varies depending on the employee’s income, filing status, and adjustments.

FICA taxes, which fund Social Security and Medicare, are mandatory. For 2025, the Social Security tax rate is 6.2% for both employee and employer portions, applied to wages up to an annual wage base limit of $176,100. The Medicare tax rate is 1.45% for both employee and employer portions, applied to all wages with no wage base limit. An additional 0.9% Medicare tax applies to employee wages exceeding $200,000 in a calendar year, for which there is no employer match.

Beyond federal taxes, many jurisdictions impose state and local income taxes, which also require withholding from employee paychecks. These tax rates and withholding requirements vary significantly by location.

Other mandatory deductions can include court-ordered wage garnishments for child support, alimony, or federal student loan defaults. These deductions are legally mandated and take precedence over voluntary deductions.

Voluntary deductions are those elected by the employee, often for benefits. Common examples include contributions to health insurance premiums, retirement plans like 401(k)s, or flexible spending accounts. These deductions reduce the employee’s taxable income or net pay. After all mandatory and voluntary deductions are subtracted from the gross pay, the remaining amount is the employee’s net pay.

Fulfilling Payroll Obligations

After calculating employee pay and withholdings, the next step involves distributing net pay to employees. Common methods include direct deposit, where funds are electronically transferred directly into the employee’s bank account, and physical checks.

Employers are required to deposit federal income tax, Social Security, and Medicare taxes with the IRS. These deposits, comprising both employee and employer portions, are typically made through the Electronic Federal Tax Payment System (EFTPS). Deposit frequency, whether monthly or semi-weekly, depends on the employer’s total tax liability from a lookback period.

Similar deposit requirements exist for state and local income taxes, as well as state unemployment taxes. The methods for depositing these funds and their frequency vary by jurisdiction, often mirroring federal requirements but with unique state-specific platforms or schedules.

Filing payroll reports is a periodic compliance requirement. Form 941, Employer’s Quarterly Federal Tax Return, is filed with the IRS to report wages paid, tips reported, federal income tax withheld, and the employer and employee shares of Social Security and Medicare taxes. This form is due by the last day of the month following the end of each quarter:
April 30
July 31
October 31
January 31
If all taxes were deposited on time, employers typically have an additional 10 calendar days to file.

Annually, employers must provide employees with Form W-2, Wage and Tax Statement, by January 31 of the following year. Employers must also file Copy A of Form W-2 along with Form W-3, Transmittal of Wage and Tax Statements, with the Social Security Administration (SSA) by January 31.

Employers are also responsible for Federal Unemployment Tax Act (FUTA) taxes, reported annually on Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. This tax funds unemployment benefits and is paid solely by the employer. Form 940 is due by January 31 of the following year, though an extension to February 10 is granted if all FUTA taxes were deposited on time.

Maintaining accurate payroll records is a continuous obligation. Employers must keep records of employee names, addresses, Social Security numbers, wages paid, and tax amounts withheld. The IRS generally requires employment tax records to be kept for at least four years after the filing of the fourth quarter for the year. Other federal agencies, like the Department of Labor, may have different retention periods for specific types of records, such as wage and hour documentation, which may be three years.