How Payroll Works

Every company, large or small, needs a payroll system. Whether you do it in-house or outsource to a professional payroll service provider, it helps to have a general understanding of how payroll works.

The purpose of any payroll system is to standardize the process of paying employees. While every payroll system is slightly different, depending on company size and needs, how payroll systems work and their basic functional capabilities are fairly universal. Payroll systems generally include the following capabilities:

  • Payroll scheduling and payment of employees. Payroll systems should manage direct deposit and set automatic payment schedules. Some also may have benefit and incentive tracking to help with HR and monitor special wages.
  • Withholding and tracking of payroll taxes. Both employees and employers have payroll taxes that need to be withheld. Payroll systems need to manage all of the calculations and make payments so the company doesn’t get in trouble with the IRS.
  • Payroll reporting. The federal, state and local government require businesses to report employee statuses, tax withholdings and payments. Your payroll system should create and file these reports.
  • Legal and state labor law compliance. There are certain rules companies have to comply with when it comes to things such as overtime, wages, termination and labor laws. A payroll system should handle management of these.

Once you understand how payroll works, you need to set up your system. Learn the basics of how to do payroll with the steps below.

How to Do Payroll

  1. Set up employees. All employees need to complete required forms, such as a W-4, and get set up in the payroll system at the beginning of employment.
  2. Figure out gross pay. Calculate number of hours worked, plus extras like bonuses, commission, overtime and any wage changes, to determine gross pay.
  3. Note exemptions or deductions. Review employee deductions and contributions for things like health insurance, retirement plans and wage garnishments. Depending on the type of deduction, it may come before or after tax.
  4. Determine employee payroll taxes. All employees will have federal and state taxes taken out of their checks, such as Federal Income Tax, Social Security and Medicare.
  5. Pay employees. Once you have figured out final pay amount, cut checks or deliver wages through direct deposit.

There are many details and factors to consider in each of these steps and the easiest way to tackle all of them is to hire a professional payroll service provider. This does have a cost associated with it, but many companies find it saves them in the long run because relying on a professional reduces the likeliness of penalties and keeps employees focused on the business.