Every business that has employees has to do payroll. That means if you’re getting ready to hire employees, you have to understand what payroll is, how it works and what options you have for processing payroll. Understanding payroll isn’t too difficult, but it’s essential to be on top of it all to ensure you are fulfilling your obligations as an employer.

So what exactly is payroll, why do you need it, and how does it all work?

Table of Contents:

What Is Payroll?

The word payroll is actually a pretty flexible one. It can be used to mean a few different things, including the employees you pay and their employee information, the amount you pay your employees in each pay period, and the process of calculating and distributing wages and taxes.

Payroll is composed of different elements that should all be considered to ensure you know how it operates. Here are some of the components of payroll and why they’re important.

Components of Payroll:

Employee Information

To run a payroll program, you need to have the relevant information from your employees. Employees are asked to complete IRS Form W-4 when they join your company, which gives you all of the information that you need. It includes basics, such as their name, address, and Social Security number, as well as information about the employee’s federal income tax withholding.

Hours Worked

Keeping track of the hours that your employees work is required if your employees are paid by the hour. It can still be useful to track hours for salaried employees, but the information isn’t as essential for payroll. For hourly employees, you need the numbers to ensure you’re paying your employees appropriately.

Time off

As well as the hours that your employees work, it’s a good idea to have information about the time that they take off work. This might include sick days, vacations or any other time employees are away from work during their contracted hours. Tracking time off is especially important for calculating sick pay or paid vacation time.

Salaries and Wages

Information on both salaries and wages is required for payroll. The difference between a salary and wage is important to take into account here. While a salary is a fixed amount, usually per year, which might also include contracted working hours, a wage is based on the number of hours worked.

When paying a salaried employee, they will receive their annual wage divided by the number of pay periods (before deductions). An employee who is paid hourly will earn their hourly amount multiplied by the number of hours they worked during a given pay period. Hours worked are used together with salaries and wages to ensure you are paying your employees correctly.

Overtime pay

Your employees may also earn overtime pay if they work enough hours. Overtime pay is due to all nonexempt employees and typically begins after the employee has worked more than 40 hours in a single week. Standard overpay is one-and-a-half times the normal rate of pay.

Each state has different overtime requirements, making it important to check and make sure that your business is compliant. You need to know how to calculate overtime according to the rules of your business’s location.

Fringe benefits

It’s also necessary to include fringe benefits in payroll. This includes benefits such as health insurance, retirement plans, and other additional assistance and products that you might extend to your employees. Some fringe benefits are taxable, which is why you need to include them in payroll.

Payroll Deductions

Before paying an employee their wages or salary, there will likely be certain deductions to make. This is any money taken off wages before payment, including tax.

Payroll Taxes

As the employer, it is your job to deduct payroll taxes from your employees’ wages before paying them. These taxes include federal income tax, state and local income tax, federal and state unemployment tax, Medicare tax, and Social Security tax.


Another deduction that you might have to take care of is garnishments. This is anything that has been court-ordered to be deducted from your employee’s post-tax pay. Garnishments are used to pay off debts, such as child support, unpaid taxes, overdue loan payments, and more. You will know if you need to deduct a garnishment, as you will receive a notice from the court.

Net and Gross Pay

Finally, you need to know the net and gross pay for each of your employees and this will need to be shown on their pay stub. Gross pay is their total pay, while net pay is the amount left after all deductions have been subtracted, i.e. the employee’s take-home pay.

How Does Payroll Work?

Now that you know the essential information that is required for payroll, it’s important to understand how to do payroll. Every business might do things slightly differently, but there are also plenty of things that every payroll department can agree on.

The key steps in organizing payroll include:
  1. Keeping paperwork up to date
  2. Setting up a payroll schedule
  3. Calculating pay
  4. Making deductions
  5. Issuing pay to employees
  6. Good record keeping

1. Collect Required Paperwork

A new business needs to gather all of the required paperwork to get the payroll system setup. Start with your employee information, including your Employee Identification Number (EIN) and your tax IDs for both state and local tax. We will then need to ask every employee to fill out a W-4 form and Form W-9, which is used to provide the employee’s Taxpayer Identification Number (TIN). At the end of the year, you will also need employees to provide Form W-2 and 1099s.

It’s a good idea to have a corporate employment attorney help you to check if you have all of the paperwork that you need for payroll.

2. Create a Payroll Schedule

A payroll schedule is necessary so that you and your employees know how often they will be paid. You can choose to pay on a schedule that suits your business, as well as your employees. Some businesses pay on the 15th of the month and the last day of the month, others pay every week, two weeks, or month.

When deciding your payroll schedule, there are a few things to consider. Firstly, take your employees’ needs into account. They have financial obligations, so they don’t want to wait too long between paydays. Additionally, think about your business’s cash flow and when it will make the most sense for you to pay employees. There are also state laws about how often to pay employees, so be sure to check the law for your state.

3. Calculate Pay

Calculating your employees’ gross pay is the first step when it’s payday. You’ll have to either calculate their salary as a percentage of their total salary, which should be the same for each pay period, or you will need to use their hourly wage, working time, and any overtime to calculate their wage.

4. Make Deductions

Next, any payments need to be deducted, including taxes and garnishments, as well as Social Security, health care, 401(k) contributions, and any other relevant deductions. Make sure you know which deductions are required by law.

5. Issue Pay to Employees

After deductions have been made, your employees can receive their net pay. Choose your method of payment to make things convenient for your company and employees. Most employers use direct deposit for payment.

6. Keep Good Records

Once your payroll is up and running, it’s essential to continue to keep good records. It will help you to correct mistakes quickly and dispute any complaints that are made. Your payroll information will be necessary when it’s time to file taxes and your accountant needs to be prepared.

Payroll Processing Options

You have a few different options to help you run your payroll. Each one has its own advantages and disadvantages.

3 Ways to Process Payroll:

Do It Yourself (DIY)

One option is to take the DIY route for your payroll. This can be a time-consuming and labor-intensive way to manage your payroll, but it could save you money. It’s likely only going to make sense for small companies with no more than a handful of employees.

Use a Payroll Software

Payroll software is designed to automate payroll operations and make them easier to carry out. You can use it to quickly generate accurate calculations and pay stubs. It can save you a lot of time and money through automation and reducing mistakes. While some small business owners might think it’s not worth the cost, there are solutions for businesses of all sizes and at various price points.

Payroll Accountant

If doing it yourself seems like too much work, you can hand it off to a payroll accountant. They specialize in payroll processing and will use their skills and expertise to ensure it’s all taken care of properly. They can help you to make sure you don’t make costly mistakes, which can be a risk if you try to DIY it.

If you have employees, you need to manage payroll appropriately. When you’re setting up your business or getting ready to hire your first employees, get ready to prepare your payroll.