What is payroll? A 2022 guide to processing payroll

Payroll is the business process of paying employees. Running payroll consists of calculating employee earnings and factoring out payroll taxes. The term payroll can also refer to:

• A business’s financial records of employees.
• The distribution of employee paycheques.
• Annual records of employee wages.

Payroll can be a business’s greatest overhead expense. The payroll process is complicated, but understanding each component of payroll can help you better understand your business’s finances. Plus, it can help ensure you remain compliant with federal and state tax and labour laws.

Steps for processing payroll

1. Collect data

When you hire a new employee, you need to follow the correct payroll processes, beginning with collecting their payroll information. Employers must withhold amounts for government taxes and may withhold money to pay for employee benefits.

2. Calculate net pay

The employee’s net pay is their gross pay minus tax withholdings and benefit payments. You’ll also calculate withholdings like health insurance taxes, Social Insurance taxes, or any taxes applicable to your country's tax laws. 

3. Issue payments

You must pay the employee’s net pay via direct deposit or by issuing a paper Cheque.

4. Report taxes

You would most likely need to submit a tax filing government tax withholdings to your country’s designed revenue agency and the state department of revenue. Your report may include items like retirement contributions, state unemployment payments, health insurance taxes, and Social Insurance taxes to other entities.

5. Withhold and pay taxes

You must forward all tax and benefit payments to taxing authorities, retirement plan firms, and other benefits providers.

Essential payroll components

There are many components in the payroll process. We’ve broken down each component into three categories: employee information, salaries and wages, and deductions.

1. Employee information

Before paying employees, they’ll need to give you some information. First, they need to complete a form that will help you gather all of your employee’s personal data. All employees found on your business’s list of employees should complete this form as soon as you hire them. This form will also include information on an employee’s income tax withholding (relevant to each country’s authorities). It also includes an employee’s personal information, such as their name, and address. All of this information will help you process payroll and distribute employee paycheques.

2. Salaries and wages

The second category is an employee’s pay. Either you pay an employee an annual salary or an hourly wage. Salaried employees earn a fixed amount per pay period. Wage-earners, or hourly employees, earn an hourly rate. An employee’s pay slip (or pay slip) may show their gross pay, time worked, overtime pay, benefits contributions and reimbursements, additional income, and net pay.

Gross pay

Gross pay is the total dollar amount you pay to a worker before subtracting deductions. Gross pay is what a worker makes “pre-tax” or “before taxes.”

Employee time

Employee time refers to the number of hours an employee worked in a pay period. Most businesses require hourly employees to track time. However, some salaried employees may also track time if they earn overtime pay.

Overtime pay

Most nonexempt employees are entitled to overtime pay. Depending on your country, the local government may establish an overtime pay rate for a nonexempt employee. The overtime pay rate applies to hours a non-exempt employee works over the full-time work period (or hours) in a workweek. Some countries manage a 38 or 40 hours workweek for a full-time employee, however, these hours may change based on your location. Another common term for overtime is “time and a half.” Usually, exempt employees don’t receive overtime pay. Your country’s labour laws may determine overtime pay rates and requirements for your workforce.

Benefits contributions and reimbursements

Benefits are contributions you might provide your employees. The most common types of benefits include health insurance, retirement plans, and paid leave. However, you must deduct many of the most common benefits from an employee’s wages. After submitting documentation, the worker is eligible for reimbursement of the deducted amounts.

An example of a benefit contribution is a health insurance reimbursement for completing a yearly screening. Another example is educational reimbursements, wherein you may compensate an employee for attending classes related to their job or pursuing a college degree.

Additional income (tips, commissions, and bonuses)

Additional income may apply to service workers, salespeople, and anyone eligible for bonuses. The most common types of additional income include tips, commissions earned on sales, and bonuses. Local and state laws may tax some forms of extra compensation at a higher rate.

Tips are a unique type of additional income. Depending on minimum wages required by your state laws, tips may contribute to an employee’s overall hourly pay. Additionally, employee tips and pay must not dip below the minimum wage. A state’s minimum wage may differ from the federal minimum wage 

Net pay

After you subtract all deductions, the remaining amount is the employee’s net pay. It’s also called “take-home pay.” Net pay is the amount employees receive on payday.

3. Deductions

Deductions are any amount removed from an employee’s paycheque for tax or other purposes. Common deductions include payroll taxes, payroll withholdings, wage garnishments, and benefit deductions.

Payroll taxes

Payroll taxes are the most common deduction. You withhold these taxes from an employee’s gross pay. Payroll taxes may refer to Social Insurance or state health insurance taxes, depending on the country you are based on.  

Payroll withholdings

These deductions refer to income and unemployment taxes. Both income and unemployment taxes will vary depending on your location. There may be federal, state, and sometimes local income tax rates. 

Wage garnishments

Wage garnishment is not a common deduction. Employees who have their wages garnished do so under a court order over a credit or civil matter.

Types of age garnishments include

• Credit, medical bills, or personal loan payments.
• Consumer debt or bankruptcy payments.
• Child support or alimony payments.
• Federal student loan repayments.

The amount to withhold will depend on the court order. Your country’s laws will determine benchmarks for wage garnishment based on an employee’s total earnings. 

Benefit deductions

Benefit deductions may include health insurance costs, life insurance, or other fringe benefits. Unlike benefit contributions, these benefits have a cost for employees in exchange for a service or coverage.

Typically, employers and employees may pay a portion of the monthly cost of health insurance. Retirement plans often take a percentage of the employee’s income and place it in a retirement account on their behalf.

Benefits that you take out before tax deductions are called “tax-deferred.” You remove taxable benefits from an employee’s gross pay after you deduct taxes. Check local, state, and federal laws around taxed benefits to ensure your business remains compliant.

How to calculate payroll

Although there are many components to payroll, not all of them apply to your business. Keep in mind that your business and your local laws may affect how you calculate payroll.

1. Calculate your employee’s gross pay

You can determine an employee’s gross pay using their pay rate and your scheduled pay periods. Most businesses will pay employees on a schedule. Most commonly, pay periods are weekly, every two weeks, or monthly.

To calculate an hourly employee’s gross pay, multiply their hours worked in the pay period by their hourly pay rate. The formula follows:

Hourly rate x total hours worked in the pay period = gross pay

Let’s look at an example. Say an employee makes $15 an hour. Their employer pays them every two weeks. The employee worked 35 hours the first week and 30 hours the second week for a total of 65 hours for the pay period. So the employee’s gross pay is $975.

To calculate a salaried employee’s gross pay, divide their annual salary by the number of pay periods in the year. The formula follows:

Yearly salary / number of pay periods in year = gross pay

Let’s look at an example. An employee makes $60,000 a year. Their company pays employees every two weeks for a total of 26 pay periods. So the employee’s gross pay is $2,307.69.

2. Make pre-tax deductions

After determining gross pay, you’ll need to factor out deductions. These are tax deductions, but other pre-tax deductions may also apply.

Some common pre-tax deductions may include:

• Retirement plans.
• Health insurance plans.
• Health Savings Account (HSA) or Flexible Spending Account (FSA) contributions.
• Some life insurance plans.

3. Deduct taxes (unemployment and income taxes)

Once you make pre-tax deductions, the remaining payment is taxed. Let's say that in our example country, the tax rate is 7.65%—or 1.45% for health insurance and 6.20% for Social Insurance taxes. Federal, state, or local laws and your employee’s W-4 selections will determine the other tax rates.

Calculate federal income taxes – most often, you will pay federal taxes when you pay Social Insurance taxes. 

Deduct your federal payroll tax from the employee’s gross pay. Your business must match each employee’s contribution, and those payments are a company expense. The business submits both the employee’s and the company’s contributions to Social Insurance and health insurance. .

For example, say an employee earned $1,120 in gross pay for the latest pay period. To calculate the employee’s Social Insurance tax contribution, multiply $1,120 by .062 to get $69.44. To calculate the employee’s health insurance tax contribution, multiply $1,120 by .0145 to get $16.24. In total, the employee’s federal payroll tax tax contribution is $85.68 for the pay period, which their employer must match. In this case, the employer is responsible for paying $171.36 to your designed revenue agency . Half is a direct expense to the company. You withhold the other half from the employee’s paycheque.

Employers don’t match income tax deductions, but they pay federal unemployment taxes. You can determine how much federal income taxes your employees owe by using your country’s designed revenue agency’s tax withholding calculator, if applicable.

Keep in mind, that the taxes that would need to be taken into account will be specific and different to each country. We encourage you to research and review the taxes in your country so you are able to correctly process your business payroll, and use these examples as a reference only. 

4. Make voluntary deductions

Once you make an employee’s pre-tax and tax deductions, the next step is to make any other post-tax deductions from the remaining wages. These may include:

• Retirement contributions.
• Some life insurance plans.
• Some long-term disability insurance plans.
• Wage garnishments.
• Union dues. 

5. Determine the employee’s net profit

After all taxes and deductions, the remaining amount is the employee’s net profit. Net profit is how much the employee will take home on payday.

Payroll Best Practices

1. Know your tax filing dates

You should file your payroll taxes based on the dates and deadlines of your country. Other tax deadlines will depend on state and local laws. Your country’s designated federal revenue agency should have a list of important small business and self-employed tax deadlines and forms. Create reminders for yourself to file your taxes throughout the year. Missing a tax deadline could result in additional charges. 

2. Avoid including freelancers and independent contractors in your payroll process

Typically, running payroll only applies to paying employees. When processing payroll, the tax burden is split evenly between employer and employee. However, independent contractors and freelancers are responsible for all their taxes and benefits.

As the business paying the freelancer or contractor, you are purchasing their service. Lumping in contractors and freelancers into your payroll process may complicate your records. Instead, report contractor or freelancer payments as business expenses.

3. Maintain accurate records for payroll

Always keep detailed records on your payroll process and employee paycheques. Accurate recordkeeping can protect your business in the event of a tax audit, or other labour lawsuits.  

• Employee’s legal name and Identification Number 
• Employee’s address and postal code
• Employee’s date of birth and legal gender
• Employee’s occupation
• Time and day of the week when the employee’s workweek begins
• Hours worked each day
• Total hours worked each workweek
• Basis of pay (hourly or weekly rate, commission, service-based, or salary)
• Regular hourly pay rate
• Total daily or weekly straight-time earnings
• Total overtime earnings per workweek
• All deductions made from the employee’s wages
• Total wages (gross and net pay) paid every pay period
• Pay dates and pay period dates

4. Understand how to classify employees

You can classify workers as either employees or contractors. Additionally, you can classify employees as either exempt or nonexempt. It’s essential that you classify employees and independent contracts properly. Correctly classifying an employee will help protect your business in case of an audit or lawsuit.

Employees and contractors each require different tax forms. To determine the classification, your country’s revenue agency will break down the employer-employee relationship into three categories: behavioral control, financial control, and relationship.

Your country’s labour authority will also define employee-versus-contractor classifications. Employees are entitled to certain employer benefits and federal payroll provisions. Independent contractors typically are not. 

You may have to pay employment back-taxes to your country’s designated federal revenue agency if you misclassify an employee as a contractor. 

Ways to Process Payroll

Now that you understand some of the ins and outs of payroll, it’s time to run payroll. You can run payroll manually, outsource it to a payroll accountant, or use a payroll service provider.

1. Manual payroll

Manual, do-it-yourself payroll is a common choice for many small businesses. But the process can be time-consuming. You’ll have to calculate everything by hand, keep track of records, and file your taxes. Running payroll is complicated, and making mistakes can get costly. Manual payroll might not be the best long-term solution.

2. Outsource payroll

You may outsource payroll to an accountant or bookkeeping firm. Paying someone to run payroll can free up some of your time. Plus, accountants are knowledgeable, so you can rest easy, knowing you have experts on your side. Keep in mind that outsourcing payroll or hiring an in-house accountant can be expensive.

3. Payroll software

In some cases, payroll software is cheaper than hiring an accountant and can help you save time when processing payroll. The right payroll service software will let you access and run payroll from anywhere. Other benefits of payroll software include

• Digitised payroll records and automated recordkeeping.
• Automated tax deductions and alerts for filing dates.
• Automated wage calculations and payday alerts.

How the Coronavirus (Covid-19) Has Affected Payroll

The coronavirus has impacted many businesses and may have affected your payroll process, too. Some governments have offered different ways to help small businesses around the globe.

If you retained employees amid the coronavirus, you may be entitled to some benefits depending on your country's labour laws.

Making your way through payroll

Payroll can be complicated and time-consuming, but you don’t have to do it alone. No matter how you run payroll, understanding the basics can help you track business finances. And although labour can be any business’s biggest expense, running payroll correctly is necessary for your small business’s health and success.