Payroll Fraud: Types, warning signs, and how to prevent it

When you think of stealing, you probably imagine shoplifting, robbing banks, and breaking into homes. But did you know, one of the most common ways for people to commit theft in the workplace is through payroll fraud.

Payroll fraud costs businesses an average of $2,800 per month and happens when an employee or employer manipulates a payroll system to take money they’re not entitled to. In QuickBooks’s recent entrepreneurship study, nearly 44% of business owners expect to invest in growth in 2025. That means finding ways to reduce the risk of payroll fraud is essential.

In this article, we’ll take an in-depth look at what payroll fraud is, some common schemes used, and what you can do to prevent payroll fraud in the first place.

Jump to:

• What is payroll fraud?
• Types of payroll fraud
• How to detect payroll fraud
• How to prevent payroll fraud
• Payroll fraud consequences
• Streamline your payroll and reduce your risk of fraud

What is payroll fraud?

Payroll fraud happens when an individual purposefully alters a payroll system to manipulate employee compensation. It’s a crime that both employees and employers can commit.

• Employees can commit payroll fraud by clocking hours they don’t work or secretly increasing their compensation rate.
• Employers can commit payroll fraud by withholding wages and benefits that they owe their employees.

In either case, one party is being deceitful and stealing from the other to enrich themselves. We’ll take a closer look at some common tactics later on.

Types of payroll fraud

As we mentioned above, payroll fraud takes various forms. Some methods are easier to detect than others. Here are some of the most common types of payroll fraud that business owners should be aware of.

Misclassification

Employers classify employees based on the number of hours they work, their relationship with the company, and other factors. Businesses typically classify employees in one of three ways:

• Full-time employees: Those who work an average of 30 hours each week or 130 hours each month
• Part-time employees: Those who work fewer than 30 hours a week or 130 hours a month
• Independent contractors: Those who are self-employed and provide services for the business

Employees with different classifications are entitled to different benefits. Sometimes, employers may misclassify employees to save on things like unemployment taxes, payroll taxes, and employee benefits. Intentional misclassification can be considered payroll tax fraud, which can result in legal consequences for the employer.

Timesheet fraud

Timesheet fraud, also called buddy punching, is when employees manipulate their timesheet to make it appear as if they worked more hours than they actually did.

There are two ways this happens. First, employees may pad their hours on the timesheet by clocking extra hours they didn’t work. Secondly, employees may access the payroll system to falsify their wages and increase their hourly pay rate.

Commission schemes

Some employees may receive bonuses or commissions when they make sales or hit milestones. These bonuses act as an incentive for employees to work hard and excel at their jobs. However, sometimes, employees may figure out how to award themselves commissions or bonuses they didn’t earn.

This is known as a commission scheme and is typically punishable as payroll fraud.

Workers’ compensation fraud

Workers’ compensation fraud is when an employee fakes an injury or falsely claims they got injured at work to collect workers’ compensation. If the company doesn’t have workers’ compensation insurance, it has to pay the full amount out of pocket, potentially hurting its bottom line.

And if the company does have workers’ compensation insurance, this type of fraud could prompt the insurance provider to raise their premiums, costing the business more each month.

Ghost payroll

Ghost payroll refers to situations in which companies are unwittingly paying nonexistent employees. This type of payroll manipulation is most often committed by a human resources employee or someone with easy access to the company payroll system.

The perpetrator can create a fake employee or keep a staff member on payroll who no longer works for the company. By falsifying employment records, they can collect the ghost employee’s paycheck as if it were their own.

Third-party payroll scams

While payroll fraud is often committed internally, external parties can also commit it. W-2 scams and payroll diversion schemes involve third-party perpetrators who target individual employees or company records.

In a W-2 scam, a cybercriminal tricks employees or HR workers into handing over sensitive employee information, such as their income and Social Security number. The cybercriminal then uses this information to file fraudulent tax returns.

In a payroll diversion scheme, cybercriminals trick employees into changing their direct deposit information. This allows the scammers to divert employee paychecks into their own accounts. They may accomplish this scam by sending fraudulent emails or hacking directly into a company’s payroll system.

How to detect payroll fraud

Most payroll fraud schemes usually come to light at some point or another. However, some forms of payroll fraud can be very difficult to identify, meaning they can go on for a long time.

In fact, according to the Association of Certified Fraud Examiners, payroll fraud schemes last an average of 18 months. Typically, there’s no single thing that will serve as a surefire indicator of payroll fraud.

However, a few red flags to watch out for include:

• Errors or gaps in payroll records
• Changes in payroll records that you did not make
• Employees who list identical addresses or bank account details
• Unexpected emails concerning payrolls you didn’t submit

These are just a few warning signs to watch out for—remember, payroll fraud can take many forms. That’s why you should review your company’s payroll and accounting records regularly. With QuickBooks Online, all your payroll information is in one place, making it easy to review records and look for irregularities.

How to prevent payroll fraud

Preventing payroll fraud is always better than trying to fix fraud after it’s discovered. When you put measures in place to detect and prevent fraud, you minimize the chances of dealing with a legal headache later on. Here are a few simple steps to reduce your risk of payroll fraud.

1. Properly classify your employees

As a small business owner, you can face serious penalties for misclassifying your workers. Therefore, it’s important to do some research to find out how to properly classify your employees. Refer to the IRS’ Employer’s Supplemental Tax Guide for worker classification guidelines, or fill out Form SS-8 to get the IRS’ own judgment. 

2. Set rules for timesheets

Provide workers with clear guidelines about when they can and cannot clock into work. You may even implement identity verification measures, such as an ID card or a fingerprint. And, of course, assign managers to review and sign off on employee timesheets each pay period.

3. Review commissions regularly 

Make sure to regularly review your company’s commissions policy. In addition, keep an eye on the records of the employees earning the most commissions. You might even consider auditing their sales to ensure they’ve earned all their commissions.

4. Create a clear policy for workers’ compensation claims 

Create a clear policy for reporting workplace injuries. Let employees know who to report injuries to and when and how to report them. You may also want to install security cameras so that any potential workplace injuries are recorded. This can help you and your employees verify that the accident happened due to their duties, not horseplay or noncovered actions.

5. Review your payroll 

Periodically review your payroll roster to make sure you’re only paying the current employees you’re supposed to. If you notice any errors or suspicious entries, investigate those errors and make changes as needed. Look for things like duplicate addresses and account numbers, and ask your bookkeepers about payroll fraud.

6. Watch for third-party scams 

Hackers and scammers are a persistent threat to small businesses. To prevent these schemes, educate your staff about common phishing scams. You might also upgrade to a secure payroll system like QuickBooks Payroll. With our payroll processing software, you can easily manage payroll while keeping your staff’s information safe from malicious third parties. 

Payroll fraud consequences

Payroll fraud can cost businesses thousands of dollars, but that’s not the only consequence you can face if you’re found guilty of this fraud.

Some common consequences include:

• Audits: The IRS may audit your business to check for fraudulent activity. This can be time-consuming, stressful, and expensive, especially if you need to hire an accountant to help you manage the audit.
• Monetary fines: Business owners who commit fraud may face fines from the county, state, or the IRS. Employees may have to pay fines to their employer.
• Jail time: Depending on the severity of the payroll fraud, you may face jail time. The length of your sentence typically depends on the laws in your area and the amount of monetary damage caused.

Preventing fraud and making sure you’re not accidentally committing fraud can protect you from these consequences.

Streamline your payroll and reduce your risk of fraud

Payroll fraud isn’t unique to any one type of business. It can happen to small and large businesses in any industry or sector. And once it occurs, it can be a huge hassle for everyone involved. One way to keep your company safe is by knowing how payroll fraud is done and following the fraud prevention tips above.

You can also minimize the risk of payroll fraud by using QuickBooks Payroll. In addition to being easy to use, our payroll software is secure, private, and thorough. Our staff monitors the service for issues around the clock, 24/7, so that we can protect your sensitive data. With top-tier protection and easy-to-use internal controls, you can run payroll with complete peace of mind.