Payroll 101: How Payroll Works and Why It Matters
Payroll is the most elemental way in which an organization honors its agreement with employees. And payroll administrators keep companies compliant throughout the year, ensuring timely and accurate compensation goes out while they safeguard a trust fund of withholdings used for taxes and benefits. Yet, as administrative responsibilities go, payroll is notorious for garnering the least appreciation in exchange for being one of the most essential, time-consuming, and stressful tasks administrators perform. By understanding how payroll works and what’s involved, administrators and executives can ensure they are taking full advantage of an opportunity to treat their employees well and to safeguard the entire organization.
How Payroll Works
Payroll was originally the term for the list (roll) of people employed by an organization; however, it’s now more commonly used to describe the total amount of money an organization pays its employees and the process of paying them.
How is payroll actually processed?
From start to finish, setting up and processing payroll follows the same basic plan for most U.S.-based organizations. It begins with obtaining an employer identification number (EIN) and ends with paychecks arriving in employees’ hands (or bank accounts). Here is how it breaks down.
Prior to running payroll, you need:
- An EIN – The number the federal government uses to identify an organization for tax purposes.
- State and local ID numbers – Like an EIN, but at the state and local level.
- Employee tax information – W-4 forms for full- and part-time employees, W-9s for contract employees.
- A payroll budget and schedule – How much you will pay employees, and how often.
- A tax payment schedule – When you will pay taxes for the organization.
To process payroll, you must:
- Calculate gross pay – For hourly employees, this means combining regular hours and overtime and multiplying by standard and overtime payment rates. If you use traditional timesheets that need to be submitted, checked for errors, and approved, this process requires a massive amount of time. Not necessarily so if you have time-tracking software.
- Calculate net pay – After calculating federal, state, and local taxes according to employees’ individual withholding information, add insurance, retirement, and any other deductions, and subtract that amount from their gross pay.
- Reserve/distribute deductions – Taxes and other deductions must be either placed in trust for later payment to the appropriate entities or paid immediately, according to your schedule.
- Issue payment – Print checks or issue direct deposits to your employees.
To ensure compliance, you need to:
- Keep records – Keeping detailed, complete, and organized records prevents issues of noncompliance in pay and makes a possible audit go smoother and faster.
- Pay taxes on time – Penalties for late federal tax payments range from 2–10 percent and state and local penalties can be even worse, making scheduled tax payments absolutely essential.
- Report changes to the IRS – Regular reporting of hiring, turnover, and other changes that affect your payroll provides a record of your due diligence and lessens the chance that your organization will be audited
More Payroll Questions Answered
What’s a typical pay schedule?
U.S. companies typically pay their employees on a weekly or biweekly (every two weeks) basis, but some pay monthly or semimonthly, usually as a result of how the company earns its revenue or due to the nature of the work performed. Hourly wage earners like construction workers and restaurant staff are more likely to be paid weekly, while professionals and salaried workers are more likely to be paid at less frequent intervals. After a company decides how much and when to pay employees, payroll processing follows the same plan from start to finish every pay period.
What are payroll taxes?
Payroll taxes are all the payroll-related taxes that organizations and their employees pay throughout the year. Payroll administrators are responsible for ensuring the amount paid by the organization and the money deducted from employees’ wages are accurate and, in the case of the organization, submitted on time. Payroll taxes taken out of wages are submitted automatically and then adjusted via annual tax returns. In the United States, payroll taxes include income tax and deducted funds for various kinds of insurance, as well as Medicare, Social Security, state, and local taxes.
The Importance of Payroll
Being paid for the work you do is the bedrock of the employer-employee relationship. It is an expectation that is almost entirely implicit—imagine, for example, asking in a job interview whether you’ll be paid on time and accurately—until something goes wrong, at which point the entire relationship is at risk. Payroll is therefore absolutely critical . . . but it’s also complicated, time-consuming, stressful, and never-ending. Even small payroll mistakes and payroll errors create huge headaches, and larger ones can land an organization in deep legal and financial trouble with employees or the government. Yet despite its critical nature, even basic payroll knowledge is relatively scarce outside of the groups or individuals who actually handle payroll.
That’s unfortunate because understanding what payroll really does and how critical it is increases the chances it will get the attention it deserves. Organizations should treat those responsible for payroll processing like gold, and make doubly sure to provide everything they need to process payroll accurately and efficiently. Whether that arrives in the form of plenty of time to process payroll manually, capable and integrated payroll software, or a third-party payroll service, the effort an organization spends on payroll proficiency will be well worth it in the end, for both employee satisfaction and the longevity of the organization itself.