Step 1. Setting Up Accounts
In order to be able to run payroll, your organization must be known to the federal and local government as a business entity, and you need to set up appropriate accounts in order to hold funds for paying taxes and fees for the operation of your business.
Those identity numbers and accounts include:
Once you’re established as a business, the next step is to choose how you want to process payroll and how you want to pay your people.
Step 2. Choosing Your Processing and Payment Methods
There are essentially two methods for processing payroll: you can either do it yourself, or you can outsource it to a third party. But like everything in life, payroll is not quite that simple. In fact, a better way to look at payroll processing is on a sliding scale, with one end being fully manual payroll processed in-house by a payroll administrator, and the other being an accounting service or independent accountant you hire to handle payroll.
Fully manual payroll is the most time-consuming and labor-intensive way to process payroll, but the fact it involves little or no initial investment means it’s often the method many small businesses choose. The responsibility may fall on a single HR administrator or bookkeeper to collect employee information, maintain a database in spreadsheets or paper files, perform wage and overtime calculations, deduct tax and benefit payments, issue checks, pay taxes, and keep records, just for a start. They also have to stay up to date on changing rules and regulations that are required to remain compliant with the state and federal government.
Payroll Software (Self-Service)
In between fully manual payroll and fully outsourced accounting lies stand-alone payroll software. Stand-alone payroll software is a step up from fully manual payroll processing because, unlike spreadsheets, it is built specifically for payroll. That generally means some automation of repetitive payroll tasks, varying levels of integration or compatibility with other HR software systems, and it may include a built-in database of payroll-specific functions like overtime calculation formulas and tax rates.
Software-Supported Payroll Providers
While it may sound extravagant, a full-service payroll provider is something to consider no matter the size of your organization. A full-service payroll provider is a third-party agency that specializes in the more complex and time-consuming aspects of payroll, like filing taxes, managing benefits, tracking time and attendance, and more. Payroll providers often provide software as part of their service package to facilitate data transfer between the customer and the agency; that software may integrate with other HR systems, or the payroll provider may even partner with an HRIS provider to create an all-in-one HR and payroll package.
PEO or Third-Party Accounting Service
At the other end of the spectrum from fully manual payroll is fully outsourced payroll in the form of a professional employer organization (PEO) or third-party accounting service. This form of payroll processing is often the most expensive, but in exchange, it requires the least amount of effort and involvement. A PEO will often offer full-service payroll in addition to HR services like benefits management, hiring, onboarding, corporate culture training, policy enforcement, and offboarding.
Why Payroll Software Is Essential
Whether you choose to self-service your payroll process or you enlist some form of external help in the form of a provider, software is almost guaranteed to figure into the equation. Payroll software is the key link between an organization and any payroll provider because, despite the name, full-service payroll providers do not necessarily handle every aspect of payroll from beginning to end. Unless you hire a full-service accountant and bookkeeper (or outsource to a PEO or accounting service), someone at your organization will likely be responsible for collecting employee tax information, tracking hours and timesheet approvals, and providing information about wages, salaries, vacation time, and benefits.
Payroll software makes it easier for both DIYers and in-house HR point people to collect, organize, and submit all of the required information, and it also usually includes helpful reports and dashboards to track your payroll processes.
Step 3. Gathering Employee Information
In order to pay your employees properly, you need all of their personal information, including their Social Security number, their bank account information (if you pay via direct deposit), and their tax withholding information. You also need to have accurate information about their pay rate, benefits enrollments, and any additional information that could affect their pay, like contributions to retirement funds or wage garnishments.
Here’s the full list of information you must gather for every employee:
- Full name and address
- Employee or independent contractor status
- Social Security number or EIN from IRS Form W-4 (for employees) or Form W-9 for contractors
- Employee tax withholding information from Form W-4 (not generally necessary for independent contractors)
- Rate of pay and other earnings such as sales commissions or tips
- Whether their earnings are subject to garnishment
- Which employee benefits they have chosen that require withholding
- Direct deposit bank account information (if that’s how you issue pay)
- Form I-9, verifying eligibility for U.S. employment
- Exempt or nonexempt status
Using payroll software makes it easy to manage all this information for each one of your employees. Some software even provides employee self service, so employees can keep their information updated without the payroll specialist having to constantly update the payroll system.
Step 4. Choosing a Pay Schedule & Pay Method
Typically, an organization pays its employees on one of four scheduled periods: monthly, biweekly, semi-monthly, or on a weekly basis. When you choose to pay employees is up to you, although there are some laws that dictate how employees must be paid.
Here are the pros and cons of each pay schedule above:
- Monthly (12 paydays per year)
- — Pros: This simplest option has the fewest payroll runs, meaning fewer benefits payments. Some payments require no escrow account. It’s also cheaper because of time saved on payroll.
- — Cons: It’s generally disliked by employees and new hires due to the long wait between paychecks. New hires may wait two months before being paid.
- Semi-monthly (24 paydays per year, typically on the 1st and 15th of the month)
- — Pros: If employees are salaried, this option is simpler and cheaper than semi-monthly thanks to fixed dates, fewer total pay periods, and the timing of benefit and tax payments. It’s often preferred by employees who use automatic bill payments for the same reason.
- — Cons: The irregular (87-hour) pay periods make paying hourly employees, commission, and overtime more difficult.
- Biweekly (26 paydays per year, typically paid every other Friday)
- — Pros: 80-hour pay periods make this a simpler way to pay hourly employees, especially if they earn commission or overtime.
- — Cons: Payroll runs do not line up with benefits and tax payments, and this option has the most payroll runs aside from weekly pay, making it more expensive.
- Weekly (52 paydays per year)
- — Pros: A nice option for employees who work irregular hours, like freelancers and on-demand staff.
- — Cons: The most expensive and time-consuming method for an organization to pay employees.