What Is Payroll and How Does It Work?
By Danica Jovic
June 17, 2023
Payroll is one of the most important components of running a business. It can also be one of the biggest expenses. So what is payroll exactly? In a nutshell, the term refers to the total amount of wages that a company pays its employees. But running payroll involves complex calculations of the employees’ earnings and tax deductions. If this sounds complicated, that’s because it is.
Luckily, we’re here to help you make sense of it all so that you can decide whether you want to take on these tasks yourself or leave them to the professionals.
Payroll Explained
Understanding payroll is essential to understanding the financial details of your business and remaining compliant with state and federal laws. In addition to calculating how much your employees need to be paid, payroll also refers to:
- Calculating tax deductions
- Annual records of employee wages or the total payroll that includes the overall workforce costs
How does payroll work?
Small business payroll processing starts the moment a company hires a new employee and ends with the conclusion of the employment period. During that time, the US payroll law obliges employers to ensure that employee payrolls don’t have any errors and are completed on time.
For many business owners, doing payroll on their own is stressful and time-consuming, especially because they need to focus on other tasks. Using free payroll software products can simplify a company’s payroll processing. However, these provide businesses with only the basic payroll features. Companies that have their own payroll sector sometimes use a combination of payroll and accounting software products to ensure accuracy when calculating tax deductions and conducting payroll preparation.
What is the payroll process?
Regardless of whether you’re planning to do your own payroll processing or hire someone else to do it for you, there are a few basics that you need to be familiar with.
Collect information from your employees
Before initiating payroll procedures, you need to decide how to pay employees for their work. There are two options. You can either pay annual salaries or hourly wages. Regardless of which option you choose, the total amount is referred to as gross pay, which is what an employee makes pre-tax and before subtracting deductions.
Each employee needs to complete Form W-4, which includes their personal details and information about their federal income tax withholding. If employees change their marital status or have kids, the appropriate changes need to be made to the payroll, meaning that you should review the withholdings of each employee every year.
Establish payment method and paydays
Another important thing to decide is how you make payments. You may use paper checks or direct deposits, but it’s crucial to establish a regular schedule. It can be weekly or monthly, depending on each employee’s payroll status.
Calculate employee time and overtime
If you have per hour workers, you need to calculate the number of hours they worked. Most businesses use time tracking software for measuring working hours and employee productivity.
When it comes to salary workers, you can ask them to use time tracking tools to calculate overtime and track their productivity.
Calculate payroll deductions
The next part in our payroll description relates to various deductions you need to make from your employees’ paychecks. Deductions are made in order to cover Social Security and Medicare taxes, which are also referred to as FICA taxes. FICA is short for the Federal Insurance Contributions Act, a payroll contribution for both employers and employees. These are the most common taxes deducted from the gross salary, but employees can ask for reimbursement of these deductions. FICA taxes and federal, state, and local taxes are also called payroll taxes. Additional deductions are made for income and unemployment taxes. Finally, there are the less common wage garnishment deductions that can cover anything from credit to bankruptcy payments.
Calculate payroll
When you are familiar with the payroll basics, you’re equipped to calculate your employees’ net salary. This is probably the most complicated part of the business because you need to know how to use the payroll formula and organize deductions.
The first thing you need to do is to calculate gross salary and then start with the deductions. It’s easier to do payroll with software, but some business owners do it manually. Since you need to submit reports to the IRS, you need basic knowledge about tax laws. This is why many business owners leave payroll to professional accountants and managers.
In order to define payroll, we also need to mention net pay. This is the employee’s gross pay after deductions. It shows on the employee’s pay stub, which can also include their gross pay, benefits, overtime, and reimbursements.