How many mistakes does the average company make per pay period? Go ahead, take a guess.

According to a 2022 report, the answer is 15. Each of these errors is costly, carrying a price tag of about $291 each. Thus, do the math – payroll mishaps cost the average company $4,365 a week, $17,460 a month, or $226,980 annually.  

While $291 might seem manageable, $226,980 is not. 

Payroll compliance is like balancing a checkbook or following a recipe: every step matters, and one small mistake can throw everything off. These errors don’t just disrupt your workflow — they cost real money.

In the article, we’ll cover the basics of payroll compliance, the key laws you need to know, and demonstrate how you can optimize your payroll procedure to avoid costly missteps.

Key Payroll Laws and Regulations

The first step in staying compliant is understanding the major payroll laws and regulations. These rules cover essentials, like taxes, overtime, and employee classifications. Let’s look at the key guidelines that every employer needs to keep payroll running smoothly and avoid costly mistakes.

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Federal Insurance Contributions Act (FICA)

The Federal Insurance Contributions Act (FICA), created in 1935, funds Social Security and Medicare. This payroll tax requires contributions from both employees and employers, helping to support vital programs for millions of Americans.

• Social Security: Employees and employers each pay 6.2%, totaling 12.4%; and
• Medicare: Employees and employers each contribute 1.45%, totaling 2.9%.

Example: If an employee earns $1,000, $62 is withheld for Social Security, matched by the employer, and $14.50 is withheld for Medicare, also matched. These small deductions add up over time, funding these essential benefits.

Federal Unemployment Tax Act (FUTA)

The Federal Unemployment Tax Act (FUTA) helps fund unemployment benefits for workers who lose their jobs. If you’re an employer paying at least $1,500 in wages to employees in a single quarter, youre responsible for paying this tax. 

The FUTA tax rate is 6% on the first $7,000 of each employee’s wages. However, if you also pay state unemployment taxes, you can receive a tax credit of up to 5.4%, bringing the FUTA rate down to just 0.6%.

Here’s how the calculation works. Imagine you have 20 employees, each earning more than $7,000 a year. Since FUTA only applies to the first $7,000, you would calculate it as follows: $7,000 x 0.06 x 20 = $8,400. This is the company’s FUTA tax liability before any credits.

If a company qualifies for the 5.4% credit by paying state unemployment taxes, the FUTA rate would drop to 0.6%, which can really help keep your overall payroll tax costs down.

Fair Labor Standards Act

Here’s a closer look at each area the Fair Labor Standards Act (FLSA) covers, starting with minimum wage.

The FLSA is a federal law ensuring fair treatment for workers. It covers minimum wage, overtime, recordkeeping, and child labor rules. It’s a guideline for employers to guarantee fair pay and conditions for both full- and part-time employees across the private and government sectors.

Let’s take a closer look at each key area of the FLSA, starting with minimum wage.

Minimum Wage

The FLSA sets a federal minimum wage of $7.25 per hour, though many states have their own, often higher, minimum wages. When federal and state laws apply, employees are entitled to whichever wage is higher. To stay compliant, employers need to check their state’s requirements and ensure they’re paying the correct rate.

Overtime Pay

Under the FLSA, employees who work more than 40 hours in a week must be paid overtime, calculated at 1.5 times their regular hourly rate. This rule doesn’t limit the number of hours someone can work in a week, but it does require that any hours over 40 be compensated at the overtime rate. Overtime rules apply regardless of whether the work is done on weekends or holidays as long as an employee surpasses 40 hours.

Child Labor

The FLSA has strict rules for hiring minors to ensure their safety and well-being. For example, children aged 12 and 13 can only work outside of school hours with written permission from a parent. There are additional restrictions on the types of jobs younger workers can do and the hours they can work, with stricter guidelines for hazardous roles.

Recordkeeping

The FLSA requires employers to keep records of each employee’s hours worked, wages, and other employment details for at least three years. This recordkeeping is essential for transparency and helps in case of an audit or compliance check. Employers should ensure these records are accurate and updated regularly to avoid penalties.

Family and Medical Leave Act (FMLA)

The Family and Medical Leave Act (FMLA) is a federal law that lets eligible employees take up to 12 weeks of unpaid, job-protected leave per year for specific family or medical reasons. FMLA is especially helpful for life events like:

• Caring for a newborn child;
• Adopting or fostering a child;
• Caring for an immediate family member with a serious health condition; and
• Taking leave for one’s own serious health condition.

Example: If an employee’s parent is diagnosed with a serious illness, FMLA allows the employee to take time off to provide care without risking job security

Equal Pay Act

The Equal Pay Act of 1963 (EPA) makes it illegal for employers to pay men and women differently for doing essentially the same job. The jobs don’t have to be exactly the same, but they need to be “substantially equal.” This means the focus is on what the job requires, not just the job title.

The EPA covers all types of pay, like salaries, bonuses, overtime, and even benefits like vacation time and insurance. For example, if a male and female employee both manage teams and handle similar responsibilities, they should be paid equally. If there’s a difference in pay, the employer can’t lower someone’s wage to balance it out — they must raise the lower wage.

If someone thinks their rights under the EPA have been violated, they can take the issue straight to court without going through the Equal Employment Opportunity Commission (EEOC). They have two years to file a claim or three years if the violation was intentional.

Understanding State Requirements

State-specific regulations play a big role in payroll compliance. Each state has unique rules for minimum wage, overtime, and taxes, often differing from federal standards. Employers must stay updated with each state’s laws to ensure compliance.

Key state variations include:

• Minimum Wage: Federal minimum wage is $7.25/hour, but many states have higher minimums. For example, California’s minimum is $15.50/hour;
• Overtime Rules: States may have specific overtime rates or requirements; and
• State Taxes: Tax rates and rules can vary significantly by state.

Essential Compliance Components

Now that we’ve covered the key payroll laws and regulations, let’s look at the core elements of payroll compliance. These are the essentials every employer needs to understand to keep payroll accurate and compliant with the law.

Payroll Taxes and Withholdings

Payroll taxes and withholdings are portions of each paycheck employers set aside and send directly to the government. They help employees pay income tax gradually instead of in a lump sum.

Each paycheck shows these withholdings, and employees receive a W-2 at year’s end detailing total earnings and withholdings. The amount withheld depends on factors like income, filing status, and claimed allowances. If more tax is withheld than needed, the IRS issues a refund. This system makes it easier to manage tax obligations bit by bit throughout the year.

Employee Classifications: Exempt vs. Nonexempt

Classifying employees correctly is essential for payroll compliance. Up to 30% of employers misclassify workers, which affects eligibility for overtime pay under the FLSA.

Exempt employees, often in administrative, executive, or professional roles, earn a salary above a certain threshold and don’t receive overtime pay for hours over 40. Nonexempt employees, typically hourly or lower-salary workers, qualify for overtime at 1.5 times their regular pay rate for hours beyond 40. Proper classification avoids wage law issues and ensures fair pay for all hours worked.

Deductions and Benefits

Deductions are amounts taken out of an employee’s paycheck to cover things like taxes and benefits. These deductions reduce the total earnings (or “gross pay”) to the amount the employee actually takes home (or “net pay”).

There are two types of deductions: mandatory and voluntary. Mandatory deductions, such as income tax and Social Security, are required by law. Voluntary deductions, on the other hand, are optional and usually cover things like health insurance or retirement contributions.

Here’s a breakdown:

• Mandatory Deductions:
• Federal and state income tax;
• Social Security and Medicare (FICA); and
• Wage garnishments (if required by court order).
• Voluntary Deductions:
• Health insurance premiums;
• 401(k) or retirement plan contributions;
• Life and disability insurance; and
• Charitable donations.

Recordkeeping and Documentation

Employers are required by the FLSA to keep payroll records for at least three years. This information helps track employee pay and hours worked, which is essential for audits or legal checks. Different states may have additional rules, so it’s always good to check your state’s specific requirements by visiting your state’s labor department website.

Payroll records should include:

• Employee’s name, Social Security number, address, and birth date;
• Occupation, sex, and the starting day of the workweek;
• Hours worked each day and week, along with pay basis (hourly, salary, commission, etc.);
• Total earnings per day, week, and pay period, including any overtime;
• Deductions, like wage garnishments and union fees; and
• Additional pay or benefits provided to the employee.

Potential Risks of Noncompliance

Not following payroll rules can lead to big problems for a business. From expensive fines to possible legal trouble, the risks of noncompliance can be serious. In this next section, we’ll look at the specific financial and legal issues that can come up if payroll compliance isn’t managed properly.

Financial Penalties and Fines

In 2021, the IRS collected almost $7 billion in payroll-related fines, a heavy burden, especially for small businesses. Noncompliance may seem minor, but these penalties add up fast.

To avoid these fines, businesses should focus on a few simple steps:

• Keep up with federal and state payroll laws;
• Use a reliable payroll system to minimize errors;
• Do regular payroll audits to catch mistakes early;
• Train employees on payroll basics; and
• Consider using payroll software or consulting with an expert.

Litigation Risks and Employee Disputes

Payroll mistakes can lead to even bigger problems, like lawsuits, besides the cost of fines. If employees think they haven’t been paid correctly or feel their rights were overlooked, they might decide to take legal action. This can turn into a costly and time-consuming process that disrupts the business.

Unpaid overtime, incorrect job classifications, and missing deductions are common issues that lead to disputes. These mistakes not only cause frustration but can also harm trust between employees and management.

The Cost of Noncompliance

For example, in 2024, Tesla was sued by former employees in California who claimed they weren’t paid for overtime, missed out on meal and rest breaks, and didn’t receive paid sick leave. The employees are asking for more than $5 million in damages. News of the lawsuit spread quickly, leading to public backlash and raising concerns about how Tesla treats its workers.

Cases like this cost companies money and hurt their reputations. When a company faces issues like unpaid wages, it can lose the trust of both employees and customers.

Common Payroll Compliance Mistakes to Avoid

Payroll compliance can be tricky, and even small mistakes can lead to big problems. Here are some common errors that businesses make and tips on how to avoid them.

Misclassifying Employees and Contractors

One major mistake is misclassifying workers as either employees or contractors. Employees and contractors are treated very differently in terms of taxes, benefits, and legal protections. When a worker is classified as an independent contractor, the business doesn’t withhold taxes or pay for benefits like health insurance. However, if the worker should actually be classified as an employee, the company could face penalties for missed taxes and benefits.

Exemptions and Worker’s Compensation Errors

Another common error is misunderstanding which employees are “exempt” from overtime. Exempt employees don’t qualify for overtime pay under the FLSA, usually because they have specific job duties and are paid a set salary above a certain amount. Misclassifying someone as exempt when they should be nonexempt can lead to unpaid overtime claims.

In addition, mistakes with worker’s compensation can occur when employers don’t account for all employees who need coverage.

Minimum Wage and Overtime Violations

Minimum wage and overtime rules are set by both federal and state laws. Mistakes happen when businesses overlook these rules or fail to pay employees the correct rate. For example, if a worker in California, where the minimum wage is higher than the federal rate, is paid the lower federal wage, the company could face penalties.

To avoid this, businesses should check both federal and state wage requirements and pay overtime as required, which is typically time and a half for hours worked over 40 in a week.

Failing to Meet Filing Deadlines

Payroll involves regular tax filings, and missing these deadlines can result in costly fines. Each payroll period, employers need to file taxes for Social Security, Medicare, and federal income tax withholding. Missing these deadlines is like forgetting to pay a bill; expect to rack up fees, and, over time, those fees can really add up.

To stay on track, businesses can use payroll software that sends reminders or automates the filing process. Ensuring these filings are on time is one of the easiest ways to avoid penalties and keep the business running smoothly.

Best Practices for Payroll Compliance

Using Payroll Software for Automation

One of the best ways to ensure payroll compliance is by using payroll software to automate the process. Automation helps cut down on errors, makes calculations more accurate, and reminds users of upcoming deadlines. Services, like OnTheClock Payroll, offer features that can manage taxes, calculate overtime, and keep track of payroll records. Automating payroll is like setting a clock to wake you up each morning — it takes the worry out of forgetting important tasks.

Tracking Important Deadlines

Meeting payroll and tax deadlines is essential to avoid fines. Each pay period has deadlines for things like tax filings and withholdings. To keep track of these important dates, consider using a payroll calendar or setting reminders in your payroll software.

Verifying Employee Classifications Regularly

Employee classification isn’t something you check once and forget. Roles and responsibilities can change over time, and a position that starts as a contractor role may evolve into something that requires an employee classification. Regularly reviewing classifications is like getting a routine check-up — it ensures everything is as it should be and prevents larger issues down the line. Make it a habit to check these classifications, especially if job roles change.

Accurate Recordkeeping for Audits

Accurate and organized recordkeeping is critical for payroll compliance. Clear records can also make the audit process smoother and less stressful.

Good records should include details like hours worked, pay rates, deductions, and withholdings. Think of it like keeping a well-organized filing cabinet — when everything is in its place, you can find what you need in seconds instead of hunting through piles of paperwork.

Submitting Withholdings on a Regular Schedule

Submitting withholdings regularly is a key part of payroll compliance. This includes deductions for things like federal and state taxes, Social Security, and Medicare. Think of it as watering plants; just as regular watering keeps plants healthy, submitting withholdings on time keeps payroll running smoothly. Make it a point to set up a routine for submitting withholdings to stay compliant and avoid any financial surprises.

Technology and Tools for Payroll Compliance

Keeping payroll compliant doesn’t have to be difficult if you have the right tools. From payroll software to time tracking systems, a few key tools can help make the process smoother and reduce the risk of errors. Here’s how they can help.

Choosing Payroll Software

Choosing good payroll software can make a big difference in staying compliant. The right software should handle payroll calculations and tax filings and keep track of important deadlines. Think of it like having a GPS — good software can help you stay on the right path without constantly checking every detail. OnTheClock Payroll, for example, can help manage taxes, generate reports, and make sure payroll is done correctly.

Implementing a Time and Attendance System

Tracking employee hours accurately is essential for payroll. A good time tracking system ensures that all hours worked are recorded, which is especially important for paying overtime accurately. Think of it like keeping an accurate calendar — you don’t want to guess or miss any details. OnTheClock’s time tracking system, for instance, records employee hours, tracks attendance, and helps ensure paychecks are accurate, making compliance easier to manage.

Creating a Payroll Compliance Checklist

A payroll compliance checklist is like a to-do list that covers all payroll-related tasks. It helps you make sure that everything, from tax filings to classification reviews, gets done on time. To set one up, list out every payroll task that needs to be completed regularly, such as filing taxes, withholding payments, and checking employee classifications. This checklist can serve as a quick, organized way to review and track your progress, helping you stay on top of compliance requirements.

Making Payroll Compliance Easier

Keeping up with payroll compliance can feel like a lot — tracking hours, meeting deadlines, filing taxes, and more. It’s easy to see how mistakes can happen, and those mistakes can get costly. But the right tools make it much easier to stay on top of everything.

Payroll software helps handle calculations and tax filings, so you don’t have to worry about every little detail. A good time tracking system, like OnTheClock, makes sure you’re accurately recording hours and paying employees correctly, which is key for things like overtime compliance. And having a simple checklist for tasks, like filing taxes and checking employee classifications, can make sure nothing important gets overlooked.

With these tools, payroll compliance becomes a lot more manageable. You can avoid mistakes, reduce stress, and show your team that you’re handling their pay responsibly. It’s a straightforward way to keep things running smoothly and build trust with your employees.