For many employees, payday is their favorite day. 

However, paychecks don’t materialize out of nowhere with the wave of a wand. Nor are they magically created like cookies in treehouses by Keebler elves. 

The payroll process requires careful tracking, accurate calculations, and timely processing. 

In this article, we'll showcase the essentials of payroll and payroll accounting, answering key questions such as: What exactly is payroll? Why is it necessary? And what options are available for effectively managing it within your company? 

Whether you're new to the world of payroll or looking to refine your understanding, this comprehensive guide will provide you with the information you need to navigate this vital aspect of your business.

Defining Payroll

Payroll is the encompassing process through which businesses compensate employees for their work over a specified period. It involves more than just issuing paychecks — it’s the entire process, from gathering the necessary employee information to calculating hours, wages, deductions, and both net and gross pay and transforming that data into bank deposits. 

For many companies, managing payroll is among their largest expenses, making its accuracy and efficiency crucial to business success. While some businesses manage payroll internally, others outsource it to specialized firms or leverage payroll technology platforms, which can be expensive and time-consuming. We’ll dig into this fork in the road a little later in this article. 

Understanding the Payroll Process

Understanding payroll is essential for any business with employees, as it encompasses a range of responsibilities and processes that ensure fair compensation for work performed. 

Typically managed by a company’s accounting or human resources department, payroll ensures employees are paid accurately and on time while also handling critical tasks like tax withholding and compliance with legal requirements.

Think of managing payroll like baking a cake: Each step is essential for the perfect outcome. Miss one, and things could get a little messy. Below is a step-by-step breakdown of the payroll process, incorporating both essential record-keeping and the execution of payroll operations.

Step No. 1: Record Keeping 

Maintaining accurate records is the foundation of any payroll process. This stage starts when an employee is hired and continues throughout the individual’s employment. Here are the key records to identify and maintain: 

• Personal Information: Gather the employee’s legal name, address, Social Security number, date of birth, and legal gender.
• Tax Forms: These include W-4 forms for employees or W-9s for independent contractors. Additionally, state withholding certificates are needed, as required, along with Form I-9 for employment eligibility verification.
• Compensation Details: Salary or hourly wages, overtime, bonuses, and commissions.
• Benefit Contributions and Reimbursements: Records of health insurance, retirement plans, tuition reimbursements, and other benefit-related payments.
• Work Hours: Number of hours worked, pay period dates, total wages (both gross and net), and any deductions from wages.

Step No. 2: Payroll Processing

Once you’ve gathered all the necessary data, you can begin calculating pay for each period. This process consists of several stages:

Data Collection

For every pay period, collect time tracking data for hourly employees and salary details for others. Be sure to account for bonuses, deductions, and any benefits. Ensure overtime, PTO accruals, and garnishments are input accurately. 

Gross Pay Calculation

Calculate each employee's gross wages, factoring in any additional compensation, such as bonuses or commissions. Deduct any benefits, contributions, retirement plans, and insurance costs from the gross pay.

Tax Withholdings and Deductions

Apply tax withholdings based on federal, state, and local tax regulations. Deduct other withholdings, like child support, garnishments, and any other legal deductions.

Net Pay Calculation

Subtract all deductions from gross pay to arrive at the net pay, which is the amount the employee will receive.

Step No. 3: Approvals and Corrections

Before payroll is finalized and distributed, it goes through a review process.

Approvals: Senior management or payroll administrators review the calculated pay to ensure accuracy and verify all tax withholdings, deductions, and employee compensation data comply with both internal policies and legal requirements.

Corrections: If errors are found during the review, such as incorrect deductions or miscalculated pay, they are corrected either in the current payroll cycle or in the next one.

Step No. 4: Paying Employees

Once payroll is approved, it's time to distribute the payments.

Payment Methods: Employees can be paid via direct deposit, check, or other electronic transfer methods. In 2023, more than 95% of U.S. workers received their paychecks via direct deposit. 

Pay Schedule: Pay periods typically follow one of these cycles — weekly, biweekly, semimonthly, or monthly, depending on company policy. Approximately 43% of employees are paid biweekly, making it America’s most popular payroll frequency. 

Step No. 5: Payroll Taxes and Reporting

This step involves remitting payroll taxes to the appropriate authorities.

Employee Tax Payments: The business submits employee withholdings for federal and state taxes.

Employer Taxes: The company is also responsible for paying its share of payroll taxes (i.e., Social Security, Medicare, etc.).

Compliance: Payroll records are maintained in accordance with IRS and Department of Labor regulations, and taxes are reported at federal, state, and local levels.

Step No. 6: Record Maintenance and Audits

Keeping meticulous payroll records is essential for compliance with IRS and Department of Labor regulations. These records may be subject to audits, making accurate records critical. 

Refresh Your Records: Retain all records of payments, deductions, tax withholdings, and employee information.

Audit-Ready: Ensure all records are readily accessible for any future audits or inspections..

Computing Payroll Taxes

Payroll taxes are necessary for both employee compensation and employer obligations. Ensuring accurate calculation and timely payment of these taxes is essential for maintaining compliance and avoiding penalties. Let’s break down how payroll taxes are calculated, step by step while touching on the key components every business owner should understand.

The IRS netted around $2.8 billion in tax penalties in 2023 and approximately 53% of companies have been penalized for payroll noncompliance in the last five years. That’s a lot of ‘oops’ moments for businesses — don’t be one of them!

Calculate Gross Pay

The first step in calculating payroll taxes is determining an employee's gross pay. This is the total amount an employee earns before any deductions. The method to calculate gross pay will depend on whether the employee is hourly or salaried.

Hourly employees: Multiply the total hours worked in the pay period by their hourly wage. 

For example:

Hourly rate x hours worked = gross pay

Salaried employees: Divide the annual salary by the number of pay periods in a year. 

Annual salary / number of pay periods = gross pay

For example: 

An employee earning $100,000 annually, paid biweekly (26 pay periods), would have a gross pay of $3,846.16 for each period.

Pre-Tax Deductions

Once gross pay is calculated, pre-tax deductions must be factored in. Pre-tax deductions are like coupons — they shrink the size of the bill before taxes even have a chance to step in, thus lowering the amount of payroll taxes withheld. Common pre-tax deductions include:

• 401(k) and other retirement contributions;
• Health insurance premiums;
• Health Savings Account (HSA) or Flexible Spending Account (FSA) contributions; and
• Some life insurance plans.

Payroll Tax Deductions

After pre-tax deductions are applied, payroll taxes are calculated. Payroll taxes generally include:

• Federal Insurance Contributions Act (FICA): This tax funds Social Security and Medicare.
• Social Security: 6.2% of gross wages (up to $168,600 in 2024)
• Medicare: 1.45% of gross wages

Both the employer and employee contribute equally to these taxes. For example, if an employee earns $1,923.08 in a pay period:

• Social Security contribution: $1,923.08 x 6.2% = $119.26.
• Medicare contribution: $1,923.08 x 1.45% = $27.88.

The total FICA contribution is $147.14, which is withheld from the employee’s paycheck. The employer must also match this amount, bringing the total contribution for this pay period to $294.28.

Income Tax Withholding

In addition to FICA taxes, federal income taxes must be deducted based on an employee’s W-4 form and IRS tax tables. State and local taxes may also apply, depending on your business location. These taxes are withheld from the employee’s paycheck, but unlike FICA taxes, employers do not match income tax contributions.

Employers are also responsible for paying federal unemployment taxes (FUTA). These taxes are not deducted from employees’ wages but are paid by the employer to fund unemployment compensation programs.

Post-Tax Deductions

Once taxes are deducted, voluntary post-tax deductions, such as Roth 401(k) contributions, life insurance, union dues, or wage garnishments, are subtracted. These are applied after taxes are calculated, meaning they do not reduce the taxable income but do affect the employee’s net take-home pay.

Payroll taxes, such as Social Security and Medicare contributions, are vital for funding essential government programs. As previously mentioned, employers also play a significant role in paying payroll taxes, contributing 6.2% for Social Security and 1.45% for Medicare on top of the employee’s contribution. This totals 15.3% of an employee’s wages being allocated toward these taxes, split equally between the employer and employee.

Manual vs. Professional Payroll Services

When it comes to managing payroll, businesses have two primary choices: handling it manually or outsourcing to a professional payroll service. Each approach has its advantages and disadvantages, as shown below. 

Manual Payroll

Manual payroll involves calculating employee wages, taxes, and deductions by hand, often requiring a dedicated payroll specialist or accountant as a company grows. The biggest advantage of manual payroll is cost – or lack thereof. For small businesses with only a few employees, this method is often the most affordable, eliminating the need for external services or software fees. Additionally, since the process is managed entirely in-house, businesses maintain full control over sensitive financial information and can quickly adjust to changes in employee status, classifications, or deductions.

However, manual payroll can be time-consuming and prone to errors, particularly as a company expands. The risk of miscalculating taxes or deductions increases, and any mistakes can result in fines, tax penalties, or disgruntled employees. Additionally, as payroll complexity increases with more employees or multistate operations, manual processing may become unmanageable without professional support.

Professional Payroll Services

Outsourcing payroll to professional services offers businesses a more streamlined and efficient way to handle employee payments. One major benefit is the ability to produce a wide range of reports that simplify accounting and tax filing, helping ensure compliance with legal requirements. These services can also track employee vacation and personal time, further reducing administrative tasks.

For larger businesses or those with complex payroll needs, professional services can be a lifesaver, especially when managing multistate payrolls or intricate benefits packages. However, this convenience comes at a cost. Payroll services often charge monthly fees, and while the price may be justified for larger firms, small businesses with tight budgets may find it difficult to justify. Another drawback is reliance on external service providers for accuracy — if they make a mistake, the company may still be liable for any fines or penalties.

Lastly, while external providers handle most of the workload, internal staff must still resolve employee payroll issues, especially in the event of errors. Outsourcing may simplify operations, but it doesn't entirely eliminate the need for internal oversight.

Both options have their merits, but the decision ultimately depends on the size and needs of the business. For smaller companies, manual payroll might be more cost-effective, while larger firms may find professional services a necessary investment for efficiency and compliance.

Payroll Software 

For businesses looking for a solution that combines the cost-effectiveness of manual payroll with the efficiency of professional services, payroll software is an attractive option. Payroll software automates many of the complex tasks associated with running payroll, such as calculating wages, taxes, and deductions while still allowing businesses to maintain direct control over the process – like a trusty sidekick that handles all the complicated stuff behind the scenes so you don’t have to break a sweat. 

OnTheClock is preparing to introduce an in-house payroll solution, OnTheClock Payroll, which exemplifies how payroll software can simplify the process while offering flexibility and affordability. OnTheClock’s payroll software, which is targeting a 2025 release, automatically processes payments on a recurring schedule. Administrators will be able to utilize employees’ information, including salary, deductions, and tax details, that already exist within OnTheClock. This will save businesses the hassle of calculating each employee's wages manually or reformatting the data to fit a third-party company’s requirements, as the software does all the heavy lifting.

While payroll software, such as OnTheClock Payroll, is more affordable than outsourcing payroll services, it will likely require a subscription cost. However, for many small to mid-sized businesses, this price is far less than what they would pay for an external payroll provider. Additionally, unlike full-service payroll solutions, the business retains full control over its financial data, limiting the number of external parties who have access to sensitive information. Additionally, OnTheClock customers retain the ability to track employee time, vacation, and personal leave, as they always have. Combining time tracking, seamless reporting, and payroll will dramatically optimize a small business’s administrative efficiency.

Streamline Your Payroll Process

Payroll is a fundamental aspect of any business, and the right approach can significantly impact both operational efficiency and employee satisfaction. Whether businesses choose to handle payroll manually, outsource it to professional services, or opt for payroll software, each method comes with its own set of advantages and challenges.

For smaller businesses, manual payroll may be the most cost-effective (albeit time-consuming) solution. Professional payroll services can streamline operations for larger companies, but the higher cost and reliance on external providers may be drawbacks. 

Payroll doesn't have to be a headache. Whether you're managing a small business or a growing company, OnTheClock Payroll can nullify the pain by simplifying the process and saving you time. Click here to join our waitlist today and be among the first to discover how OnTheClock Payroll can transform the way you manage your business. Let us handle the details so you can focus on growing your business.