Before hiring employees, it’s important to take the time to learn how to calculate payroll for your business. It’ll save you time from having to correct errors and possibly thousands in fines, and you might even experience lower turnover by eliminating paycheck frustrations.
While you can choose to compute everything manually, use an online small business payroll calculator, or rely on software, it’s important to familiarize yourself with the basic process to ensure accurate and timely payments. To calculate payroll for your team, here are the steps you’ll need to follow:
Step 1: Identify the Pay Period
The first step to doing payroll is selecting the recurring time period for which your employees receive their salaries. This schedule helps determine if you’re paying employees weekly, biweekly, monthly, or semimonthly. While pay periods are fixed, you can also run off-cycle payroll if you want to separately process bonus payouts and pay adjustments, such as a cost of living raise for applicable employees.
Before deciding on a pay period, I recommend checking state laws and industry norms, as some might have specific pay period rules. Following these regulations and standards will help you remain competitive and ensure payroll compliance.
For example, California and New York have laws against processing employee payments monthly. Meanwhile, in manufacturing industries, the usual pay period for hourly workers is weekly.
Step 2: Determine Total Time Worked for the Period
You need to figure out how much time each employee has worked for the period, including overtime hours. For hourly employees, this will be total work hours and minutes if you want to pay exact amounts. For salaried staff, it’ll be a set number of hours agreed upon at the time of hire, such as a standard 40 hours, regardless of actual hours worked.
If you want to learn more, check out our article on hourly vs. salary workers, which covers everything small business owners need to know.
Total Work Time for Salaried Employees
You should pay your salaried employees the same amount per pay period—unless, you have a nonexempt salaried position and are legally required to pay out any overtime worked. The key difference between these two employee types is whether or not their salaries and job roles meet the standards set under the Fair Labor Standards Act (FLSA).
To help you correctly classify workers, read our exempt vs nonexempt employees guide. You can also click the below tabs to determine how work hours are tracked for both employees.
Total Work Time for Hourly Employees
Calculating total work time for hourly employees is a little more involved than it is for salaried workers but not too complicated. Essentially, you’ll add all of the hours and minutes an employee worked for the pay period.
Here’s a payroll example. Let’s assume that an hourly employee worked various hours throughout the work week and on Saturday, but none on Sunday. The number of hours and minutes are as follows:
- Monday: 8.67
- Tuesday: 8.17
- Wednesday: 8.75
- Thursday: 8.75
- Friday: 7.08
- Saturday: 2
To get the total work time for the week, you simply add all the work hours for the period:
8.67 + 8.17 + 8.75 + 8.75 + 7.08 + 2 = 43.42 hours
Some work hours are easier to compute than others (e.g., 4 p.m. vs 4:05 p.m.). Knowing how to calculate payroll for employees who worked partial hours is important to ensure accurate payments. The best way to do this is to express the minutes as decimals. To determine the corresponding decimal value for minutes one through 60, simply divide the minutes by 60, which is the total number of minutes in an hour.
For example, the decimal value for four minutes would be 0.07—if rounded up to the nearest hundredth. This is calculated as:
4 minutes ÷ 60 minutes = 0.07
If you need help, check out our guide on how to convert minutes for payroll, which contains a minute conversion chart you can download for free. Note that you can also round up the work hours to the nearest quarter. However, I suggest checking FLSA guidelines before you decide to follow this approach.
If you’d rather skip the manual computations and minutes-to-decimals calculations, use a time card calculator. You can enter hours worked and breaks taken each day, and it will calculate the total hours worked for you automatically.
Total Overtime Work Hours
In addition to determining the total regular hours that employees worked in a pay period, you should also keep track of their approved overtime hours. While FLSA guidelines require you to pay at least 1.5 times the employee’s regular pay for hours worked over 40, you should check state laws for overtime-related rules as some may have different requirements. For example, Minnesota requires overtime payment for hours worked beyond 48 in a workweek.
To learn more, read our guide to calculating overtime.
Step 3: Calculate Gross Pay (Before Deductions & Taxes)
Once you know how many hours you’ll be paying per employee, you can calculate gross pay. Gross pay is the total pay an employee earns before taxes and other deductions are subtracted, or more simply put, their pay rate multiplied by time worked.
For example, Jenny is an hourly employee who is paid $15 per hour. For this weekly pay period, she worked 35 hours. Her corresponding gross pay is $525. Here’s the payroll calculation:
$15 × 35 hours = $525
Learning how to calculate payroll before any deductions are withheld can be simple—provided you understand the different income types (such as overtime, bonuses, and tips) included in the gross pay. Knowing the employee’s gross pay is also important because it is used to determine the percentage or amount to be deducted for pay-based deductions (e.g., retirement plan contributions, Social Security, and Medicare).
Step 4: Determine Your Payroll Deductions
Legally, you have to subtract payroll deductions from an employee’s gross pay before determining their final payout. I suggest compiling a full list of the deductions each employee has. Nontax payroll deductions can include numerous items, such as those in the below list. Note that this doesn’t include the payroll tax deductions, which I’ll tackle in the next step.
- Insurance premiums: Health, dental, vision, life insurance
- Flexible Spending Account (FSA) & Health Savings Account (HSA) contributions: Pretax accounts to help you save money for qualified out-of-pocket medical expenses
- Retirement contributions: 401(k), 403(b), IRA accounts
- Child support payments: Legal draft of your employees’ check that’s usually initiated by the state in which their child lives
- Wage garnishments: Court-ordered garnishments of an employee’s paycheck when they don’t pay their debts; third-party debtors can sue to hold them liable
- Union dues: Membership fees for being part of the union
I just listed a few, but there are plenty more that may be unique to your employees or company. For instance, some employers provide benefits like allowing workers to sign up for company phone plans for their personal use to get low rates. If you offer a similar perk, this will require you to include employee phone charges on your business’ phone bill. If you wanted to recoup some of the money, you could charge them a low monthly cost (with proper written authorization) and deduct it from their paychecks.
You’ll need to add all payroll deductions together to get a grand total. Most deductions, like insurance, have premiums that are the same amount each month, though you may encounter some that are based on the employee’s pay for the period (such as retirement contributions).
For example, in pay-based cases, just multiply the percentage the employee wants withheld (say, 4%) by the gross pay amount (say, $850) to find the total you should withhold. The calculation would be:
$850 x 4% or 0.04 = $34
Step 5: Find the Sum of Payroll Taxes
You’ll need to find the total taxes your employees owe. This can be tricky without using a payroll calculator. Your employees should have completed a W-4 form upon hire; you can use this to help you figure out the percentage of their income that you need to withhold for federal, state, and local taxes. The IRS website is also a good resource if you want to learn more about employment taxes.
Here’s a list of payroll taxes you may have to track, withhold, and send to the appropriate agencies:
- Federal income taxes: Most employees are subject to this unless they’re minors or are exempt because they earn too little.
- State income taxes: States like Florida and Texas don’t have a state tax, but most others do. Some are a flat percentage, and others charge tax based on the employees’ income level (if they earn more, you withhold a higher percentage).
- Local income taxes: Local taxes aren’t as common as state taxes. States like New York and California have several different ones, so be sure to withhold money for all that apply.
- Social Security taxes: This is a 6.2% tax that goes toward each employees’ government retirement fund. Once an employee earns $168,600 in a year, it no longer applies. You are also responsible for paying 6.2% (in addition to what the employee pays).
- Medicare taxes: This is a 1.45% tax that goes toward the government medical fund for seniors. There is no income cap on this one, and you must also pay a matching amount out of your business funds. Note that employees who earn more than $200,000 in a year are subject to an additional 0.9% Medicare tax. However, unlike the 1.45% rate, you don’t have to match this.
Note that you apply the payroll taxes after deducting nonpayroll tax items (except post-tax deductions like wage garnishments and union dues). Here’s an example:
Bert’s gross income for a weekly pay period is $1,250. His HSA deduction per pay period is $50. To determine the applicable Medicare and Social Security taxes, use these formulas:
$1,250 gross pay – $50 HSA deduction = $1,200 taxable income
$1,200 taxable income x 1.45% or 0.0145 Medicare tax = $17.40 Medicare deduction
$1,200 taxable income x 6.2% or 0.062 Social Security tax = $74.40 Social Security deduction
Federal, State & Local Income Tax Rates
Deciding how much you should withhold in taxes is probably one of the most confusing parts of processing payroll. Income tax rates can vary depending on your worker’s W-4 information like marital status and the number of allowances they claim. Use the IRS withholding calculator or refer to Publication 15-T to determine how much to withhold for federal income taxes.
When it comes to state income tax rates, you should expect to withhold around 10% or less. However, if you are in states like California and Hawaii, which traditionally have the highest state income tax rates, your employees could be responsible for paying from 11% to 13% of their income. There are a number of city and county taxes that may apply as well; for instance, if you operate in New York City or your employees live in Yonkers. For a closer look at your state’s specific tax rates, check out our comprehensive state guides via our State Payroll Directory.
Reminder: Make sure that you make all pretax deductions for federal income tax and FICA before calculating the employees’ tax withholdings. These deductions help lower the employees’ taxable income so they don’t end up paying a big amount for taxes.
Subtract Nontaxable Income Before Calculating Tax Amounts
Nontaxable income is important to consider when figuring out employee taxes to withhold because you will need to exclude it from your calculations. This can include work-related amounts that employees paid using their own money that you now need to reimburse. These can be staff mileage reimbursements or transactions to refund workers for approved purchases of company office supplies. Be sure to deduct these amounts before calculating any taxes so you do not end up withholding too much.
Let’s say that Fern’s state tax rate is 9% and her gross pay for a biweekly pay period is $3,500. Of that, $350 is for a reimbursement she is receiving for a hotel stay that she paid on behalf of the company. Here’s how to calculate payroll state tax for this example.
$3,500 gross pay – $350 in hotel reimbursement = $3,150 taxable income
$3,150 taxable income x 9% or 0.09 state tax = $283.50 state tax amount
The same rule applies in calculating payroll taxes, such as Medicare and Social Security. Here’s an example:
Fern has a $350 hotel reimbursement claim, and her gross income for a biweekly pay period is $3,500. To compute the applicable Medicare and Social Security deductions, follow these formula:
$3,500 gross pay – $350 in hotel reimbursement = $3,150 taxable income
$3,150 taxable income x 1.45% or 0.0145 Medicare tax = $45.68 Medicare deduction
$3,150 taxable income x 6.2% or 0.062 Social Security tax = $195.30 Social Security deduction
Employer Payroll Taxes & Other Payroll Expenses
In addition to the taxes you need to withhold and remit for employees, you are also responsible for payroll taxes. It’s not the most exciting part about being an employer but is necessary to avoid paying additional money in penalties and fees.
Here’s a list of taxes and other payroll-related expenses you are responsible for paying out of your business’ bank account:
- FICA taxes: These are the Social Security and Medicare taxes that employees pay. You also need to pay similar tax rates, which are 6.2% of their income for Social Security and 1.45% for Medicare.
- Workers’ comp: Most states require employers to purchase workers’ comp insurance to protect employees in the event of an injury in the workplace. Rates vary, depending on factors like previous claims, length of time in business, industry, and so on.
- Unemployment taxes (or insurance): You may be liable for both state and federal unemployment insurance. This goes toward government funds from which money is distributed when employees aren’t working. The federal unemployment tax rate is 6%, but state rates vary.
- Family Leave Act premiums: Some states (like California and New York), require you to pay money toward family leave insurance. This funds the accounts that pay employees when they take leave for big events (childbirth). Premiums can be less than $1 a month per employee.
- Disability insurance: Some states also require you to pay into their disability fund. Rules and rates vary by state but usually depend on factors like your total payroll amount.
Step 6: Subtract Deductions & Taxes From Gross Pay
To reach the employee’s final paycheck amount or net pay, you should start with the gross amount you calculated in step three. You’ll also need the total nontax deductions and taxes calculated in steps four and five. Don’t forget to identify if those deductions are pretax or post-tax. At this point, you’ll simply deduct all withholding amounts from gross pay.
For example, let’s look at Jill’s gross pay. It’s $2,600 for a two-week period. Total nontax deductions equal $343, and total tax deductions equal $440. She doesn’t have a wage garnishment order and reimbursement claims. Her net pay amount would be $1,817, so you would process a check or direct deposit in this amount.
Gross pay – (Nontax deductions + tax deductions) = Net pay
or
$2,600 – ($343 + $440) = $1,817
If you follow these steps to calculate payroll, you should be able to avoid lawsuits from employees, IRS penalties for inaccurate and/or untimely tax payments, and all of the back-end work that goes into correcting payroll errors.
However, even with all the necessary tools, everyone makes mistakes from time to time. If you do happen to find that you underpaid an employee, you can use a retroactive pay calculator to quickly compute the amount you need to pay the employee so the situation is resolved.
Keep in mind though, you’ll also need to determine the tax impact to remain in compliance. However, using payroll software makes it easy because all of the calculations (paycheck and taxes) are done for you.
Payroll Calculation Methods
There are several ways of calculating payroll. To help you determine which one is best for your small business, click the tabs below.
Regardless of which method you use, having basic knowledge of how to calculate wages and deductions is essential. This will help you avoid potential payment errors and compliance issues, especially if you have different types of employees and hire contract workers.
Further, the process of paying contractors is simpler than paying employees because you don’t have to withhold and remit contractor taxes—they handle this themselves. You only need to pay contractors their wages and keep track of how much you paid so you can prepare year-end tax documents for Form 1099 reporting, which is required if you pay a contractor $600 or more in a year.
To learn more, read our guide to paying independent contractors. If you want to know the key differences between employees (W-2 workers) and contractors (1099 workers) when it comes to the tax rules and federal labor laws that cover them, check out our W-2 vs 1099 workers article.
Frequently Asked Questions (FAQs) About Calculating Payroll
Yes, you can use a payroll system to automate calculations for salaries, overtime pay, deductions, and taxes.
If you made a mistake in calculating payroll for your employees, notify the affected workers and apologize for the incident. Let them know when they can expect to see the corrected amounts reflected in their pay. You should also take a look at your payroll process to prevent similar incidents from happening in future pay runs.
You must fix payroll errors as quickly as possible to prevent potential issues, such as increased feelings of unhappiness and distrust among employees and paying penalty fees for tax filing mistakes and payroll release errors. Note that some states, like California, collect penalties from employers who fail to pay employees on time.
Knowing how to calculate payroll accurately is vital for ensuring compliance with federal regulations and labor laws. It also keeps employees happy if they receive their salaries on time and without payroll calculation errors.
