How to Do Payroll for Small Businesses (+ Video & Template)

To run payroll, register as an employer, choose a pay schedule, collect employee forms, track hours, calculate gross pay and deductions, pay employees and tax agencies, file required reports, and retain payroll records. Small businesses can handle these steps manually, but payroll software usually reduces calculation and filing errors.

This guide walks you through the payroll process in eight steps, from setting up your business as an employer to maintaining the required records. Because payroll and tax requirements vary by location, verify the federal, state, and local rules that apply to your business.

Follow the steps below, watch the instructional video, and download our free payroll checklist to keep the process organized.

Step 1: Set Up Your Business as an Employer

Before running payroll, register your business with the appropriate tax agencies and confirm the employment requirements that apply in your state and industry. Assuming you’ve already established your business and obtained the necessary licenses, complete these steps:

1. Apply for a federal employer identification number (EIN).
2. Determine whether you need a separate state employer or tax identification number. Requirements and registration processes vary by state.
3. Enroll in the Electronic Federal Tax Payment System to make federal tax deposits.
4. Consider opening a dedicated payroll bank account to keep wage and tax payments separate from other business transactions.
5. Register for any required state and local payroll tax accounts and electronic payment systems.
6. Check your state’s workers’ compensation insurance requirements and purchase coverage if required.
7. Confirm whether you must register for state unemployment insurance and determine your reporting and payment obligations.

Some states and localities have additional requirements, including industry-specific payroll rules, mandatory pay frequencies, and local payroll taxes. Verify the rules for every location where your employees work before processing your first payroll.

Step 2: Establish Your Payroll Process

Next, decide how you’ll collect payroll information, calculate wages and deductions, approve payroll, and pay employees. Document the process so everyone involved understands their responsibilities and deadlines.

Consider the following:

• Pay schedule: Choose whether to pay employees weekly, biweekly, semimonthly, or monthly. Confirm that your schedule complies with applicable state pay frequency requirements.
• Employee classifications: Identify which workers are full-time or part-time and exempt or nonexempt. Classification affects timekeeping, overtime eligibility, and payroll calculations.
• Time tracking: Decide which employees must record their hours, what time-tracking method they’ll use, and when managers must review and approve their timesheets.
• Compensation: Document hourly rates, salaries, overtime rules, commissions, bonuses, tips, shift differentials, and reimbursements that payroll must process.
• Benefits and deductions: Determine which benefits you’ll offer, how costs will be divided between the business and employees, and whether each deduction is taken before or after taxes.
• Payroll taxes: Identify the federal, state, and local taxes that apply, along with their deposit and filing deadlines. Review our guide to federal and state payroll taxes for more information.
• Processing method: Choose whether to calculate payroll manually, use a spreadsheet, or use payroll software or a service. Manual or Excel-based payroll is generally best limited to businesses with few employees and straightforward payroll needs.
• Payment method: Decide whether to pay employees by direct deposit, paper check, pay card, or another method permitted in their work location.
• Payroll approval: Assign responsibility for reviewing hours, confirming payroll totals, approving payments, and correcting errors. 

Create a payroll calendar containing employee paydays, internal approval deadlines, tax deposits, required filings, and year-end reporting dates. For more guidance, see our tips for managing payroll effectively.

Step 3: Collect Your Employees’ Payroll Forms When Hired

Collect the required tax, work authorization, and payment forms during onboarding so you can add each employee to your payroll system and calculate their pay and tax withholding accurately.

Common payroll forms include:

• Federal Form W-4: Employees complete Form W-4 so you can calculate the amount of federal income tax to withhold from their pay.
• State withholding form: Depending on the employee’s work location, you may need a separate state or local withholding form. Requirements and form names vary by jurisdiction.
• Form I-9: This form verifies an employee’s identity and authorization to work in the US. Employees must complete Section 1 no later than their first day of employment, while employers generally must complete Section 2 within three business days of that date.
• Direct deposit authorization: Employees choosing direct deposit may need to authorize electronic payments and provide their bank account and routing information. Your bank or payroll provider may also request supporting account documentation.
• Benefits and deduction forms: Collect any forms authorizing benefit contributions, retirement plan deductions, garnishments, or other payroll deductions that apply.

Store payroll records securely and limit access to employees who need the information for their work. Consider keeping Forms I-9 separate from general personnel files to make them easier to produce during an inspection without exposing unrelated employee information.

You must also report newly hired and rehired employees through the appropriate state new-hire reporting program. Federal law generally requires reporting within 20 days, but some states impose shorter deadlines or different requirements. Check the rules for each employee’s work location rather than relying on payroll software to determine whether the report has been filed.

For additional requirements, select the employee’s work state from the payroll directory below.

Step 4: Collect, Review & Approve Time Sheets

Collect each employee’s hours for the pay period, then review and approve the records before calculating payroll. Employers generally need accurate time records for hourly and other nonexempt employees, including salaried nonexempt employees who may qualify for overtime.

Each timesheet should capture:

• Regular and overtime hours
• Start and end times, where required
• Paid and unpaid breaks
• Paid time off and other leave
• Shift differentials or other time-based premiums
• Manager corrections and approvals

Do not automatically exclude every lunch break. Under federal rules, an unpaid meal period generally must last at least 30 minutes, and the employee must be fully relieved of work duties. Short breaks of about five to 20 minutes are typically paid. State requirements may differ.

Before approving timesheets, check for missing entries, unapproved overtime, unusually long or short shifts, duplicate hours, and discrepancies with employee schedules. Address errors with the employee or manager and document any corrections before running payroll.

Small businesses may begin with paper or spreadsheet-based timesheets. As the team grows, time-tracking software can automate time collection, approval reminders, overtime alerts, and payroll exports.

The example below shows a Hubstaff digital timesheet. Hubstaff is particularly suited to remote, mobile, and project-based teams because it can organize tracked hours by employee, project, and task.

Step 5: Calculate the Payroll

Once you know how much an employee has worked for the pay period, you can start figuring out the important payroll calculations. That includes gross pay, taxes due, deductions for insurance premiums and other benefits, and final net pay.

Calculating Gross Pay

Calculating gross pay is as simple as adding up the straight time hours (up to 40 hours within a week) and multiplying by the employee’s hourly rate. Then, add up the overtime hours worked in the pay period and apply the employee’s overtime pay rate to those hours. 

Under federal law, covered, nonexempt employees generally earn overtime at 1.5 times their regular rate for hours worked over 40 in a workweek. Some states impose additional overtime requirements, so check both federal and state rules before calculating pay.

Calculating Payroll Deductions & Taxes

After calculating gross pay, determine the taxes and other amounts to withhold from each employee’s paycheck. The employee’s withholding depends on factors such as taxable wages, Form W-4 elections, work location, benefits, and any court-ordered or authorized deductions.

Common employee withholdings include:

• Federal, state, and local income taxes
• The employee’s share of Social Security and Medicare taxes (FICA)
• Employee contributions to health insurance and retirement plans
• Wage garnishments and other legally required deductions
• Other authorized pre- and post-tax deductions

Keep employer-paid payroll costs separate from employee deductions. These may include the employer’s share of Social Security and Medicare taxes, federal unemployment tax (FUTA), state unemployment taxes, and employer-paid benefit contributions. FUTA generally should not be deducted from employee wages.

Use the following basic formula:

Gross pay − employee taxes − other employee deductions = net pay

Payroll software can calculate withholding and deductions based on the information entered into the system, but you should still confirm tax settings, employee elections, wage limits, and deduction amounts before approving payroll. Review our guide to federal and state payroll taxes and our complete payroll calculation guide for more detailed instructions.

Free Payroll Calculators

Use our calculators in the articles below to make doing payroll yourself even easier.

Gross Pay Calculator | Overtime Pay Calculator | FICA Tax Calculator

FUTA Tax Calculator | Time Card Calculator | PTO Accrual Calculator

Employee Mileage Reimbursement Calculator

For more help, check out our payroll calculation guide.

Step 6: Pay Employees, Tax Agencies & Benefits Providers

After reviewing and approving payroll, pay each employee their net wages by the scheduled payday. Depending on the methods permitted in the employee’s work location, you may pay by direct deposit, paper check, pay card, or another approved option. Allow enough processing time to ensure employees receive their wages on the established pay schedule.

You must also send withheld taxes and deductions to the appropriate agencies and providers. These payments may include:

• Federal, state, and local income taxes withheld from employee pay
• Employee and employer portions of Social Security and Medicare taxes
• Federal and state unemployment taxes
• Health insurance and retirement plan contributions
• Wage garnishments and other required payments

Do not assume all payments follow a monthly schedule. Federal tax deposit deadlines may be monthly, semiweekly, or next-day, depending on your tax liability, while state agencies and benefits providers establish their own deadlines. Use a payroll calendar to track every payday, tax deposit, benefits payment, and filing due date.

Step 7: Do Year-end Payroll Tax Reports

At the end of each calendar year, reconcile your payroll records before preparing employee and contractor tax forms. Confirm that names, taxpayer identification numbers, wages, tips, benefits, and tax withholdings match your payroll reports and quarterly filings.

Prepare and distribute the applicable forms:

• Form W-2: Provide each employee with a Form W-2 showing their taxable wages and taxes withheld. Employers generally must also file Forms W-2 and Form W-3 with the Social Security Administration by Jan. 31 of the following year.
• Form 1099-NEC: Prepare this form for contractors and other nonemployees who received reportable nonemployee compensation. Generally, you must provide a copy to the recipient and file it with the IRS by Jan. 31 of the following year.
• Federal and state payroll reports: Complete any required annual or fourth-quarter payroll tax returns, including Form 940 and, when applicable, Form 941 or Form 944. State and local filing requirements may differ.

When a deadline falls on a weekend or federal holiday, it generally moves to the next business day. Check the current instructions for each form and correct any payroll discrepancies before filing.

Download the latest forms and instructions from the IRS below:

Step 8: Document & Store Your Payroll Records

Maintain complete payroll records for every pay period. These records help support tax filings, resolve employee questions, and demonstrate compliance during an audit or investigation.

Keep records such as:

• Employee names, addresses, Social Security numbers, and employment dates
• Hours worked, pay rates, overtime, and gross wages
• Tax withholdings and employer payroll tax contributions
• Benefit contributions, garnishments, and other deductions
• Pay stubs and payment confirmations
• Forms W-4, W-2, and other payroll tax forms
• Tax deposits, filings, and agency correspondence
• Documents supporting bonuses, commissions, reimbursements, and pay changes

Federal retention periods vary by record. The IRS generally requires employers to keep employment tax records for at least four years after the tax becomes due or is paid, whichever is later. Under federal wage laws, payroll records generally must be retained for three years, while records supporting wage calculations, such as timesheets and schedules, generally must be kept for two years. State laws or other requirements may call for longer retention.

Whether you use payroll software or maintain records manually, protect payroll data with access controls, strong passwords, secure backups, and appropriate document-disposal procedures. Confirm that your payroll provider allows you to export records so you can retain access if you change systems.

If you’re still unsure about the basics, check out our guide to payroll for more information.

Payroll Processing Options and Alternatives

Processing payroll in-house can be complex and time-consuming, especially for larger organizations or those with more intricate payroll needs. There are several alternatives to handling payroll processing yourself:

1. Payroll Software: Consider using dedicated payroll software solutions. These tools are designed to streamline the payroll process, automate calculations, and ensure compliance with tax laws and labor regulations. Popular payroll software options include Gusto, ADP, Paychex, and QuickBooks Workforce. For more options and information, read our guide to the best payroll software.
2. Professional Employer Organization (PEO): PEOs are organizations that provide comprehensive HR services, including payroll processing, benefits administration, and compliance management. By partnering with a PEO, you can outsource many HR functions, allowing you to focus on your core business operations. Check our roundup of the best PEO companies to help you get started.
3. Bookkeeping or Accounting Firms: Some accounting firms offer payroll processing as part of their services. They can handle payroll calculations, tax compliance, and reporting on your behalf, ensuring accuracy and legal compliance.
4. Outsourcing to a Payroll Provider: There are numerous payroll service providers that offer outsourcing services, where they take care of all aspects of payroll processing, from data entry to tax compliance. This can be a cost-effective solution, especially for small to medium-sized businesses.

Review Payroll Before Submitting It

Before paying employees or sending taxes and deductions to other parties, review the payroll register for errors. Correcting a mistake before submission is usually easier than reversing a payment or amending a tax filing.

Compare the current payroll register with the previous pay period and examine anything that changed. A large difference is not necessarily an error, but it should have a clear explanation before you approve payroll.

Here’s what to check:

• Employee information: Confirm names, Social Security numbers, work locations, and bank details, especially for new hires. One incorrect digit in a bank account number, for example, could delay an employee’s direct deposit.
• Hours and earnings: Review regular hours, overtime, commissions, bonuses, tips, shift differentials, and reimbursements. If an hourly employee usually records 40 hours but shows 55 this period, verify the overtime with the employee’s manager.
• New hires and departures: Confirm start and termination dates, final wages, unused paid time off, and applicable final-pay requirements. If someone left halfway through the pay period, check that the system did not issue a full period’s salary automatically.
• Taxes: Make sure withholding settings match each employee’s forms and work location. If an employee recently moved to another state, confirm that the correct state and local taxes are being applied.
• Deductions: Review benefit contributions, retirement deductions, garnishments, and other authorized deductions. If an employee enrolled in health insurance during the pay period, check both the effective date and the amount deducted.
• Payroll changes: Compare gross pay, net pay, taxes, and deductions with the previous payroll. A sharp change could be legitimate, such as a bonus or new benefit election, but investigate it before submitting payroll.
• Funding: Confirm that the payroll account can cover employee net pay, employer taxes, benefit contributions, and processing fees. Account for any pending transactions that could reduce the available balance.
• Approval: Give the designated approver the payroll register and supporting reports early enough to conduct a meaningful review rather than request a last-minute signoff.

After approving payroll, save the final register, approval record, and any reports or documents supporting changes made during the pay period.

Unpaid Payroll Tax Penalties

Unpaid payroll tax penalties can vary depending on the jurisdiction and the specific circumstances of the non-compliance. Payroll taxes typically include Social Security, Medicare, and federal income tax withholdings, as well as state and local payroll taxes where applicable.

Penalties for unpaid payroll taxes can be assessed by both federal and state tax authorities. Here are some common penalties associated with unpaid payroll taxes:

1. Failure to Deposit: Employers are required to deposit withheld income taxes and payroll taxes periodically, such as monthly or semi-weekly, depending on the size of their payroll. Failing to make these timely deposits can result in penalties. The amount of the penalty depends on how late the deposits are and the amount owed.
2. Late Filing: Failing to file required payroll tax forms, such as Form 941 (Employer’s Quarterly Federal Tax Return) or Form 940 (Employer’s Annual Federal Unemployment Tax Return), by the due date can lead to penalties. The penalty amount can increase the longer the filing is delayed.
3. Failure to Pay: This penalty is imposed when employers don’t pay the full amount of payroll taxes owed by the due date. The penalty is typically a percentage of the unpaid amount and can increase the longer the taxes go unpaid.

In addition to penalties, interest charges can accrue on unpaid payroll taxes. The interest rate is typically determined by the tax agency and can compound over time.

Bottom Line

Learning how to do payroll can be a pain. You have to make sure your business registers with all the right agencies. You’ll also need to fill out forms for each employee and purchase workers’ compensation coverage, all on a tight deadline (less than 20 days for most states by law). Even seasoned business owners can get overwhelmed by the complexities of payroll compliance. That is why simple software solutions are the easiest and most time-saving options for business owners overall.