When people think of payroll, they immediately jump to number crunching. Although calculations are a part of it, if you really want to learn how to do payroll, you’ll need to understand the overall process. It includes everything from setting up your business as an employer to paying your employees, tax agencies, and other applicable entities.
For most small business owners who don’t want to take on the various steps involved in how to do payroll such as calculations or tax deductions, we recommend using a service such as Gusto. It not only makes employee onboarding much faster but lifts a huge burden when it comes to calculating payroll taxes and sending funds to government agencies. You can also use it to pay employees via direct deposit at no additional cost. Gusto offers a 30-day free trial.
The 8 Steps to Small Business Payroll
You must establish your business before you can hire and pay employees. This includes setting up your business to legally run payroll and making some decisions about pay frequency, pay rates, and processes you want to establish, like due dates for employee time cards.
Free Small Business Payroll Checklist
Here’s a checklist you can download to make sure you don’t miss any steps. This checklist will also be helpful if you use payroll software to do payroll.
The following eight steps will take you through what’s required to do payroll. You’ll typically do the first and second steps (establish your business as an employer) once, before you start processing payroll for employees. Step 3 (collecting employee payroll forms) is done once for each new hire. If you’re doing payroll for existing employees, and already have their data in your files, skip ahead to Step 4 (collecting timesheets).
1. Set Your Business up as an Employer
Assuming you’ve already established your business and applied for any required licenses, the first step to doing payroll is ensuring your business has met all of the legal requirements to operate as an employer. Consider any industry-specific payroll rules you may have to follow as well.
- Apply for a federal employment ID number (EIN)
- Verify your state tax identification number is the same as your federal; if not, determine whether you need to apply for one or if it’s automatically assigned
- Sign up for an account with the Electronic Federal Transfer System
- Start a bank account solely for payroll transactions (separate from your main business account)
- Sign up for any applicable state electronic tax payment accounts
- Purchase workers’ comp insurance; most states require it.
2. Establish Your Payroll Process
Now, you will need to make some decisions that will impact how you run payroll each period. You’ll need to invest time into determining what will work for your business. Explore the “why” behind each area. Then, consider the needs of both your employees and your business in addition to any legal requirements for payroll.
- Pay schedule: Will you pay weekly, biweekly, or semimonthly?
- Types of employees (not contractors) you’ll have: Full-time vs part-time? Exempt vs Nonexempt?
- Tracking work time: Will you need to track work hours? If so, how will you do it, and when will they need to be reported to you?
- Benefits: Will you be offering benefits? Who will pay for them? If employees are paying for them partially or in full, how will you manage the payroll deductions?
- Taxes: How often will you need to pay taxes, and which ones are you subject to? Will you need to pay state taxes? Local? Find out the rates in advance, so you know how much to withhold
- Payroll processing & calculations: Will you calculate and process payroll using Excel, by hand, with a calculator, or a payroll service?
- Paychecks: Will you be cutting checks and/or paying via direct deposit? Pay cards? Cash?
3. Collect Your Employees’ Payroll Forms When Hired
Once your employee is ready to start work, you need to collect some important payroll documents. These include tax and work authorization forms, which the employees need to sign.
You’ll use the data on the forms described below to add the employee to your HR or payroll system if you have one. And, it’s a good idea to store this information in a paper or electronic personnel file as well.
A W-4 is the federal tax withholding document that tells you what tax rate to use for the employee. Collect a signed Federal W-4 form for tax withholding. You don’t need to submit this to the IRS, but you should store it in a paper file or electronically in a personnel file.
State W-4 (or equivalent)
The state tax withholding document is similar to the federal and may be called by a different name in your state. Collect a signed State W-4 form for tax withholding and store it in a paper personnel file or electronically.
Collect a signed I-9 Form for work eligibility verification (within three days of the employee’s start date). You’ll want to make sure the employee can verify their identity and eligibility to work in the United States with a passport or two forms of identification.
Other Payroll Forms
Get direct deposit information from employees via a voided check (if applicable).
Also, you’ll need to register your employee in your state’s New Hire Reporting Program (within 20 days). Make sure that you report all new or rehired employees to your state. Payroll software programs like Gusto often file these reports automatically.
The final three steps will be a part of your regular payroll process, unlike the prior three that you only need to do once.
4. Collect Timesheets, Review & Approve
Now you’re ready to start collecting data on your employees’ work time to help determine how much you need to pay them. You’ll need to find total hours worked for the period if you’re paying hourly employees. Salaried employees typically receive the same pay each period, but you can still track their work hours for visibility if needed.
Calculating hours worked is as simple as having the employee write down their start and end times each day and counting up the hours. Lunch breaks are not counted in the total.
Most businesses start out with a simple time sheet. As they grow, they often move up to a time and attendance system or time clock to manage employee schedules, break time, and hours worked. Here’s an example of an electronic time sheet app from our recommended timekeeping vendor, Homebase.
5. Do Payroll Calculations
Once you know how much an employee has worked for the pay period, you can start figuring the important payroll calculations. That includes gross pay, taxes due, deductions for insurance premiums and other benefits, and final net 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 employees’ overtime pay rate to those hours. Straight time is paid at the employee’s regular pay rate, while overtime is calculated at 1.5 times the regular rate of pay.
Payroll Deductions and Taxes
Doing payroll requires you to know in advance what payroll deductions you’re going to make. Deductions include federal and state payroll taxes, benefits you might offer, and things like unemployment insurance or Social Security.
Here’s a list of potential deductions with links to more information such as how to determine what to deduct for each employee. If you use payroll software like Gusto, deductions are processed automatically.
- Social Security and Medicare (FICA)
- Federal unemployment tax (FUTA)
- Deductions based on benefits you offer employees, like health insurance
- Tax deductions based on employee tips
- Miscellaneous deductions such as a uniform expense
To process those deductions, add up all the deductions for each employee to get a total, then subtract that total from the employee’s gross pay. Alternately, you can list each deduction as a line item and subtract them one by one from the employee’s gross pay until you come up with a net pay amount.
NOTE: If you’re primarily struggling with the numbers side of payroll, our article on payroll calculations may be a better fit. Just be sure you also have a good grasp of the general steps you should take to run payroll.
6. Pay Employees, Tax Agencies, Benefit Providers
Once you subtract deductions from gross pay, you’ll know the net pay amount that you need to pay each employee, along with totals for employment taxes and benefits you need to pay out. Be sure to follow the pay schedule you initially set, so employees always know what to expect (if you committed to paying wages every Friday, give yourself enough time in advance to process).
Taxes and benefit providers have their own due dates. Many employers are required to pay these expenses on a monthly basis, but it can vary. You’ll need to pay out the amounts you withheld from your employees’ paychecks in addition to any employer payroll tax and premium amounts your business owes.
Always check before making any payments to determine whether you have enough funds in your payroll bank account. Spending more money than you have can result in unnecessary fees and litigation.
7. Document & Store Your Payroll Records
To remain compliant with federal labor laws, you’ll need to document specific data for each pay period. Retain payroll documents like timecards, pay stubs, and any information regarding pay increases.
If you’re using software like Gusto, the documents are already online or can be uploaded and attached to the employee record. If you’re maintaining documents manually, you’ll want to ensure they’re stored securely.
8. Do Year-end Payroll Tax Reports
As the end of the year draws near, you’ll need to prepare to distribute year-end payroll tax reports. Employees must receive their W-2 forms by Jan. 31 of the following year, and the forms must show their total earnings and taxes paid. If you’re paying independent contractors, you’ll need to prepare 1099 forms instead; this will show earnings but no taxes.
Frequently Asked Questions (FAQs) About How to Do Payroll
Payroll is full of so many complex rules and regulations that we realize you may have additional questions. Below we answered some of the most common questions small business owners have about doing payroll.
What Are the Risks of Doing Payroll Without Software?
The biggest risk to your business is that you’ll make a mistake. Without a system to guide you, you may forget to pay taxes, collect deductions, or apply the correct overtime rate, for example.
What Are the Most Common Mistakes Made When Doing Payroll?
The most common mistakes are misclassifying employees and paying the wrong wages or taxes, according to software provider Patriot. To avoid these mistakes, we recommend you understand the difference between employees (W2) and contractors (1099), as well as exempt vs non-exempt staff.
What Happens if I Make a Mistake Doing Payroll?
The good news is that if you make a mistake in good faith, you can notify the employee and fix the mistake with no ramifications by providing retro pay.
However, that doesn’t allow you to willingly violate labor practices such as minimum wage, overtime, or sick time pay. Those kinds of mistakes can cost big fines if you’re audited. Educate yourself on labor laws and workplace requirements in your state and location to avoid as many mistakes as possible.
Learning how to do payroll can be a pain. You have to make sure your business is registered with all the right agencies, fill out forms for each employee, and often purchase workers’ compensation coverage—all on a tight deadline (less than 20 days for most states by law!). Even a seasoned business owner can get overwhelmed when they want to learn how to do payroll that is why simple software solutions are the easiest and most time-saving options for business owners overall.