Setting up your payroll process requires making some administrative decisions before you run your first payroll cycle. These eight steps for how to set up payroll include choosing a payroll provider, deciding what benefits to offer and choosing how and when to pay your employees.
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How the Payroll Process Works
The payroll process itself is fairly straightforward as illustrated in the image below. Employees work, and you calculate their pay.
However, setting up payroll using the steps below requires some decisions to be made in compliance with federal labor laws. For example:
- Worker types: Employees or contractors
- Payment methods: Hourly, salary or by commission
- Employee status: Exempt vs. non-exempt
Your payroll process needs to be set up so that you make the correct deductions, such as benefits and taxes from employee earnings and make payments to the IRS correctly.
The eight things you need to set up your payroll process are listed below and captured in the free downloadable infographic checklist above.
1. Set Up Your Business Entity
Before you can set up payroll, you’ll need a business tax ID and most likely need to apply for a business license. Your business entity consists of your business name and taxpayer identification number (TIN), which is likely your employer identification number (EIN).
You may also need a local business license or other paperwork. This article assumes that you wouldn’t need to set up a payroll process unless you already have a business.
2. Determine How to Classify Your Workers
The federal government classifies workers to clarify payment rules, including what to pay, what to deduct and when. Most employees are direct hires, meaning they work for you — not themselves — and their work is under your supervision. Employees are the most common of the two basic types of workers, W-2 and 1099, also known as direct hire and contract employees.
- Direct hire employees: Receive a W-2 at year end and are paid net wages, meaning they work for you
- Contract employees: Receive a 1099-Misc at year end and are typically paid gross wages; they are self-employed with you as their client
Misclassifying workers is a costly mistake that some new business owners make when they decide how to set up payroll. The government provides strict rules for what kind of workers and what kind of work can be considered “contract” work. For example, contract workers must have control over their work, in terms of hours worked and work methods. Employees typically don’t have that flexibility as they must work prescribed hours and in a manner dictated by their supervisor, job description or employee handbook.
Set Up Payroll Processing for W-2 Employees
Direct hire employees work for your business. The government requires that you pay them their earnings (gross wages) after you have taken out taxes and required federal, state and local deductions, such as Social Security and unemployment insurance.
The resulting payment is referred to as net pay and must be paid each pay period. In turn, you pay the employee’s taxes to the government for them and document those payments on a year-end W-2 tax document. In order to set up payroll for W-2 employees, you will need to gather specific new hire forms.
Set Up Payroll Processing for 1099 Contractors
Contract employees perform work for you, but they are self-employed and receive a 1099 at year end instead of a W-2. They pay their own taxes and deductions. When you hire a contract employee, you calculate their pay and provide them gross wages. It’s up to them to pay the taxes they owe at year-end. When they are paid can be determined based on your agreement.
For example, you may pay a contractor for a project or a milestone, rather than for hours worked. In addition, you may not need to pay a contractor until the job is complete. If they make more than $600 in a given year, you must report their annual earnings on a year-end 1099-MISC tax form.
3. Determine How Your Employees Are to Be Paid
Employees can be paid in multiple ways. Federal and state laws dictate the lowest pay rates allowed, referred to as minimum wage. However, there’s no upper limit on what you can pay. Most employers research pay rates by job types on job salary sites like Indeed or Glassdoor.
New business owners often start out paying employees hourly, but there are actually four common types of pay that businesses can use to compensate employees: paying the employee an hourly wage, paying the employee an annual salary, paying the employee for work they do by the project (such as contract employees) or piece or paying employees a commission.
Employees and contractors are paid hourly when the work schedule or work product varies. For example, if one week Sal works 12 hours and another week Sal works 37 hours, then it’s best to pay Sal hourly. Hourly workers are typically considered non-exempt, which is a human resources and legal term that means they must be paid for overtime; they are not “exempt” from overtime.
Overtime is usually paid on more than 40 hours worked in a week at 1.5 times the employee’s regular pay rate. However, some states, like California, require overtime to be calculated on hours worked per day. For example, in California, any hours more than eight that are worked in one 24-hour period must be paid using the overtime pay rate.
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Employees are paid a salary when their pay doesn’t change from week to week. They’re paid based on an annual amount, regardless of how many hours they work in a given week or pay period. Often, the employer will suggest that their pay is based on a stated number of hours each week, but there’s typically no hour-by-hour tracking of that time worked for payroll purposes.
For example, a part-time employee can be paid a salary for 15 or 20 hours per week. A full-time employee can receive a salary for 30, 32, 35 or 40 hours per week, as examples. The hours are up to the employer and employee at the time of hire and based on what’s stated in the employee’s offer letter or employee handbook.
The difference between an exempt employee paid a salary and one paid a non-exempt hourly rate is that employees paid a salary can work more hours if they want, but they will not be paid overtime for those extra hours, such as for checking email or returning phone calls at night. Salaried employees are typically be considered “exempt” from overtime, unless otherwise specified in their employment agreement.
By the Piece
While less common, some employees are paid by the piece. For example, an employee fixing auto windshield glass may be paid based on the number of installs per day or a manufacturing employee may be paid based on the number of units produced. Paying by piece can be risky as the Fair Labor Standards Act (FLSA) requires that resulting earnings received do not fall below minimum wage. For example, if an employee doing piecework sews 12 garments and receives $10 per garment (piece) after working a 40-hour week, the resulting wages ($3 per hour) would not meet minimum wage requirements.
Commission-only or salary plus commission is a common type of pay for businesses that employ sales staff. For example, a radio advertising executive might be compensated based on a percentage of radio advertisements he or she has sold in a given month. An appliance salesperson might be paid a small base salary for working in the store with a weekly commission based on a percentage of each sale.
A Note About Payment Types & Minimum Wage
Regardless of the payment type, the government requires that minimum wage rates be upheld so that employees don’t fall below minimum wage equivalents for the given number of hours worked.
Federal minimum wage as of July 2009 has remained at $7.25 per hour. However, many states have adopted higher minimum wage rates to provide a living wage in their location. At the time of publication, states like New York, Colorado and Arizona require minimum wages of $10 or more per hour. Some cities like New York City and Seattle have their own minimum wage — some as high as $15 per hour.
It’s worth noting that some states provide lower minimum wages for smaller employers in terms of revenue or number of employees. Other states provide different pay rates depending on whether the employer offers health benefits, is age 18 or younger, is in a specific occupation (tipped employees) or is in training. Some cities, have higher minimum wage rates than the state they’re in does.
Therefore, it’s important to verify your state and local payroll laws or use a payroll provider like Gusto that manages state and local wage and hour compliance for you.
4. Determine When to Pay Employees — Your Payroll Cycle
The U.S. Department of Labor (DOL) and the FLSA provide federal requirements on the frequency of paying employees. However, state laws often determine payroll rules within the payroll process. In general, employees must be paid on a regular pay cycle or pay date — typically within seven to 30 days of when they worked and earned their pay.
The most common payroll cycles are weekly (52 payroll cycles per year) or every other week (26 payroll cycles). However, some employers prefer to provide payroll twice monthly (24 payroll cycles per year) and others, mostly government agencies and larger firms, pay monthly.
Below are the four most common payroll cycles:
Paying employees each week is best for businesses with part-time and entry-level workers, such as hotels, restaurants and retailers. It helps ensure that hourly workers living paycheck-to-paycheck can receive their earnings and pay bills, such as gas and rent. If you pay employees weekly, you’ll run 52 weekly payrolls per year.
Calculating payroll weekly makes it easy to determine whether an employee worked overtime (more than 40 hours in one week) as the pay period covers exactly 168 hours every week. However, some payroll providers charge per payroll run, so payroll costs can add up if you pay employees weekly.
Paying employees every other week is the most common method. It reduces the number of payroll runs the business has to process by half (26 payroll cycles per year instead of 52), but it requires employees to budget their expenses.
Biweekly payroll is most commonly used in businesses that hire professional and administrative staff that are paid a salary and/or are exempt from overtime. If overtime calculations are needed, they must be done based on a weekly start and end date to ensure overtime hours are calculated correctly.
A bimonthly — or semimonthly — payroll is one that is run only 24 times a year instead of 26 times a year like biweekly; employees are paid twice per month, most commonly on the first and 16th of each month. Some employers pay based on the number of work hours each pay period. Others take the employee’s annual salary, divide it by 24 and pay that same amount each pay period regardless of the actual hours worked. This helps to stabilize their payroll expenses by keeping them the same each pay period.
Similar to an every-other-week payroll, bimonthly is often used by organizations that hire professional staff who are paid a salary and have an employment status of exempt. Paying employees bimonthly makes non-exempt overtime calculations more difficult as overtime would have to be determined based on hours worked per work week start and end times.
A monthly payroll is easiest for businesses and agencies that have an all-salaried exempt staff. However, it’s not preferred by employees as they may go 28 to 31 days between paychecks. Some states don’t allow business employers to pay monthly and others allow it only for executives. However, monthly payroll is the most common form of payroll used to pay government workers and educational staff, such as college professors.
A Note About Payroll Cycles & Final Wages
Employees have a right to receive their wages in a timely manner. At the federal level that means they must be paid no later than the end of the next pay period. However, state rules are often more strict.
How quickly final wages need to be paid may depend on whether the employee quit (voluntary termination) or was fired (involuntary termination.) Some states require an employee who is fired to be paid immediately, regardless of what cycle payroll you run. One attorney weighs in:
“The final paycheck does not have to be handed to the employee there and then. Employers have a reasonable time to mail the terminated employee the final paycheck. The amount should be the net value accrued by the employee; thus, what the employer owes minus what the employee may owe. The full amount of what the employer is owed must include accrued vacation time and earned bonuses. An employee may owe the employer some vacation time back that they took in preparation for work later in the year.”
– Brad Biren, Senior Associate, Johnston/Martineau
5. Determine If You’re Going to Provide Benefits
If you don’t plan to offer employee benefits, like health insurance or a 401(k), you can skip this step. However, offering benefits is a terrific way to attract and retain employees to your company.
“The most important thing in offering employee benefits is to know what the employees really want. They may not need health care if their spouse has it in their job. Some want more time off if they are parents. Others want more money if they offer valuable suggestions or improve productivity. Ask your employees. They will tell you what’s important to them.”
– Dr. Gayle Carson, Chief S.OB., Spunky Old Broad LLC
You, the business owner, ultimately get to decide — based on your company’s size — what benefits to offer, You also can choose whether to provide a paper check or an alternate payment method like direct deposit.
6. Determine How You Are Going to Run Your Payroll
Knowing how you’re going to run payroll is often based on how you answered the questions posed in each previous step. For example, are you going to outsource payroll processing to a third party? Run payroll using software? Find a co-employer to manage HR and payroll for you or do it yourself on a spreadsheet?
Here are some examples of different ways for how to set up and run payroll:
If you have one employee, and that employee works part-time a few days a year, such as to help you with inventory, then you may be able to process payroll yourself using nothing more than a payroll calculator that you can find online. You can then track your payroll within your accounting system by entering payroll data manually.
However, if you employ workers that work hourly and are likely to work overtime, you’ll want to make sure you have payroll software that is labor-law compliant, able to calculate overtime correctly for your state and able to process payroll in all states that you do business in. Labor law and payroll fines are no joke. Most free payroll software can do the basics for you.
In addition, if some of your workers are contractors and others are employees, make sure your payroll software can process both. For example, free payroll software can often process employee payroll, but not contractor payments. The best payroll software providers are able to do both.
Looking for a quick and easy way to set up your payroll? Gusto is a small business payroll provider that makes it easy to manage payroll taxes, make direct deposit payments, and stay compliant with federal and state employment laws. Start a free 30-day trial.
Payroll services are a pricier option for businesses that want more than just payroll. For instance, they may want to add employee benefits, such as health insurance and 401(k) plans. Outsourced payroll services can usually provide these, in addition to providing labor-law compliant payroll and helping you avoid payroll audits and fines.
Professional Service Organization
Professional service organizations (PEOs) are co-employers that manage all the HR, benefits and payroll for your small business. They hire your employees on to their payroll and lease them back to you.
This is often the easiest way for a small business to manage their employee payroll expenses, while also providing the employee with the experience of a larger business — with full benefits and other perks like EAP programs, paid holidays and vacations. PEOs end up being the most expensive way to manage your payroll but may be worth it from an employee engagement and retention point of view.
A Note on Finding a Payroll Provider, Service or Software
The easiest way to find a payroll provider that fits your small business needs is to read online payroll reviews like the ones we provide. These include comparative costs and services so you can match your payroll needs to the service providers and find the best fit.
7. Set Up Your Payroll Account
Before you sign up for payroll software to write your first paycheck, you’ll want to set up a bank account specifically for payroll. You’re probably aware that your business funds should be kept separate from your personal funds. The same is true if you want to set up an easy-to-audit payroll process.
To set up your payroll account, go to your business bank and request a separate checking account that you will use solely for payroll. Even if you’re processing payroll manually, you’ll want to transfer funds each payroll cycle from your business bank account to your payroll account, before handing employees their checks. That way, you can clearly delineate your labor costs from other business expenses and keep track of any uncashed checks.
If you want to provide direct deposit or payroll cards as payment methods for your employees, you’ll tie your payroll account to employee bank accounts so that those payments can be managed electronically through your payroll system. You’ll also want to determine which accounts to use to pay state and federal taxes. When you finish setting up your process, you’ll be ready to run payroll.
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8. Manage Your Payroll Files
Setting up your payroll process requires you to figure out, in advance, where all your payroll-related documents are going to be stored and how long they’ll be retained. Online payroll software like Gusto lets you sign and store documents electronically. This is important because government agencies like the IRS and DOL have a right to audit your employee payroll documentation. Don’t be caught off-guard without a filing system.
Who Should Set Up & Run Payroll: HR or Accounting
Many small businesses haven’t the financial resources to segregate duties like HR/payroll and payroll accounting. It’s often done by the same person, such as the business owner, his or her spouse, a bookkeeper or office worker. However, this depends on how large your payroll is and what other duties need to be done. Considerations are noted below for having payroll managed by HR vs. accounting.
Payroll Set Up & Managed by HR
Having a certified HR manager set up and manage payroll helps prevent labor law violations because HR staff are typically aware of employment law, including overtime regulations and sick time rules. Therefore, HR experts are in a good position to set up and manage payroll, even if just to approve employee timesheets and oversee the leave balances on payroll runs done by a third-party payroll software or provider.
On the other hand, it’s best to have payroll, like any financial function, managed by users with distinct duties to minimize the potential for fraud. For example, an employee may input time into a timekeeping system like Homebase, and a manager might approve that time. Then, HR would then push the data through to payroll and run the paychecks.
Payroll Set Up & Managed by Accounting
Whereas HR is more likely to notice and be able to correct labor law issues, having accounting set up payroll is often the more common option in a small business because both accounting and payroll revolve around payments, including debits and credits. They also both have tax implications. Therefore, it’s more likely your bookkeeper will be able to advise you how best to save tax dollars through various payroll options, such as paying an employee wage vs. paying a contractor service payment.
However, if you go this route, make sure your bookkeeper or accountant is aware of federal labor laws and payroll laws in your state. For example, California requires overtime after eight hours in a day and also requires paid sick leave. Making mistakes in these areas can result in expensive fines.
Frequently Asked Questions (FAQs) About Setting Up a Payroll Process
Here are some questions newer business owners may have about setting up a payroll process for their employees.
Can’t I print paychecks myself?
Paycheck paper is different than the regular paper you feed into your printer. However, if you get the right paper and software or use a paycheck calculator, you can print paychecks yourself and avoid the cost of having a third-party vendor print and mail the paychecks and stubs for you.
Can’t I pay employees cash and have them pay their own taxes?
Actually, you can’t. At least not legally. As an employer, you’re required to abide by the DOL and FLSA, along with other labor laws that require you to pay employees a net pay after you, as the business owner, withhold taxes and other deductions. Then, it’s up to you to pay the taxes to the IRS.
Some unscrupulous business owners may try to get away with paying employees under the table, but the potential risks and fines are high. You could pay contractors for work, but if they’re truly working as employees and not-self-employed, then you run the risk of labor law violations due to employee misclassification. Again, costly if you’re caught. Flavia Berys, an attorney in California, cautions business owners about the risks of paying employees under the table.
“Paying employees improperly can be a huge liability for a business. It’s something that can devastate a small company or even cause it to close its doors if the business makes it a regular practice. The liability arises not only from the tax agencies, both state and federal, but also from lawsuits initiated by the employees themselves. Another high-risk activity is paying workers as independent contractors when they are actually employees under law.”
– Flavia Berys, Attorney, Berys Law
How can I set up payroll so that it goes to employee’s checking account or to a pay card for my employees who don’t have a bank account?
Although you could work with your bank to set up direct deposit for each employee, it is much easier to work with a payroll provider who does direct deposit or can set up pay card options for your employees without bank accounts as part of the employee data set up.
For example, with Gusto, setting up direct deposit is as easy as asking each employee to update their payroll data with a bank account and routing number in their system.
As a small business with less than 50 employees, I don’t have to provide health insurance, but what if I want to? How do I do that?
Many small businesses want to provide health insurance for themselves and their employees. This is where working with a third party payroll provider is best. Some, like Gusto, offer benefits and can take the stress out of finding a benefits provider, managing the enrollment process, processing deductions and handling employee changes.
Whether you choose to work with an HR provider that offers benefits or a payroll service, there are many payroll outsourcing options that will help even the smallest of employers obtain health insurance.
Setting up payroll requires you to go through a thought process and make decisions and choices — from the kinds of employees to hire, to the payroll process and pay cycles you want to use.
You can’t go rogue and pay people cash under the table. There are labor laws and tax rules at play. We hope the eight steps we’ve provided will help you navigate your payroll set up correctly the first time. That way, employees can be paid correctly, and you don’t risk audits and fines.
Don’t forget to check out Gusto when you’re ready to set up your payroll process. It allows employees to self-onboard, automatically calculates payroll taxes, and integrates with free timekeeping software Homebase to ensure labor law compliance for overtime calculations. Try it free for 30 days.