Payroll fraud occurs when a worker cheats the system to get a higher paycheck. A study by the Association of Certified Fraud Examiners showed that payroll fraud cases cost its victims a median of $63,000 a case. Small businesses are more likely to be at risk than larger ones because they place a higher level of trust in their employees and often have fewer safeguards in place.
1. Buddy Punching
What it is: Also called “buddy clocking,” this is when a worker gets someone else to clock in and out for them, whether clocking them in early, clocking them out late, or clocking them when they aren’t even there.
How to prevent it: The easiest way to prevent buddy clocking is with time tracking software that includes authentication such as a password, a fingerprint, an ID badge, or facial recognition. Check out our reviews of the best time tracking software to find one with these features.
2. Pay Rate Alterations
What it is: Just like it sounds, someone alters the pay rate of an employee in the payroll system itself. This usually requires someone who works with the payroll system, although it could be on behalf of another employee or someone hacking into the system. Smart fraudsters will alter the rate just before payday and change it back after or do it intermittently to reduce the chance of being caught.
How to prevent it: Start by ensuring that your payroll software is password protected and that you limit access to the features each employee needs. Next, be sure to match pay rate authorization documents to the payroll register.
3. Padding Work Hours
What it is: This is one of the most common types of payroll fraud cases and involves padding time sheets, usually in small increments.
How to prevent it: First, have a clear policy about clocking in and out so that employees understand the rules. The easiest next step is to sync your payroll software with your time tracking software to feed the data automatically. Some software can be set up with predefined rules that will not let employees clock in or outside a specific time window. Finally, enforcing manual approval of overtime and arranging payroll audits can catch problems.
4. Outstanding Advances/Not Repaying Overpayments
What it is: In these cases, an employee asks for an advance or accidentally gets overpaid and does not pay it back. Sometimes, the accounting department may classify this as “expenses,” and it goes unnoticed.
How to prevent it: Some of this may be caused by confusion of the employee—a common search engine question is, “Do I have to pay back an overpayment of wages?” If giving an advance or discovering an overpayment, be sure the employee understands this must be repaid. Spell it out in the company handbook as well.
To prevent purposeful fraud, ensure your accounting practices are tight and that you have oversight such as periodic payroll audits. Many payroll software and PEOs will allow advances and automatically deduct them from the next paycheck.
If you are experiencing payroll fraud problems and want to upgrade your payroll system, a solid payroll software like Gusto makes sense. You can assign an administrator to manage the company account and adjust permissions for each employee so that they can access only the parts that they need to do their job. It also has some stellar reporting options you can use periodically to check for huge swings in pay. Sign up for a free trial.
5. Ghost Employees
What it is: Someone who is on the payroll but doesn’t exist in the company. This occurs when someone with access to the payroll software either creates a fake employee in the records or doesn’t delete a terminated employee and then alters the records so that the direct deposit or check goes to them.
How to prevent it: Periodic audits against employee lists can spot this—check not only for phantom names but also fake Social Security numbers and duplicate addresses. Also, look for non-contractor paychecks that have no deductions attached. (Usually, the perpetrator wants to get the maximum amount.) Finally, be sure your offboarding procedures include purging the employee from the payroll system.
6. Paycheck Diversion
What it is: This fraud happens when an employee takes and cashes the check of another employee.
How to prevent it: If you can, pay employees by direct deposit or pay card. If you pay via paycheck, keep strict control over them by requiring employees to be positively identified before getting their check (with ID if needed), and then lock up any unclaimed checks.
7. Expense Reimbursement Fraud
What it is: When a worker gets paid back for expenses that didn’t happen, were personal expenses, or cost less than the employee reported—and they pocketed the difference.
How to prevent it: First, have clear spending policies such as what expenses are claimable and what the limits are. Next, have security checks in place like micro checks to look at receipts to ensure they amount to the pre-approved charges, and macro checks for periodic reviews for reimbursements for any individual or departments that are oddly above average.
If you have payroll software, ask about tools that can automate this tedious process. Some will allow you to upload documentation of the expense so that you have backup handy when you decide to do a thorough review.
8. Fake Commissions
What it is: When a worker inflates their sales report or has someone in payroll overpay their commission.
How to prevent it: In addition to clear policies and double-checking percentages and pay vs sales, look for suspicious activity such as an increase in commissions when sales are dropping. Also, periodically check top performers or those who make a sudden rise in commissions.
Reporting Payroll Fraud
Businesses can respond to fraud by reporting it as a criminal action, suing the perpetrator, or doing nothing. Many organizations will not prosecute a fraudster because of fear of bad publicity or cost, and some just decide that internal discipline (such as firing or docking future paychecks) is sufficient. Criminal proceedings were almost three times more likely than civil litigation to find in favor of the business vs the employee.
Take Careful Notes
If you suspect fraud (or have discovered it and want to report it), start by keeping or gathering your evidence, as successful prosecution depends on accurate notes. Record dates and times, activities, and locations as applicable, and note the amount of money involved. If you can download the reports from the payroll software, store them in a separate file. Take screenshots with timestamps in case the evidence is tampered with later.
Report to the Authorities
You have two options.
- Reporting in-house: If you are not the owner or overall boss in the company, reporting in-house may be tricky. You may not be sure who is involved or concerned about retribution. So, choose a manager you trust (in the accounting or HR department or the fraudster’s chain of management), and do not be afraid to skip levels of management if you have doubts. Many businesses offer anonymous tip lines; in fact, most tips come from anonymous sources. Just be sure to have your evidence available.
- Reporting to outside authorities: If you are the business owner or are an employee concerned that reporting within your company may put you in danger or threat of being fired, your best bet is to contact the FBI, which specializes in this kind of fraud. The second choice is the state attorney general. Some states have hotlines dedicated to payroll fraud reporting.
Do small businesses need to be concerned about payroll fraud?
Absolutely! While it seems logical that large businesses would have more to be concerned about fraud, a 2017 study by ACFE found that small businesses lose twice as much to fraud as large corporations do. Businesses with under 100 employees are also more than twice as likely to experience payroll fraud.
What are the top ways to detect fraud?
According to the aforementioned study, tips account for 40% of occupational fraud detection, followed by internal audit (15%), then management review (13%).
How can I prevent fraud?
Start by promoting a positive and honest company culture. Some other ideas include:
- Following up on applicants who were fired from their past jobs
- Clearing payroll policies in the company handbook
- Training payroll personnel and managers on payroll management and the software you use
- Conducting third-party approval of time sheets by an executive or someone outside payroll
- Keeping good payroll records
- Applying user permissions so that staff members have access only to the parts of your payroll program they need
- Using a payroll service rather than DIY
What are some red flags for payroll fraud?
Oddly, background checks generally don’t always identify potential fraudsters, noted the ACFE study. Most perpetrators are first-time—or first-timers, as far as the new employer knows. Many companies do not choose to prosecute fraudsters and simply let them go. Most fraudsters displayed at least one behavioral red flag, such as:
- Living beyond their means
- Experiencing financial difficulties
- Complaining about inadequate pay
- Having family or personal problems
- Displaying a wheeler-dealer attitude
- Exhibiting control issues, unwilling to share duties
- Demonstrating irritability, suspiciousness, defensiveness
- Working all the time (never taking PTO)—An employee committing fraud (especially in the payroll department) may be afraid to take time off for fear of being caught.
What industries are most likely to be victims of payroll fraud?
According to the ACFE study, the top five industries are:
- Religious, charitable, or social services (22%)
- Healthcare (17%)
- Professional services (15%)
- Construction (14%)
- Technology (8%)
What departments are most likely to be part of payroll fraud?
The top five departments per the ACFE study are:
- Accounting (14%)
- Administrative support (13%)
- Executive/Upper management (12%)
- Finance (6%)
- Operations (5%)
To learn more tips and tricks on the ins and outs of payroll, check out our article on how to get the best payroll training.
The longer payroll fraud happens, the more costly it is for the business—and most often, businesses do not get back their losses. By understanding the types of payroll fraud and applying procedures to prevent them, you can reduce your chances of becoming a victim. Some steps are as simple as clear pay and clock-in guidelines, and others may already be available to you. Also, investing in a payroll software that has anti-fraud tools will be beneficial.