What Is Payroll?

Payroll is the compensation a business must pay to its employees for a set period or on a given date. It is usually managed by the accounting or human resources department of a company. Small-business payrolls may be handled directly by the owner or an associate.

Increasingly, payroll is outsourced to specialized firms that handle paycheck processing, employee benefits, insurance, and accounting tasks, such as tax withholding. Many payroll fintech firms, such as Atomic, Bitwage, Finch, Pinwheel, and Wagestream, are leveraging technology to simplify payroll processes. These solutions pay employees with greater convenience and speed and provide digital payroll-related documents with innovative technology-enabled services required by the gig and outsourcing economy.

Payroll can also refer to the list of a company's employees and the amount of compensation due to each of them. Payroll is a major expense for most businesses and is almost always deductible, meaning the expense can be deducted from gross income lowering the company's taxable income. Payroll can differ from one pay period to another because of overtime, sick pay, and other variables.

Key Takeaways

  • Payroll is the compensation a business must pay to its employees for a set period and on a given date.
  • The payroll process can include tracking hours worked for employees, calculating pay, and distributing payments via direct deposit or check.
  • However, companies must also perform accounting, record-keeping, and set aside funds for Medicare, Social Security, and unemployment taxes.
  • Companies can use professional services and outsource their payroll or use cloud-based software if they do not want to do it themselves.
  • Calculating payroll involves many components and can be complex.

Understanding Payroll

Payroll is the process of paying a company's employees, which includes tracking hours worked, calculating employees' pay, and distributing payments via direct deposit to employee bank accounts or by check. However, companies must also perform accounting functions to record payroll, taxes withheld, bonuses, overtime pay, sick time, and vacation pay. Companies must put aside and record the amount to be paid to the government for Medicare, Social Security, and unemployment taxes.

Many companies use software solutions to manage their payroll. The employee inputs their hours through an API, and their pay is processed and deposited into their bank accounts.

Many medium- and large-size companies outsource payroll services to streamline the process. Employers track the number of hours each employee works and relay this information to the payroll service. On payday, the payroll service calculates the gross amount the employee is owed based on the number of hours or weeks worked during the pay period and the pay rate. The service deducts taxes and other withholdings from earnings and then pays the employees.

Special Considerations

Employers with gross sales of $500,000 or more per year are subject to the requirements of the Fair Labor Standards Act (FLSA) passed in 1938. This is a U.S. law that protects workers from certain unfair pay practices. The FLSA sets out various labor regulations, including minimum wages, requirements for overtime pay, and limitations on child labor. For example, FLSA rules specify when workers are considered on the clock and when they should be paid overtime.

The law requires overtime—hours worked in excess of 40 hours per week—to be paid at one-and-a-half times the regular hourly rate. Some employees are exempt from the FLSA, and the Act does not apply to independent contractors or volunteers because they are not considered employees.

Some hourly workers are not covered by the FLSA but are subject to other regulations. For example, railroad workers are governed by the Railway Labor Act, and truck drivers fall under the purview of the Motor Carriers Act.

The FLSA also sets out how to treat jobs that are primarily compensated by tipping. In the case of tipped service workers, the employer must pay the minimum wage to the employee unless they regularly receive more than $30 per month from gratuities.

Advantages and Disadvantages of Using Professional Payroll Services

One major benefit of payroll services is their ability to produce a variety of reports that simplify accounting procedures and help companies ensure they are in compliance with legal and tax filing requirements. The payroll service may also maintain a record of how much vacation or personal time employees have used.

With respect to disadvantages, when companies outsource their payroll system, they must rely on individuals outside the business for accurate accounting. In the event of an error, the company's on-site personnel must deal with upset employees. Companies might also face tax penalties for errors made by the payroll service.

Another disadvantage are that payroll services are more expensive than running payroll in-house. The services may charge a set monthly fee or offer different payment structures for varying tiers of service. Because of their cost, payroll services may not be the best option for small companies with tight operating budgets.

As a business grows, its accounting needs become more complex. Larger firms may need to invest in a custom enterprise resource planning  (ERP) system for its accounting and payroll functions.

Pros of Professional Payroll Services
  • Access to a variety of reports

    Simplified accounting and tax compliance

  • Record of vacation time and personal time taken by employees

Cons of Professional Payroll Services
  • Individuals outside the business are privy to financial and tax information.

    Internal staff must still help employees with payroll problems.

  • The company may face tax penalties due to errors by the payroll service.

  • Payroll services can be expensive, which is a concern for small businesses.

Payroll Software Programs

In lieu of using specialized payroll services, some companies opt to rely on payroll software programs. Once the company purchases the software, there are no additional monthly fees. Software programs usually include printable tax forms and withholding tables.

In addition to financial savings, internal payroll systems help companies keep confidential financial information private. However, software programs can be time-consuming, which can pose a problem for small companies with few staff.

Small business owners benefit from accounting software because it helps them track accounts receivable and accounts payable, gauge their profitability, and prepare for tax season. A small business is one that can use out-of-the-box software without requiring extensive customizations. As a business grows, its accounting needs become more complex, and a custom enterprise resource planning (ERP) system is often needed.

There are many different types of cloud-based accounting software available for small businesses. The type of industry and number of employees are two factors that will dictate which accounting software is appropriate. For example, a freelancer would not need the same features in accounting software as a restaurant owner.

Investopedia conducted an overview of accounting software for small businesses and evaluated their cost, ease of use, features, integrations, and scalability. QuickBooks Online was considered the best overall software, while Xero was considered the best for micro-business owners. FreshBooks was best for service-based businesses, and QuickBooks Self-Employed was best for part-time freelancers, but Wave was the best free software.

What Is a Payroll Tax Cut?

Payroll taxes include Social Security, which takes out 6.2% of your income up to $132,900.  Payroll taxes also pay for Medicare, which takes out 1.45% of your income. Employers also pay payroll taxes. They pay 6.2% of your income, so the government gets 12.4% of your total income, and your employer pays 1.45% of your income toward Medicare.

A payroll tax cut would mean that less Social Security and Medicare taxes are withheld and taken out of paychecks. The idea is that workers and businesses would take home a little extra with each paycheck and that would encourage them to spend more and stimulate the economy. 

What Is a Payroll Tax Holiday?

A payroll tax holiday is a deferral of payroll tax collection until a later date, at which point those taxes would become due. A payroll tax deferral is intended to provide some temporary financial relief to workers by temporarily boosting their take-home pay.

How to Calculate Payroll Taxes?

How you calculate payroll taxes will depend on your business and your local laws. However, here are some general guidelines provided by QuickBooks. The first step is to calculate your employees' gross pay.

1. Calculate your employees' gross pay

You can determine an employee’s gross pay using their pay rate and your scheduled pay periods. Most businesses will pay employees weekly, every two weeks, or monthly. To calculate an hourly employee’s gross pay, multiply their hours worked in the pay period by their hourly pay rate. The formula is as follows:

Hourly rate x total hours worked in the pay period = gross pay

To calculate a salaried employee’s gross pay, divide their annual salary by the number of pay periods in the year. The formula is as follows:

Yearly salary / number of pay periods in year = gross pay

For example. An employee makes $50,000 a year. Their company pays employees every two weeks for a total of 26 pay periods. Therefore, the employee’s gross pay is $1,923.08.

2. Take out pre-tax deductions

After determining gross pay, you’ll need to factor out deductions. These are tax deductions, but other pre-tax deductions may also apply. Pre-tax deductions include:

  • 401(k) and some retirement plans
  • Health insurance plans
  • Health Savings Account (HSA) or Flexible Spending Account (FSA) contributions
  • Some life insurance plans

3. Deduct taxes (FICA, unemployment, and income taxes)

Once you have taken out pre-tax deductions, the remaining pay is taxed. The FICA tax rate is 7.65%—1.45% for Medicare and 6.2% for Social Security taxes. Other tax rates will be determined by Federal, state, or local laws and your employee’s W-4.

Calculate federal income taxes using IRS tax tables. Most often, you will pay federal taxes when you pay Social Security and Medicare taxes. Report all payments on IRS Form 941.

Deduct the 7.65% FICA tax from the employee’s gross pay. You, as the employer, must match each employee’s contribution. The business submits both the employee’s and the company’s contributions to Social Security and Medicare.

For example, an employee earns $1,923 in gross pay for the latest pay period. To calculate the employee’s Social Security tax contribution, multiply $1,923 by .062 to get $119.26. To calculate the employee’s Medicare tax contribution, multiply $1,923 by .0145 to get $27.88. In total, the employee’s FICA tax contribution is $147.14 for the pay period, which the employer must match. In this case, the employer must pay $294.28 to the IRS. Half is a direct expense to the company, and the other half is withheld from the employee’s paycheck.

Employers don’t match income tax deductions, but they pay federal unemployment taxes. The IRS's Income Withholding Assistant will help you determine how much federal income taxes your employees owe.

4. Any voluntary deductions must be taken from the remaining wages.

These may include:

After all taxes and deductions, the remaining amount is how much the employee takes home on payday.

Bottom Line

Processing payroll is a complex and time-consuming endeavor that requires adherence to strict federal and state rules and regulations. It requires extensive record-keeping and attention to detail. Small businesses often handle their own payroll using cloud-based software. Other companies choose to outsource their payroll functions or to invest in an integrated ERP system that manages the overall accounting and payroll.