How Payroll Works: The Ultimate Guide

Ever wonder what kind of process leads to employees receiving salaries - timely, accurately, and compliantly? The payroll process has always been a bit complex.

However, since the introduction of remote work, overseas employees, international payments, and digital wallets, even the most senior human resources employees have been struggling.

This guide will help both small business owners and senior executives who’ve been in the business for decades. The trends are changing, the laws are too, and your responsibility is to keep up.

What is payroll?

Let's start with the fundamentals. Payroll is essential to any business since it allows you to compensate all of your employees adequately.

An employer is responsible not only for distributing earnings to their employees but also for withholding taxes, making Medicare tax, and other employee benefits.

Employers can decide if they want to pay their employees semi-monthly or follow a different schedule and if their workers are paid by the hour or have a fixed salary.

All of this information is part of the payroll process, usually done through a payroll system that allows the employer to operate with as few mistakes as possible. Let’s break down the payroll process into steps. There are key payroll best practices to implement, we’ve laid them out for you here.

If you have employees all over the globe, check out our global hiring guide and guide to international payroll processing to help you understand the process better.

Three stages of the payroll process

We can divide the payroll process into three stages: pre-payroll, payroll, and post-payroll activities.

Pre-payroll

Pre-payroll breaks down activities to complete before the actual payroll takes place. One of the crucial steps that many skip is policy creation. It is a company’s responsibility to create a detailed policy—for payments, pay periods, benefits, absences, etc.

The more you define, the less you leave to be up for debate. Ensure your management has approved the payroll policy and that the language is clear enough for everyone to understand. Payroll processing is a lengthy process, so is much easier when everyone is on the same page.

Another essential step during payroll preparations is data gathering. To someone inexperienced, handling payroll might seem like a purely analytical job, where direct contact with people is minimized. However, this couldn't be further from the truth.

To gather all the employee information, payroll employees need to interact with every department and, at times, with every employee. And not only do they have to gather the data, but they also need to ensure that it is validated every month before payroll payments are made.

Switching to an automated payroll solution can reduce the time spent each month.

Payroll processing

Once all the preparations are finalized, it's time for the actual payroll process.

All of the data gets entered into the payroll system, which generates net pay. This is, of course, done after all the deductions for taxes and benefits have been made.

Since no system is perfect, we suggest checking for errors before any employees' wages have actually been deposited.

Post payroll

After employees have received their salaries, the company has responsibilities toward the state. Statutory compliance is a crucial part of payroll distributions.

The payroll administrator is responsible for sending the appropriate amount to all the government agencies, such as TDS (Tax Deduction at Source), EPF (Employment Provident Fund), ESI (Employee State Insurance), etc.

If you are dealing with both full-time workers and independent contractors, some payment processing steps are different. Independent contractor payroll can entail more payment options but less tax filing. And you don't have to worry about paystubs and time cards.

Paying independent contractors is different. We’ve put together a number of resources to help:

• Understand the intricacies of 1099 independent contractor payroll
• Learn the difference between an independent contractor and an employee
• Discover how to hire independent contractors worldwide legally

What is a payroll system?

Regardless of the number of workers, running payroll is a primary function to distribute salaries and plays an essential role in compliance and taxation, allowing the company to operate risk-free.

The way payroll is processed can have serious repercussions. Firstly, companies are obligated to report their payroll tax withholdings to the IRS and local, state, and federal governments.

Failure to do so can result in hefty fines and potential misclassification of employees. In addition, deducting income taxes, social security, and Medicare payments is necessary for every payroll payment. If you fail to account for employment tax deductions, you expose your business to severe risks and hefty fines.

Secondly, payroll processes need to comply with several labor laws and account for minimum wage, overtime payments, hiring and termination procedures, as well as vacation and sick leaves.

In addition to all of this, payroll impacts employees' morale. If you are distributing salaries timely, consistently, and as fairly as you can, this will contribute positively to a company's culture.

The financial compensation that you offer your employees and the bonuses and benefits are all processed through payroll. So, it's no surprise that the way payroll is processed impacts a company's reputation in the market. Learn about the types of compensation and what to include in your compensation plan here.

A payroll system must meet obligations towards employees and the state, deadlines and newest laws, and much more. It needs to organize sometimes chaotic requirements and be functional and easy to use.

When choosing the appropriate payroll system, ensure to future proof it, so it translates to all future members of the payroll department.

How does the payroll system work?

Although each company has its own system of running payroll, how payroll works is universal. There are several necessary steps to ensure compliant, timely processing.

Organizing paperwork

Getting your paperwork in order is something you essentially only have to do once and then update as new employees join your ranks. If you are not a new business, you probably have all of this already, but it wouldn't hurt to double-check.

Your existing payroll structure needs to have the following information:

• Employer's EIN number
• Employees' tax identification number
• All the accompanying financial information on appropriate tax forms

Setting up a payroll schedule

You need to consider several factors before you decide your payroll schedule.

One is your current cash flow. Employee's paychecks will indeed comprise a significant part of your budget, so you need to make sure that you won't have any issues distributing them.

If the end of the month is too tricky for you, you can choose to distribute salaries biweekly. Some states have laws that determine the frequency of payments.

Here’s a guide to help you with pay stubs.

Calculating gross pay

Since the total amount of earnings can vary based on many different factors, you will need to calculate gross pay for each employee individually.

Of course, for salaried employees, the calculation will be the same for every payment. However, you will need to adjust the earnings for hourly workers based on time worked, vacations, sick leaves, etc.

This means you will have to keep track of employee time worked, absences, and overtime, preferably in real-time. Ensure your employees who are working overtime are non-exempt, so you will be able to comply with all the guidelines issued by the Department of Labor.

Making deductions

Making deductions is undoubtedly the most complicated step in every payroll process. Once you calculate the gross pay, you have obligations towards the state - to deduct income tax, social security, healthcare, and many others.

You also need to be informed about the local tax laws and different requirements of every state where your business is located.

The ones we've mentioned are obligatory, and they need to be made for every employee on your payroll. In addition to them, you can also have elective deductions, like when an employee wants the company to make deposits into their retirement account.

Information about all of this needs to be easily accessible, neatly organized, and with accompanying instructions so that any new person dealing with it can use the system without issues.

Paying employees

After all the deductions have been made, what's left is what the employee receives, called net pay. Bear in mind that not all the employees are aware of the payment process and structure, so it is your responsibility to inform them to avoid confusion come payday.

Each employer decides how they will distribute their salaries. Although paper checks have been used for many years, switching to direct deposit would be advisable. That way, you can control your cash flow, and your employees can easily access their earnings through their bank accounts.

It can be very time-consuming to process all of this manually. In contrast, outsourcing could be challenging, mainly because it requires dealing with sensitive information (private information about employees and their tax payments). However, using payroll software and automating the process can benefit you tremendously.

It usually takes up to five days for employees to receive their salaries after the pay period end date. If a company is using software to run payroll, it doesn't take more than two days to do calculations. After that, it's about two to three days for the amount to be distributed to employees.

Keeping detailed payroll records

A payroll record is any document related to an employee’s compensation, which an employer must maintain for all its workers. Payroll records span all records connected to an employee’s wages, from hiring documents, to pay periods, payroll tax, wage rate, employee benefits, payroll deductions, etc.

What should be included in a payroll record?

According to the US Department of Labor (DoL), all employers covered by the Fair Labor Standards Act (FLSA) need to keep the following payroll records, as a minimum, when documenting employee wages:

Employee’s personal information

Within the personnel records, payroll teams need to keep the following information for each of their employees:

• Employee's full name
• Social security number
• Address, including zip code
• Birthdate, when an employee is younger than 19
• Sex
• Occupation

Records about the pay period

When keeping payroll documents on the pay period, employers should preserve the information typically outlined in the pay stub (or payslip). These normally include:

• Employee’s workweek, including information on time and day of the week
• Time card information, i.e. hours worked each day and total hours worked each workweek
• The basis on which employee’s wages are paid

Although FLSA requires employers to preserve pay stubs, they are not obliged to provide pay stubs to employees.

Records on employees’ income

• Regular hourly pay rate
• Total daily or weekly straight-time earnings
• Total overtime earnings for the workweek
• All additions to or deductions from the employee's wages
• Total wages paid to the employee during each pay period
• Date of payment and the pay period covered by the payment
• Tax records and any information on employment taxes and tax withholding
• Wage garnishments, i.e. information on any court order whereby the employee earnings are withheld in order to cover an outstanding debt

While the FLSA does not specify the form of these documents, it’s crucial that business owners ensure the accuracy of payroll-related employee records for all non-exempt employees.

As for the income tax records, it is the Internal Revenue Service (IRS) that has the authority to specify record keeping requirements, including how the wages should be taxed while issuing requirements and assessing compliance related to the proper filing of Form W-4 and Form W-2.

Federal vs state labor laws on payroll records

In managing compliance with payroll records, business owners need to be mindful of both federal labor legislation and also state laws and local government rules.

The key pieces of legislation that regulate payroll include the already mentioned FLSA, but also the Family and Medical Leave Act (FMLA), and the Employee Retirement Income Security Act (ERISA).

• FLSA regulates vital payroll issues, such as minimum wage, overtime work, child labor, payroll recordkeeping, and hours worked.
• FMLA is a piece of legislation that safeguards the rights of employees with respect to qualified medical and family reasons, requiring covered employers to provide their employees with job-protected and unpaid leave for these reasons.
• ERISA lays down the minimum standards for pension plans in private industry. It regulates how the federal income tax affects transactions related to the employee benefit plans and as such is directly related to the payroll records for each employee.

Besides the federal law requirements, business owners also need to take into account state-wide specificities, as in some cases, additional requirements need to be met.

For example, when it comes to overtime work pay, in Alaska, Nevada, and California and Nevada, employees must be paid overtime premiums for all hours they worked past the eighth-hour mark in a single day. Also, employees in California are entitled to be paid double time when they work 12 hours a day.

As for agencies that oversee payroll records compliance, the Wage and Hour Division of the U.S. Department of Labor is tasked with enforcing federal labor laws.

In addition, the Equal Employment Opportunity Commission (EEOC) regulates any workplace discrimination, including payroll issues, so employees should keep abreast with the new and amendment requirements.

Payroll record retention requirements

When preserving payroll records, employers should create a comprehensive strategy that takes into account both federal and state laws.

Where federal and state laws are conflicting, federal law takes precedence. At the same time, where state laws prescribe more stringent requirements, employers should guide their record keeping in line with the state laws.

As a general rule, all payroll records need to be made available for inspection to the representative of the Wage and Hour Division. They may require employers to extend, compute or transcribe the records for compliance assessment purposes.

Also, a good piece of advice is to keep payroll records in an electronic format, readily available for short notice disclosure requests by regulatory bodies or eDiscovery purposes.

How long do you need to keep payroll records?

Under the FLSA, as a rule of thumb, payroll records need to be kept for a minimum of three years.

Meanwhile, some records, such as time cards, piecework tickets, wage rate tables, work and time schedules, and records of additions or deductions from wages should be retained for two years.

But again, when it comes to payroll record keeping requirements, some states might impose more stringent regulations.

A case in point is the state of New York, where employers need to maintain payroll records for at least six years, and the employer must provide a detailed wage statement to employees each week.

Where to store your payroll records

Traditionally, payroll records have been stored in paper form. Such record keeping was prone to serious non-compliance, records spoliation, and lack of vital documents, as manual efforts often resulted in non-consistent payroll record keeping.

Many business owners, including both large corporations and small businesses, use payroll software that automatically preserves required payroll records in a standardized way. This ensures full compliance across the board and provides easy access to legal advice at all times.

Benefits of using payroll software

Now that you've learned about the payroll process, you will surely understand why using payroll software is a good idea. It allows you to come up with a custom-made solution that will take care of all your needs, eliminate the possibility of human error, and help tremendously with record keeping.

Just the fact that the software will automatically deduct the amount required for federal taxes, state unemployment taxes, and the ones you owe according to FICA should sway you into using it. Nevertheless, here are a couple more benefits.

Using an automated payroll system will make your payroll management faster, thus saving you time, leading to more cost-efficiency. It will also help with security, which is a crucial benefit for sensitive information required to make payroll calculations. Switching to payroll software means that you will have everything you need in one place, available in one click, and accessible from anywhere.

You can also consider using software that offers full-service payroll that is accessible through mobile devices. It should be cloud-based, so your online payroll system can always be at your fingertips.

There are many payroll solutions that you can implement to make the process easier. It is certainly complicated and complex to do all the necessary tasks in calculating payroll, and many choose to hire a third party to do it for them simply. But if you want to keep this essential process in-house, choosing payroll software is your best option.

Once you start choosing a payroll service that will provide you with the solutions you require, make sure they have everything you need. Aside from essential functions, make sure you can manage absence, garnishment payment, create multiple types of reports, and use various payment options.

You may decide to change how you are running payroll, and your payroll software should be able to adapt to it.

Streamline international payroll with Deel

Payroll doesn't need to be complicated. Deel unifies contractor payments, payroll management, and international employee payroll into one accessible dashboard.

Book a demo to explore global payroll, the Deel way.