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How Does Payroll Work?

Sammi Caramela
Sammi Caramela

If your business has several employees, you need a payroll system to properly compensate them for their work. Here's how to process payroll as a small business owner.

  • Payroll software automates all the necessary requirements of accurately running payroll.
  • As a small business owner, you want to understand which payroll forms are necessary for your company and its workers.
  • Some common payroll periods are monthly, semimonthly, biweekly and weekly, with the most frequent schedule being the most expensive and most complicated. 

Payroll is an essential function of any business. As an employer, it's your job to make sure your workers are compensated. From tracking hours worked to paying your workers, your responsibilities can be overwhelming. That's where payroll systems come into play. 

Payroll software helps automate the entire payroll process, so you don't have to manually complete every step yourself. Understanding the methodology of payroll systems, the costs associated with payroll, how to set a system up and how to find the best solution can be the difference between an intuitive, efficient system and one that is confusing and causes headaches every payroll period.

Why is a payroll system necessary?

Whether it's a cloud-based solution or manual process, you need a system in place to track employee hours, understand deductions and issue payments to your workers. Adopting a manual process can be a huge time suck for a growing small business. If you have several employees, you have to manually track their hours and rates. Then you have to research both federal and state tax law so you're deducting the correct amount for taxes from each paycheck. 

After all this, you have to pay employees, track year-to-date spending and keep an eye on time-off payouts. There are several responsibilities and factors to juggle when processing payroll manually. If you're trying to work on payroll and run your business, it's easy to become overwhelmed. 

Payroll technology automates a lot of these processes. It  provides online portals for your employees to view important payment information, like tax deductions, 401(k) withdrawals and other breakdowns of benefits. More importantly, it helps business owners focus on running their business rather than spending all of their time on administrative tasks.

How much do payroll solutions cost?

Finding the right payroll solution means assessing your revenue and understanding what kind of system you need and can afford. There are two standard cost structures when it comes to payroll: monthly payments and per-payroll payments. 

Monthly pay structures entail a base monthly fee and then a fee per employee. Base fees range from $30 to $150 per month, and the employee fees range from $2 to $15 per employee, per month. A flat monthly fee allows for unlimited payroll runs at no extra cost. 

If you have a lot of contract or 1099 employees, this means you can pay them at no additional cost to your business. 

Per-payroll price structures mean you pay a fee every time you run payroll, plus a per-employee fee. These per-payroll fees can vary between $10 and $100 per run. The employee costs are usually between $2 and $15 per employee, per month.

How do you determine the best payroll system for your business?

As with choosing any business service, start by assessing your business's needs. There are several important things to consider before choosing a payroll service:

  • What features do you need? This can include features like multiple payment options, garnishment payments, paid time-off management, workers' compensation administration, unemployment insurance and detailed payroll reports. One of the most important features, multiple payment options, means you can pay employees through direct deposit, paper checks or pay cards.

  • Which cost structure works best for your business? If you're running payroll on a biweekly or semimonthly basis, paying per payroll run may be more cost-effective for your business. If you run payroll several times each month, it may be better to pay a monthly fee.

  • Do you need to integrate your payroll software with time and attendance or HR software? Some solutions offer open APIs or more prebuilt integrations than others. Look for a flexible solution if you need your payroll software to integrate with other platforms you rely on, such as your accounting software.

  • Does the payroll solution provide employees with self-service access? Employees should be able to log in and view pay stubs, end-of-year tax forms and some payroll reporting features.

  • Do you need your payroll provider to manage time off for your employees? Some payroll systems include time-off features, allowing your employees to request time off directly in the system and applying it to their pay checks.

  • Do you need your payroll provider to report new hires to the government on your behalf? Many payroll software platforms offer compliance reporting tools that make it easy to keep state and federal government agencies apprised of your workforce as it changes and grows.

Once you have a better idea of the type of service you need, you can check out some of the major players. Business News Daily reviewed more than 70 payroll providers to determine which were the best for small business. Based on our research, OnPay, QuickBooks Payroll, Gusto and SurePayroll are the best companies for small business. You can view a full breakdown of the best picks here. On our sister site, business.com, you read our reviews of other top payroll service providers.

How to do payroll for a small business

The payroll process can seem daunting feat, especially for small businesses. However, by using payroll software, you won't have to manually complete as many steps. 

Payroll providers offer a seamless solution by automatically calculating deductions and gross and net pay. Additionally, all the necessary paperwork exists in one place and is easily accessible to all employees/managers. 

As a small business owner, there are many payroll forms you need to familiarize yourself with. Some important ones you might need include: 

  • Form W-9, which is used by contractors to provide their tax ID number.

  • Form W-2, which reports how much you paid your employees and the amount of taxes you withheld from their paychecks in the last year.

  • Form W-3, a form that summarizes information from all of your W-2s.

  • Form W-4, which determines the amount of taxes each worker will have withheld from their wages.

  • Form 1099, a form that reports compensation for contract workers/nonemployees.

  • Form 1096, a form that summarizes information from all of your 1099s.

  • Form 940, which reports your Federal Unemployment Tax Act taxes.

  • Form 941, a form that reports payroll taxes and employee wages.

  • Form 944, which reports federal income and FICA taxes once annually (replaces Form 941 if eligible).

  • Form 1095-B, a form for employers who offer employees self-insured health plans.

  • Form 1094-B, which summarizes information from all of your 1095-Bs. 

When choosing a payroll schedule, consider what works best for your business and your employees. Some common payroll periods are monthly, semimonthly, biweekly and weekly, with the most frequent schedule being the most expensive and most complicated (burdening accountants and often impacting benefit premiums). However, most employees prefer being paid more frequently. 

Figure out how your workers want to receive their compensation (e.g., direct deposit, paper check, etc.) and how often (e.g., one of the options listed above) to determine which choice is best. 

Additionally, when building your payment calendar, factor in quarterly tax dates, holidays and annual tax filings. Tax implications vary by the state, but at a high level, you might expect to pay: 

  • Federal taxes
  • Social Security witholdings
  • State taxes
  • Local taxes
  • Medicare
  • 401(k) contributions
  • Workers' compensation contribution
  • Other benefits 

When deciding which payroll provider is right for your business, it's also important to consider which options best fit your budget while still meeting the requirements you have set. For instance, if you want specific features (like paid time-off management and multiple payment methods), you might have to pay more than what you originally intended. Don't settle for a less expensive option that doesn't cover your payroll needs. 

For more information on setting up a payroll system for small businesses, check out our guide on how to process payroll.

What are some free payroll options?

While the best companies charge small businesses for their services, there are some free solutions that are ideal for small businesses. Some options include Payroll4Free.com, Wave and eSmart Paycheck

Before deciding to use a free payroll provider, though, assess your needs and pick a service that suits your needs and your business. Many free providers are situation-specific, providing services to international companies, companies employing independent contractors and very small companies.

How does payroll work?

Payroll software automates all the necessary requirements of accurately running payroll. They automatically calculate the correct amount your employees should be paid each pay period based on the number of hours they've worked. If you have salaried employees, payroll software tracks salaried employees and pays them accurately. 

The biggest advantage of using payroll software is having taxes automatically deducted from employee paychecks. You won't have to worry about paying payroll taxes or misreporting employees' wages. Many payroll companies will give you a 100% accuracy guarantee, so if there is a mistake, the payroll company takes responsibility, and your business isn't on the hook with the IRS. Because payroll systems work through an automated process, you can focus on running your business.

How do you set up a payroll system?

As an employer, the first step to setting up a payroll system for your business is contacting the company with the services you're interested in. You can work with a salesperson to get the right plan for your company. Your employees will have to fill out necessary forms and be onboarded, and your business will have to establish important tax information. 

Once you handle the necessary paperwork, you can work with the company to establish the type of pay period for your business as well as outline employee compensation information. Keep in mind that some companies may charge you to set up the system.

Are payroll systems easy to learn and use?

Much like setting up your software, learning how to use the system falls on the company you're partnering with. Running payroll through a software application usually involves basic tasks like manager (or owner) approval of time cards and then establishing a day or time to run payroll. 

If you work with a company that fits your needs and is a reputable industry player, these payroll services are intuitive and fairly easy to use. Many companies also provide training and points of contact for basic questions and support.

How can payroll software help me with payroll taxes?

Payroll software automatically calculates and deducts both state and federal taxes from your employee's wages. It also handles payroll tax payments to the government. 

Make sure you ask the company you're considering partnering with about this feature. Most companies provide payroll tax payment support, but some may not. In any case, one of the major advantages of working with a payroll software provider is not having to worry about taxes. Tax law and employee taxation change. Payroll companies have team members dedicated to monitoring these changes and implementing them in your business. This kind of attention can keep you compliant, and you don't have to spend time sifting through tax law.

Is payroll an HR or finance function?

Payroll functions both in an HR and finance capacity. It involves finance because payroll is one of your business's overhead costs. Payroll is also a function of HR as it involves tracking things like hours worked, time-off requests and benefits information. 

Many payroll companies integrate with existing time and attendance software and HR management tools. Some companies, like ADP, may provide their own versions of these services to bundle with your payroll offering.

How do you migrate your data between payroll providers?

If you already work with an online payroll provider and you want to switch to a new service, it's possible to do so with minimal headaches. 

The best time to switch is usually at the end of a quarter or the beginning of the year, but this is not a requirement set in stone. Before preparing to switch, talk to your new payroll provider (or prospective new service), and ask for advice. 

Based on your business's specific situation, it could make sense to ask your new payroll provider when the best time to switch is, what information should be prioritized in the move and how long the switch will take. 

According to Insperity, there is some basic information you should have ready when you switch:

  • Employees' names, addresses and Social Security numbers
  • Deduction information or W-4 information
  • Employees' bank account information
  • Your federal, state and any other tax ID numbers
  • Year-to-date and quarter-to-date totals
  • Voided checks
  • Copies of your tax forms from the previous quarter 

There may be additional information, or additional circumstances, that are specific to your business's situation. Talk with your new payroll provider to make the switch as seamless as possible. 

Additional reporting by Matt D'Angelo.

Image Credit: AndreyPopov / Getty Images
Sammi Caramela
Sammi Caramela,
Business News Daily Writer
See Sammi Caramela's Profile
Sammi Caramela has always loved words. When she isn't writing for business.com and Business News Daily, she's writing (and furiously editing) her first novel, reading a YA book with a third cup of coffee, or attending local pop-punk concerts. She is also the content manager for Lightning Media Partners. Check out her short stories in "Night Light: Haunted Tales of Terror," which is sold on Amazon.