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How Does Payroll Work?

Updated Oct 20, 2023

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Payroll is an essential function of any business. As an employer, it’s your job to ensure your workers are compensated correctly and on time. From tracking hours worked to calculating employee wages, 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 complete every step manually. Understanding the methodology of payroll systems, the costs associated with payroll, how to set up a system and how to find the best software solution can be the difference between an intuitive, efficient system and one that causes headaches every payroll period.

Why is a payroll system necessary?

Whether it’s a cloud-based solution or a 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 massive drain on time and resources for a growing small business. If you have several employees, you have to track their hours and rates manually. Then you have to research both federal and state tax laws, so you’re deducting the correct amount for taxes from each paycheck for taxes. 

Editor’s note: Looking for the right payroll service for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.

After all this, you have to pay employees, track year-to-date spending, and keep an eye on time-off payouts. If you’re trying to work on payroll and run your business, it’s easy to become overwhelmed. 

Payroll technology automates all the necessary requirements of accurately running payroll. It automatically calculates 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 them and pays them accurately. It can even account for and calculate overtime pay.

One of the most significant advantages of using payroll software is having taxes automatically deducted from staff paychecks. You won’t have to worry about paying payroll taxes each spring or misreporting employees’ wages. 

Payroll systems often provide online portals for your employees to view important payment information, such as tax deductions and 401(k) withdrawals. 

Most importantly, payroll technology allows you to run your business rather than spending time on administrative tasks.

Did You Know?Did you know

Many payroll companies will give you a 100% accuracy guarantee, so if there is a mistake, the payroll company takes responsibility and your company isn’t on the hook with the IRS.

How much do payroll solutions cost?

If you’re going to use an outside service, finding the right payroll solution means assessing your revenue and understanding what kind of system you both need and can afford. There are two standard cost structures when it comes to payroll services: 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, while the employee fees are $2 to $15 per employee per month. A flat monthly fee allows for unlimited payroll runs at no extra cost. 

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 $2 to $15 per employee per month.

Did You Know?Did you know

If you have contractors or 1099 employees, you can pay them at no additional cost to your business.

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

There are several important things to consider before choosing a payroll service:

  • What features do you need? Consider if you need multiple payment options, garnishment payments, paid-time-off management, workers’ compensation administration, unemployment insurance and detailed paycheck records. One of the most critical features is multiple payment options, which means you can pay employees through paper checks, direct deposits 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 current 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, which will correspond to your employee time-off policy. For example, you may want to allow your employees to request time off directly in the system.
  • 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, research some major players. Business News Daily reviewed more than 70 payroll providers to determine which were the best for small businesses. Check out our OnPay review, Gusto Payroll review and SurePayroll review to learn about companies we identified as the best payroll providers for small businesses.  


If you’re looking for a broader overview, check out our in-depth reviews of the best payroll software providers. Compare their features and determine what solution is right for your company.

How should my small business complete payroll?

The payroll process can seem daunting, especially if this is your first small business. However, after you’ve partnered with a payroll provider, purchased payroll software or otherwise set up a payroll system, you won’t have to manually complete as many steps.

Check out these options for completing your company’s payroll:

  • In-house payroll: In-house payroll is when your company establishes its own process for completing payroll and keeping records. Either you or your firm’s HR representative usually handles in-house payroll. All information is processed manually, with no automated services or programs.
  • Payroll software: There are countless payroll software options – both free and paid – available online to help streamline your company’s payroll process. These programs automate the process by paying employees on set schedules and accurately determining how much should be taken out of wages for tax purposes.
  • Payroll provider: Payroll providers offer services to help other companies manage their payroll. Depending on your needs, a payroll provider can monitor your employees’ time off, run scheduled payroll, report new hires and file taxes on your company’s behalf. While an expensive option, most payroll services provide peace of mind by offering 100% accuracy protections in case your documents or taxes are filed inaccurately.  
  • Professional accountant: An accountant can manage your company’s finances while offering business advice and guidance when needed. Accountants can run payroll on your company’s behalf, manage employees’ insurance and 401(k) benefits, and file taxes for your business while keeping you compliant with local laws.

You may find that less expensive payroll options suit your small company’s needs. However, to ensure you’re filing taxes accurately and efficiently, larger companies will want to consider looking into a payroll provider or software. 


If you’re leaning toward hiring an accountant, learn how to find an accountant with the skills your small business needs.

What are some free payroll options?

While the best payroll companies charge for their services, free solutions may be ideal. Some options are, Wave and eSmart Paycheck. 

Before deciding to use a free payroll provider, assess your needs and choose a service that meets your business and industry requirements. Many free providers are situation-specific – providing services to international companies, businesses employing independent contractors and very small organizations.

How do you set up a payroll system? 

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

The first step to setting up a payroll system for your business is contacting the company with the services you’re interested in. Work with a salesperson to get the right plan for your organization.

When you set up a payroll system, there are a few steps you’ll need to take – including collecting payroll forms, choosing a payroll schedule, choosing how to pay employees and calculating withholdings. 

1. Collect payroll forms.

Once you’ve decided on your payroll provider, your employees will have to fill out necessary forms during onboarding. Here are some payroll forms you should be familiar with:

  • W-9: This form is used by contractors to provide their tax ID number.
  • W-2: Form W-2 reports how much you paid your employees and the amount of taxes you withheld from their paychecks in the last year.
  • W-3: This form summarizes information from all of your W-2s.
  • W-4: W-4s determine the amount of taxes each worker will have withheld from their wages.
  • 1099: This form reports compensation for contract workers or nonemployees.
  • 1096: This form summarizes information from all of your 1099s.
  • 940: Form 940 reports your Federal Unemployment Tax Act taxes.
  • 941: Form 941 reports payroll taxes and employee wages.
  • 944: This form reports federal income and FICA taxes once annually. It replaces Form 941 for eligible businesses.
  • 1095-B: Form 1095-B is for employers who offer employees self-insured health plans.
  • 1094-B: This form summarizes information from all of your 1095-Bs. 

2. Choose a payroll schedule.

When choosing a payroll schedule, consider what works best for your business and employees. Some standard 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 workers prefer being paid more frequently.

When building your payment calendar, you’ll also need to factor in quarterly tax dates, holidays and annual tax filings. 

Did You Know?Did you know

When deciding how frequently to run payroll, consider that companies with more hourly employees may need to run payroll more often. There are also federal and state laws that cover payroll frequency, so you should review the regulations in your area.

3. Choose how to pay your employees.

You’ll also need to decide how you plan to pay your employees. Payment can be made in the form of a paper check, direct deposit or pay cards. Consequently, the more payment options you offer, the more it will cost to run payroll. 


Ask your employees what payment method they’d prefer for their paychecks. While 93% of employees prefer direct deposit, this method requires a bank account, which not every employee may have.

4. Calculate payroll withholdings.

To avoid issues with the IRS, you must calculate payroll withholdings to ensure you’re deducting the correct amount of taxes from employees’ paychecks each pay period. You’ll need to deduct various taxes – including state and federal taxes. 

Tax implications vary by state, but you might expect to pay these contributions: 

  • Federal taxes
  • Social Security withholdings
  • State taxes
  • Local taxes
  • Medicare
  • 401(k) deposits
  • Workers’ compensation

Are payroll systems easy to learn and use?

Much like setting up your software, learning how to use the system depends on the company you’re partnering with. Processing payroll through a software application usually involves basic tasks like approving timecards, and 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 systems are intuitive. Many companies provide training and points of contact for basic support.

Key TakeawayKey takeaway

When deciding on a payroll provider, you should consider which options best fit your budget while still meeting your set requirements. For instance, if you want PTO management and multiple payment methods, you might have to pay more than you originally intended.

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 support and payments to the government. 

Make sure to ask the company you’re considering 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 changes. Payroll companies have team members dedicated to monitoring these subjects and implementing any changes 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 workers’ hours, time-off requests and benefits. 

Many payroll companies may integrate with your existing time and attendance software and your 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 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 switching, talk to your new payroll provider – or prospective 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 is to switch, what information should be prioritized in the move and how long the switch will take. 

According to Insperity, here is some basic information you should have available 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 company’s situation. Talk with your new payroll provider to make the switch as seamless as possible. 

Sammi Caramela and Matt D’Angelo contributed to the writing and research in this article.

Sean Peek
Contributing Writer at
Sean Peek has written more than 100 B2B-focused articles on various subjects including business technology, marketing and business finance. In addition to researching trends, reviewing products and writing articles that help small business owners, Sean runs a content marketing agency that creates high-quality editorial content for both B2B and B2C businesses.
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