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Updated Feb 07, 2024

How Does Payroll Work?

Learn the processes behind this essential business function.

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Sean Peek, Business Ownership Insider and Senior Analyst
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This guide was reviewed by a Business News Daily editor to ensure it provides comprehensive and accurate information to aid your buying decision.

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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?

Every business with employees needs a system to track employee hours, deal with deductions, and issue accurate and timely payments to workers. You can handle payroll manually or implement an automated payroll system to deal with all the necessary tasks involved. 

Manual payroll systems

Processing payroll manually can be a massive drain on time and resources for a growing small business. You’ll do the following by hand: 

  • Track hours and rates: If you have several employees, you must track their hours and rates manually. 
  • Calculate payroll taxes: You must research federal and state tax laws to ensure you deduct the correct amount of tax dollars from each paycheck. These taxes are known as payroll taxes. They may be levied at the federal, state and, less frequently, municipal levels.
  • Pay employees and more: After all this, you must pay employees, track year-to-date spending and monitor time-off payouts. 

If you’re trying to handle payroll and run your business, it’s easy to become overwhelmed. 

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.

Automated payroll systems

Payroll technology automates all the necessary requirements for accurately running payroll. It can do the following: 

  • Automatically calculate wages: Automated payroll systems automatically calculate the correct amount your employees should be paid each pay period based on the 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.
  • Handle payroll taxes: 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. 
  • Facilitate employee self-service: 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 instead of spending time on administrative tasks.

Did You Know?Did you know
In addition to handling everything on your payroll checklist, many payroll companies provide a 100 percent accuracy guarantee. If there's a mistake, the payroll company takes responsibility, and your company isn't on the hook with the IRS.

How is payroll processed?

The payroll process can seem daunting, especially with your first small business. However, after partnering with a payroll provider, buying payroll software or otherwise setting up a payroll system, your payroll process will be streamlined.

You have several options when it comes to payroll processing: 

  • In-house payroll: In-house payroll is when your company establishes its own process for completing payroll and keeping records. Business owners and HR representatives typically handle in-house payroll. In this scenario, all information is processed manually with no automated services or programs.
  • Payroll software: Countless payroll software options exist — both free and paid — to help streamline your company’s payroll process. These programs automate the payroll process by paying employees on set schedules and accurately determining how much should be taken from 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 this can be an expensive option, most payroll services provide peace of mind by offering 100 percent accuracy protections.
  • 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, file taxes for your business, and keep 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 should consider payroll providers or software. 

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

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

If you’d prefer outside help with your payroll, evaluate the following crucial considerations before choosing a payroll service:

  • What features do you need? Consider whether you need multiple payment options, wage garnishment payments, paid time-off management, workers’ compensation administration, unemployment insurance and detailed paycheck records. Offering multiple payment options is crucial. Businesses appreciate the flexibility of paying 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 that correspond to your paid 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. 

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 is in one place, easily accessible to all employees. 

When setting up a payroll system, take the following steps: 

1. Collect payroll forms.

Once you’ve decided on a payroll provider, your employees must complete the 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. More frequent schedules tend to be more expensive and complicated, burdening accountants and often impacting benefit premiums. However, most workers prefer being paid more frequently.

When building your payment calendar, you must also consider 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. Federal and state laws also cover payroll frequency, so you should review the regulations in your area.

3. Choose how to pay your employees.

You must also 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 if they prefer direct deposit or direct deposit alternatives like pay cards. While 93 percent 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 deduct the correct 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

The best payroll software

Once you have a better idea of what you need, it’s time to research and evaluate the best payroll service for your business. Consider the following excellent options:  

  • OnPay: We like that all OnPay customers get access to the exact same roster of products and services at the same affordable prices. It’s particularly outstanding that OnPay offers employee benefits to all users and that its executives are part of its customer support team. Learn more via our OnPay review.
  • Gusto: One of our favorite things about this platform is that it offers extensive HR features alongside payroll tools. We also like how intuitive Gusto’s interface is to navigate. Most of the tools you’ll need are easy to spot from the dashboard. Read our detailed Gusto payroll review to learn more.
  • SurePayroll: When you log into SurePayroll, you’ll see a quick list of payroll tasks to complete. This platform also makes paying both standard small business employees and household employees especially easy. Explore this payroll service further via our in-depth SurePayroll review.
  • Intuit QuickBooks Payroll: We like that Intuit QuickBooks Payroll offers next- or same-day deposit, depending on your pricing plan. Direct deposit this rapid isn’t guaranteed with most payroll providers, and only QuickBooks Payroll offers extensive accounting features alongside its payroll tools. Dive deep into this payroll offering from accounting software’s gold-standard name via our comprehensive Intuit QuickBooks Payroll review
  • Rippling: Between Rippling’s 90-second payroll runs and over 500 third-party integrations, we are consistently impressed with this platform’s usability. We also like how intuitive Rippling makes it to reimburse your employees for expenses incurred on your behalf. Learn more via our complete Rippling payroll review.

Payroll FAQs

Payroll service costs vary widely. It's crucial to assess your needs and set a budget to determine the right system. Payroll services typically have two cost structures: monthly payments and per-payroll payments. However, per-payroll payments are falling out of favor these days, and monthly pricing models are becoming standard. Monthly pricing models include a base fee and a per-employee fee (sometimes just the latter). Base fees range from $35 to $170 monthly, while employee fees run about $5 to $20 per employee per month. A flat monthly fee allows for unlimited payroll runs at no extra cost. Did you know? If you have contractors or 1099 employees, you can often pay them at no additional cost to your business.
While the best payroll companies charge for their services, free solutions may be ideal. Some options are and eSmart Paycheck. Before choosing 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.
Like setting up any business software, learning payroll systems depends on the company and its platform. Most popular payroll systems are highly intuitive and provide training and points of contact for basic support.
Payroll software automatically calculates and deducts state and federal taxes from your employee's wages. It also handles payroll tax support, payments to the government and payments for your team's taxable fringe benefits. One of the primary advantages of working with a payroll software provider is not having to worry about taxes, tax laws and employee taxation changes. Payroll companies have team members dedicated to monitoring these subjects and implementing changes in your business. This kind of attention can keep you compliant, and you don't have to spend time sifting through tax law.
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 an HR function because it involves tracking workers' hours, time-off requests and benefits. Many payroll services integrate with your existing time and attendance software and HR management tools. Some companies — like ADP — provide their own versions of these services to bundle with your payroll offering. (Read our ADP Payroll review to learn more.)
If you already work with an online payroll provider and want to switch to a new service, you can 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 set requirement. 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 about the best time to switch, what information should be prioritized in the move, and how long the switch will take. 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
Additional information or circumstances may be specific to your company's situation. Talk with your new payroll provider to make the switch as seamless as possible.

Making payroll work for you and your team

With the right payroll provider, you’ll barely have to think about paying your team promptly and accurately. The same goes for withholding the correct taxes or plan premiums to comply with regulations and keep your employee benefits intact. Choose a platform that offers all the features you need while falling within your budget, and you’ll no longer work to make payroll happen. Instead, you’ll make payroll work for you and your team.

Max Freedman and Sammi Caramela contributed to this article. 

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Sean Peek, Business Ownership Insider and Senior Analyst
Sean Peek is the co-founder of a self-funded small business that employs more than a dozen team members. His years of hands-on entrepreneurial experience in bootstrapping, operations management, process automation and leadership have strengthened his knowledge of the B2B world and the most pressing issues facing business owners today. Peek uses his expertise to guide fellow small business owners and aspiring entrepreneurs in the areas of marketing, finance and software technology. Peek excels at developing customer bases and fostering long-term client relationships, using lean principles to drive efficiency and cost-saving, and identifying growth areas. He has demonstrated his business savvy through collaborations with Forbes, Inc., Entrepreneur and the U.S. Chamber of Commerce.
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