How to Process Payroll in 8 Easy Steps

What is payroll processing?

Processing payroll means paying your employees for their work at your business. It involves calculating total wages, withholding deductions, tax filing, and compensating employees. Payroll processing is the procedure taken to pay employees at the end of a payroll period. This process involves multiple steps to ensure that pay is properly calculated, tracked and doled out and that the correct amounts for tax, company benefits and other deductions are withheld. Payroll is often managed and administered by a dedicated payroll professional, but it could also fall under the purview of human resources.

Basic payroll processing steps

Think of these basic steps as a roadmap for your payroll process. If you have payroll experience and need a quick refresher, this first set of steps can be a quick resource. If you’re looking for a deeper dive, keep scrolling to see a more detailed guide.

Take these steps before you start calculating pay:

• Get an employer identification number (EIN).
• Establish state or local tax IDs.
• Collect employee tax and financial information, including W-4 forms.
• Set up a payroll schedule.
  • Choose the right payroll schedule for your business.
  • Establish tax payment dates.

Follow these steps to manually process payroll:

• Review employee hourly schedules.
• Determine overtime pay.
• Calculate gross pay.
• Determine deductions.
• Calculate net pay.
• Issue payments to employees through their preferred delivery method (e.g., paper check, direct deposit).

Keep these things in mind after each pay period:

• Keep payroll records.
• Be aware of potential miscalculations and mistakes.
• Report new hires to the IRS.

How to process payroll

Step 1: Establish your employer identification number.

The first step in processing payroll is to establish your EIN and your state and local tax IDs. The government uses these identifications to track your business’s payroll taxes and ensure you’re meeting requirements.

If you don’t know your EIN or you don’t have one, you can visit the IRS website to set one up. For your state and local tax IDs, you’ll have to go through your state and municipality. [Looking to find the best payroll system reviews for your small business? We can help!]

Step 2: Collect relevant employee tax information.

Before you start processing payroll, your employees will have to fill out various tax forms so you can account for allowances and other tax details. These forms include the W-4 and I-9 (if it is a new employee). There are various state and local forms you will have to provide, but these will depend on where your business is operating.

Before processing an employee’s first paycheck from your company, you should also have these documents on hand:

• Job application: Even if the employee never filled out a formal application, having this document on file ensures that all key payroll information is in one place.
• Deductions: The employee may participate in company benefits, such as health insurance, a health savings account or a retirement savings plan. Proper payroll processing ensures that the correct amounts for these benefits are withheld each pay period.
• Wage garnishments: You may be required by law to garnish your employees’ wages if they owe money, such as IRS payments or child support. Wage garnishments are court-ordered; ensure you have the proper documentation on hand and in your records.

Step 3: Choose a payroll schedule.

Once you have the relevant tax and legal information to set up payroll, you can choose a schedule that works best for your business. There are four main schedules: monthly, semimonthly, biweekly and weekly. It’s important to understand each plan before deciding which is best for your business. Once you choose a schedule, set up a calendar with paydays, and make note of the days when you’ll have to process payroll for your workers to get their money on that defined day.

Build in important quarterly tax dates, holidays and annual tax filing dates. Keep in mind that you’ll have to do this at the start of every year. You’ll also want to establish the preferred delivery method for each employee. For example, many businesses allow employees to choose between paper check and direct deposit.

Step 4: Calculate gross pay.

Now that you’ve set a payroll schedule, you can start processing your first payroll. To do this, you must calculate each employee’s gross pay, which is the total number of hours an employee works in a given pay period multiplied by their hourly rate.

Start by calculating the number of hours an employee has worked in a given pay period, and take note of overtime hours. The extra time has to be paid out at a higher rate consistent with federal law. If an hourly worker puts in more than 40 hours per week, you’ll have to pay time and a half, or an employee’s hourly wage plus half that wage.

Here’s an example of a gross-pay calculation:

• Worker A has worked 50 hours for your weekly pay period and earns $10 per hour.
• 40 hours x $10/hour = $400
• 10 hours x $15/hour (time and a half) = $150
• Gross pay = $550

Step 5: Determine each employee’s deductions.

Gather information from your workers’ W-4s, federal and state requirements, insurance requirements, and benefits requirements to determine each employee’s deductions. This can get complicated; each state collects different taxes from small businesses, so you’ll have to research your state’s policies before you complete this step. Here are some examples of common requirements:

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

Step 6: Calculate net pay, and pay your employees.

Subtract each employee’s deductions from their gross pay. The amount left over is the employee’s net pay, or take-home pay. This is the amount you’ll pay each employee. You’ll have to hold the deductions and pay them with your payroll taxes each month or quarter, depending on the schedule you establish.

Once you’ve established each employee’s net pay, you can pay them on their scheduled payday. Here are some examples of ways to pay your employees:

• Paper checks mailed to their home or distributed at the office
• Direct deposit to their bank accounts
• Prepaid cards that are loaded with their take-home pay
• Mobile wallet into which you can deposit your employees’ pay
• Cash (although this method requires more detailed recordkeeping and might be a safety concern)

Step 7: Keep payroll records, and make any necessary corrections.

As you process payroll, it’s important to keep records of your transactions for tax and compliance purposes. If an employee disputes payment or the IRS needs some kind of documentation down the line, you need to have records at the ready. Especially in the case of an employee disputing a paycheck, it’s important to maintain records, including year-to-date payment, so you can sort out any issues that arise.

Step 8: Be mindful of ongoing considerations.

Keep in mind that you have to file your business’s taxes quarterly and annually. It’s important to consult an accountant to ensure you understand how your payroll taxes fit into this aspect of your operations. You’ll also have to report any new hires to the IRS. When you work with a payroll solution or an accountant, this usually isn’t your responsibility.

Editor’s note: Looking for information on payroll systems? Use the questionnaire below, and our vendor partners will contact you with the information you need: 

What are unpaid payroll tax penalties?

It’s important to ensure that your payroll taxes are paid properly and on time. Unpaid payroll tax penalties are levied on businesses when they fail to pay these taxes or don’t pay them on time. You can incur these penalties when you fail to do any of the following: provide returns to employees, file Form 941 in a quarter, or remit taxes withheld from employee paychecks for Social Security or Medicare.

Payroll processing resources

These resources provide additional support as you start your payroll operations:

• IRS withholding calculator
• Payroll steps from the U.S. Small Business Administration
• Employer identification number application
• U.S. Department of Labor recordkeeping and reporting guidelines
• IRS recordkeeping guidelines

Using payroll services

If you partner with an accountant or sign up for payroll software, you don’t have to complete any of these steps. If you work with an accountant, you can coordinate with them to ensure your business’s payroll is being processed properly and on time.

With payroll software, you just provide relevant employee information and approve the hours worked. The platform calculates the deductions, gross pay and net pay automatically. Payroll providers usually have online portals where workers can log in to view pay stubs and end-of-year tax documents and update their information. [If you’re interested in a payroll provider, check out some of our reviews of companies such as OnPay, Gusto, and Paychex].

Stella Morrison contributed to the writing and research in this article.