FAQ
What is payroll processing? A guide to setting up payroll
Looking for an easier way to run payroll?
Payroll processing is the process of calculating employee wages, withholding taxes and deductions, issuing payments and maintaining payroll records. It helps ensure employees are paid accurately and on time while supporting compliance with applicable tax and employment regulations.
Key takeaways:
- Payroll processing involves calculating wages, withholding deductions and taxes, maintaining records, and delivering accurate, timely employee payments.
- Payroll regulations include federal, state and local requirements governing minimum wage, overtime, tax payments, pay schedules and recordkeeping.
- Payroll setup documents typically include employee tax and work authorization forms, banking information, and written authorization for voluntary deductions.
- Payroll cycles may be weekly, biweekly, semimonthly or monthly, depending on state requirements, employee needs and the employer’s budget.
- Payroll software can reduce manual work and errors by automating calculations, tax filing and recordkeeping while integrating with HR, timekeeping and accounting systems.
Table of Contents
Processing payroll means compensating employees for their work. It involves calculating total wage earnings, withholding deductions, filing payroll taxes and delivering payment. These steps can be accomplished manually, but an automated process is usually more accurate and efficient and may help you comply with various payroll regulations.
How to set up a payroll system
To set up a payroll system, obtain the necessary federal, state and local tax identification numbers, gather employee payroll documents, choose a pay schedule and payment method, establish payroll policies, and designate someone to manage payroll. If you choose to process payroll manually, you will need to keep precise records of hours worked, wages paid and worker classifications, among other details. You must also ensure your calculations are correct and file all necessary taxes and paperwork with government authorities on time. This is usually only possible for small businesses with very few employees. As you add more employees, tracking and calculating everything manually becomes more challenging, and the cost of errors increases, potentially resulting in costly tax penalties.
Payroll’s impact on cash flow
Even if you’re not paying someone else to do payroll for you, it’s still considered a business expense. This is because your employees’ wages and your share of payroll taxes cut into your profit margin. And if business slows down, you may be faced with the difficult decision of delaying payments or diverting money from other resources.
One way to limit payroll’s impact on your cash flow is to pay your people using direct deposit or digital pay options instead of paper checks. Because you don’t know when someone will cash a paycheck, it becomes more difficult to ensure you always have sufficient funds in your bank account. With direct deposit, you only need to cover the cost of payroll on certain days of the month, allowing you to better manage your finances. Plus, going digital cuts the expense of printing paper.
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Payroll regulations
Certain aspects of payroll processing are regulated by the Internal Revenue Service (IRS) and the Department of Labor (DOL). Some of the laws you must comply with include:
Fair Labor Standards Act (FLSA)
The FLSA entitles nonexempt workers to a minimum wage of not less than $7.25 per hour (effective July 24, 2009) and overtime pay at a rate not less than one and one-half times the regular rate of pay after 40 hours of work in a workweek. This means that you need an accurate means of tracking time and attendance so you can apply overtime wages in accordance with the law.
The FSLA also requires you to keep certain records for each nonexempt worker. Payroll records, for example, typically include hours worked each day, total hours worked during the workweek, the basis on which employee wages were paid, regular hourly pay rate, total overtime for the workweek, date of payment and the period covered, and total wages paid each period. These records must be kept for at least three years and the records on which payroll calculations are based, such as time cards, need to be kept for two years.
Federal Insurance Contributions Act (FICA)
FICA requires that a portion of every employee’s gross earnings help pay for Medicare and Social Security benefits. Each pay period, you must deduct 6.2% for Social Security tax (until the wage base is met) and 1.45% for Medicare tax. You’re also required to match these deductions, which brings the total FICA tax per employee to 15.3%.
Federal Unemployment Tax Act (FUTA)
Most employers contribute to the federal and state unemployment programs that compensate workers who have lost their jobs. As such, FUTA is not a payroll deduction because it only applies to employers, not employees. To comply, you must pay 6% in taxes on the first $7,000 you pay an employee in a year. Exemptions may apply, however, if you have household or agricultural workers.
Payroll processing state by state rules and regulations
In addition to federal regulations, you must abide by state payroll processing laws. Each state has its own rules, some stricter than others, governing minimum wage, payday schedules and recordkeeping. So, if you’re conducting business across state lines, your payroll compliance becomes that much more difficult.
Lori Rosen, Founder of the Rosen Group — a boutique public relations firm in New York — has a multi-state and hybrid workforce. So managing state and local regulations is something she’s very familiar with. Having ADP as a partner means that Lori doesn’t have to worry about legal, tax or compliance issues when new state and local laws are passed or existing ones change.
“When we have compliance or tax questions about our employees in different states, the answers are always quick, reliable and accurate,” says Lori. For over 30 years, Rosen Group has relied on ADP to help them manage not just payroll, but compliance as well.
“That’s one of the reasons we’ve stayed with ADP,” says Lori. The professional service and reliability factor is something you can’t get just anywhere, especially from a start-up or newer company that hasn’t been in business as long as ADP.”
For businesses not partnered with a provider that helps manage compliance, a good way to stay compliant is to task an executive or someone from your legal department to compile a list of all the labor laws that apply to your organization. Ask that they track changes to existing laws and document any proposed new laws. Review these findings on at least a monthly basis so you can adequately adapt your operations and avoid penalties.
View state payday requirements
View state minimum wage laws
View all state labor laws
Apply for an EIN
An employer identification number, also known as federal identification number, is a nine-digit number (format: 00-0000000) the Internal Revenue Service (IRS) uses to track your organization for tax purposes. Think of it as a Social Security number for your business. You can apply for an EIN free of charge online or by sending Form SS-4, Application for Employer Identification Number (EIN) to the IRS. Once approved, it can’t be canceled and will stay associated with your organization for as long as you stay in business. Some state and local governments may also require you to have a separate tax identification number.
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Documents required for payroll
Before you begin processing payroll, you generally need to gather these documents, some of which may be required by government agencies:
Payroll setup forms and documentation
Payroll setup typically begins with collecting the forms and employee information needed to calculate wages, confirm work status and apply the correct tax withholding.
- Form W-4: Employees use this form to indicate federal income tax withholding preferences so employers can calculate the appropriate withholding from wages.
- Form W-9: Independent contractors generally provide this form so the business has the taxpayer identification information needed for year-end reporting. This document is for your records and does not get sent to the IRS. At the end of the year, you will use the information on the W-9 to file a Form 1099-NEC, Nonemployee Compensation, which shows how much you paid independent contractors.
- Form I-9: Employers use this form to verify an employee’s identity and authorization to work in the United States.
Bank information
If you plan to offer direct deposit, you will need your new employees to provide you with the name of their bank and an account number and a routing number. Or, they can supply a voided check.
Medical insurance forms
You may have the best intentions and truly care about your employees’ health, but you can’t deduct insurance premiums from their pay without first obtaining written authorization.
Retirement plan documents
Like health benefits, retirement plans are a voluntary payroll deduction and require an employee’s signature before you can withhold contributions to a 401(k) or other retirement account.
How to classify workers
Classify workers by evaluating the degree of behavioral and financial control the business has and the nature of the working relationship. Employees generally work under the direction and control of the employer, while independent contractors typically control how they perform their work. In order to comply with federal payroll tax laws, you need to properly classify you workers as either employees or independent contractors. The general steps to do this are:
Assess the nature of the work being done.
A worker may be an independent contractor if you have the right to control or direct only the result of the work, not what will be done and how it will be done. If you control both what will be done and how it’s done, the worker is usually an employee. The IRS lays out three common law rules that provide evidence of the degree of employer and control and employee independence. They are:
- Behavioral control: Does the company control or have the right to control what the worker does and how the worker does the job?
- Financial control: Does the business direct or control the financial and business aspects of the worker's job. Are the business aspects of the worker's job controlled by the payer? Things like how the worker is paid, are expenses reimbursed, who provides tools/supplies, etc.
- Relationship of the parties: Are there written contracts or employee type benefits such as pension plan, insurance, vacation pay? Will the relationship continue and is the work performed a key aspect of the business?
Determine if payroll deductions apply.
Withhold income tax, Social Security tax and Medicare tax only on wages paid to employees, not independent contractors. These types of workers pay self-employment tax on their income.
File Form W-2, Wax and Tax Statement with the IRS for employees.
Include all forms of compensation paid to employees, including wages and tips, as well as the taxes that were withheld.
File Form 1099-NEC, Nonemployee Compensation for independent contractors.
You generally must report payments of $600 or more to nonemployees. The completed form gets sent to both the IRS and the worker.
Pay particular attention to details when determining a worker’s status. Misclassifying a worker can result in penalties and you may be responsible for any unpaid wages, including overtime. If you need help determining the status of a worker, you can submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding to the IRS.
What is a typical payroll cycle?
The most common payroll cycle or pay period in the United States is biweekly. See how it compares to other payroll frequencies:
| Payroll Cycle | Paychecks Per Year |
|---|---|
| Biweekly | 26 |
| Weekly | 52 |
| Semimonthly | 24 |
| Monthly | 12 |
Payroll schedules are a matter of preference, but minimum standards may apply. Some states require at least semi-monthly payments for all employees, while others have specific frequencies for different types of workers. If you are not bound by state payday requirements, you can choose whichever pay period works best for you and your workers. Employees, especially those in low-wage jobs, usually prefer to be paid more often, but as your pay frequency goes up, so does your payroll processing costs. You’ll need to carefully weigh the expectations of your workforce and your budget and comply with all state laws.
Create a payroll policy
To ensure that your payroll is accurate, processed timely and in accordance with all regulations, you’ll need to establish guidelines with both your employees and your payroll department. A typical payroll policy covers:
How to define your payroll schedule
A payroll schedule should reflect the needs of the business, employee expectations and any applicable state payday rules. Before choosing a frequency, review cash flow, administrative capacity and the types of workers you employ.
- Workweek definitions: Establish the seven-day workweek used to calculate overtime and support consistent timekeeping.
- Payroll schedule considerations: Consider state requirements, employee preferences, processing time and the cost of each payroll run.
- Pay periods: Document whether employees are paid weekly, biweekly, semimonthly or monthly, and specify the regular payday.
Wage structure
Be transparent about the different ways employees are compensated at your business, whether it’s hourly pay, salary, bonuses, commission or stock options. In addition, pay careful attention to state laws covering the payment of final wages to those who leave your organization.
Time and attendance tracking
Time and attendance tracking helps payroll teams calculate regular hours, overtime and paid or unpaid time accurately. A consistent tracking process can also help managers review exceptions before payroll is finalized.
- Time and attendance: Define how employees record time worked and how managers approve time records.
- Break periods: Clarify whether meal or rest breaks are paid or unpaid and how employees should record them.
- Overtime: Identify who is eligible for overtime and how overtime hours are calculated and approved.
Tax withholding and deductions
Tax withholding and deductions should be clearly defined so payroll calculations are consistent and employees understand what is being withheld from their pay. Organized processes can reduce errors and make recordkeeping easier.
- Calculate taxes: Use current federal, state and local tax rates and employee withholding information to determine required withholdings.
- Mandatory payroll deductions: Account for required deductions, such as applicable taxes and court-ordered garnishments.
- Voluntary payroll deductions: Document employee-authorized deductions, such as benefits, retirement contributions or other elective programs.
- Additional payroll deductions: Track any other approved deductions and maintain supporting authorization or documentation.
Payroll recordkeeping
The FSLA and state authorities require payroll records to be kept on file for certain periods of time. Document the recordkeeping laws that apply to you and how you will maintain confidentiality.
Designate a payroll processor
Those who excel as a payroll processor have a specific skill set. They tend to be detail-oriented, organized, analytical and technically inclined. Their success, however, requires the collective teamwork of employees, managers and the human resources department. For example, workers must submit accurate information and managers need to promptly approve timecards in order for payroll processors to manage payroll correctly and on time.
Payment and compliance
Payment methods and compliance requirements are key parts of payroll planning because they affect how employees receive wages and what information the business must provide. Employers should document payment options, pay statement practices and any state-specific requirements.
- Pay statement compliance: Provide required wage, hour, deduction and net pay details in the format required by applicable law.
- How to issue paychecks: Define whether wages will be paid by paper check, direct deposit, pay card or another permitted method.
- Direct deposit vs. pay cards: Compare employee access, setup requirements, timing and state rules before choosing electronic payment options.
How can I improve my payroll process?
You can improve your payroll process by standardizing pay periods, automating repetitive tasks, integrating payroll with timekeeping and accounting systems, and staying current with regulatory requirements. A payroll service provider may also help reduce administrative work, improve accuracy and support compliance. Long hours spent on administrative work and responding to letters from the IRS or court orders for wage garnishments are tell-tale signs that your payroll process could use some improvements. Here are some tips to streamline your operations:
Unify your pay periods
Paying different types of workers on different schedules (i.e. paying hourly employees weekly and salaried employees semimonthly) complicates payroll. Find a pay period that complies with state laws and works best across your entire workforce.
Invest in payroll software
The automated features available in payroll software eliminate repetitive tasks, like manual data entry. This reduces errors, saves time and improves compliance.
Integrate your payroll with other processes
Many types of payroll software can be seamlessly integrated with time clocks and accounting ledgers. When these operations are in sync, you may have more accurate payroll calculations.
Use digital timekeeping solutions
Paper timesheets often lead to mistakes. Time tracking software uses biometric identification to prevent fraud and automatically calculates the hours worked.
Keep current with regulatory requirements
Laws governing payroll and employment are constantly changing. Staying informed of the latest legislation will help you maintain compliance and avoid expensive penalties.
Work with a payroll service provider
Often, the surest way to improve your payroll process is to work with a provider who can handle all aspects of payroll on your behalf. You may have peace of mind knowing that your employees are paid on time and your taxes are prepared correctly.
How to choose a payroll system or software
Choosing the right payroll system or software is a foundational decision for any business because it can affect payroll accuracy, tax compliance, employee onboarding and administrative workload. The best option should fit current needs while being able to support future growth.
- Business size and scalability: Select a system that can support your current headcount and scale as the business grows.
- Compliance and tax filing capabilities: Look for tools that help calculate withholdings, prepare filings and keep pace with changing regulations.
- Integration with HR and accounting tools: Prioritize systems that connect payroll data with timekeeping, benefits, accounting and HR workflows.
- Ease of employee onboarding: Choose software that helps collect payroll forms, direct deposit details and employee information efficiently.
- Reporting and recordkeeping features: Ensure the system can generate payroll reports and retain records needed for audits or compliance reviews.
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Payroll processing FAQs
Learn what other employers are asking about payroll processing:
What is a payroll processor?
A payroll processor is someone who administers payroll. Employers can hire someone specifically for this purpose, but in most cases, the role is filled by an office manager, human resources director or even the owner. As a result, many payroll processors have responsibilities beyond simply running payroll. They’re often tasked with providing customer support and answering employee questions, analyzing the payroll system, keeping up with regulatory issues, working with auditors, and troubleshooting technical errors.
How long does payroll take to process?
The method you choose to process payroll will determine how long it takes. Manual calculations can take hours to days, depending on how many employees you have and the laws that you must comply with. If you’re a large business that operates across state lines, processing payroll this way is usually unfeasible. A more efficient approach is to use payroll software, which can run payroll in minutes thanks to automation.
What is full-cycle payroll processing?
Full-cycle payroll processing is the complete process of calculating employee wages, withholding taxes and deductions, issuing payments, and maintaining payroll records for each pay period. The amount of time in between each pay day is known as a payroll cycle. It can be as short as a week or as long as a month. During this period, several repeatable steps take place:
- Employees work and track their hours
- Gross pay is calculated based on hourly wage
- Taxes and other deductions are withheld from wages
- Net pay is delivered to employees via paycheck, direct deposit or pay card
What is end-to-end payroll processing?
End-to-end payroll processing integrates payroll with other aspects of workforce management, such as performance measurement, training, scheduling, benefits and compensation. By making this connection, you can improve communication, recordkeeping, analytics and efficiency throughout the employee life cycle.
Why is the payroll process important?
Payroll processing is important because paying employees late or filing taxes incorrectly may result in penalties and interest on back taxes. Payroll that’s unreliable can also hurt employee morale and tarnish your business reputation. When you consider these ramifications, it’s often best to dedicate the necessary resources, whether it’s time or money, to make sure you get payroll right.
What is the payroll process?
The payroll process involves collecting employee information, tracking time worked, calculating gross wages, withholding taxes and deductions, issuing payments and maintaining accurate payroll records. To run payroll for the first time, employers generally must perform the following:
- Apply for a federal employer identification number (EIN)
- Obtain state and local tax identification numbers, if applicable
- Gather employee tax documents (Form W-4, Form I-9 and Form W-9)
- Open a bank account specifically for paying employees and taxes
- Hire or designate a payroll manager
- Develop a payroll schedule
- Create a company payroll policy
What are the four types of payroll processing?
The four types of payroll processing are do-it-yourself payroll, outsourcing to an accountant, using payroll software and working with a managed payroll provider. When it comes to processing payroll, you have several options to choose from, depending on the size of your business and individual needs. The most common are:
- Do it yourself (DIY)
- Outsource payroll to an accountant
- Purchase payroll software
- Work with a managed payroll provider
In house payroll processing vs outsourcing
The in-house payroll processing vs. outsourcing debate can be a difficult decision for some businesses. Ultimately, the choice depends on a number of factors, including your current needs and your familiarity with running payroll. There are advantages to both options.
In-house payroll allows you to retain complete control of the payroll process and employee data management. Outsourcing, on the other hand, can save you time spent performing payroll tasks, like calculating wages and withholding and remitting taxes. A payroll partner also stays on top of employment regulations and can help you support compliance.
Effective payroll processing helps businesses pay employees accurately and on time while meeting tax and recordkeeping requirements. Whether you manage payroll in-house, use software or work with a payroll provider, the right processes can reduce errors, save time and support compliance as your business grows.
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This guide is intended to be used as a starting point in analyzing an employer’s payroll obligations and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
Tax figures provided are as of the 2020 tax year.
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