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Step by Step: How Payroll Is Run

Woman smiling while completing work at a desk. (Complete Guide to Payroll for Small Businesses - Guidant Financial.)

As you can see, much information gathering and decision-making is involved in payroll before any payment actually makes it to employees. Once all the data is entered and the payments, withholdings, and benefits are tabulated, the payment is actually issued — whether through an electronic transfer or physical paycheck.

Some small business owners do this themselves. Others use an accountant or service provider to ensure accuracy and that the books are balanced appropriately. Regardless of who or what you use, knowing the process is essential. Why? Because doing it correctly — and in the correct order — is key to both paying you and your employees in a timely and accurate way. Doing so also helps avoid errors that can cause fines, penalties, and legal action. Let’s review the four steps of how to run payroll:

Step 1: Determine the Hours Worked

The first step is to calculate the hours worked for each non-exempt employee.

Step 2: Calculate the Gross Pay

The second step is to calculate the gross pay for each employee. For non-exempt employees, the hours worked are multiplied by their hourly pay rate.

You need to include any tips non-exempt employees receive. If your non-exempt employees have worked overtime, you must adjust their hourly pay for each overtime hour (hour over 40 in a given week), according to the FLSA, by multiplying it by a minimum of one and a half their hourly rate.

Remember to check your state’s rules on when employees must be paid overtime. States vary, but some mandate that overtime begins after 8 hours in one day rather than 40 in a week.

For non-exempt (salaried) employees, the gross pay is the gross weekly salary multiplied by the number of weeks in the pay period.

Step 3: Calculate Payroll Deductions

The next step is to calculate payroll deductions. They must be calculated and subtracted from gross pay in the following order:

Pretax deductions: Subtract any pretax deductions, such as 401(k) retirement plan contributions or healthcare contributions.

Statutory deductions: Calculate statutory deductions, such as Federal, state, FICA, and local taxes. Subtract them next.

If employees are subject to any after-tax deductions, make them after the statutory deductions. These include Roth IRA retirement plan contributions, wage garnishments, and union dues.

Step 4: Arrive at Net Pay and Issue Payment

After all these deductions are made from an employee’s gross pay, the final result will be the net pay (sometimes called take-home pay). Once net pay is calculated, payment is issued using whatever method you’ve decided upon.

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