Calculating Payroll for Employees: Everything Employers Need to Know
This article is part of a larger series on How to Do Payroll.
Before hiring employees, it’s important to take the time to learn how to calculate payroll for your business. It’ll save you time from having to correct errors and possibly thousands in fines, and you might even experience lower turnover by eliminating paycheck frustrations. You can perform calculations manually (hours worked X pay rate), use an online calculator, or rely on software.
You can always start with calculating payroll by hand and switch to an affordable payroll software like Gusto later on. Once you finish Gusto’s set-up process, you can easily enter work hours into the system and have all calculations done for you. If your team is paid the same amount each period, you can even set your payroll up on autopilot to process automatically. If you’re interested in seeing how it works, Gusto offers a free 30-day trial.
To calculate payroll for your team, here are the five steps you’ll need to follow:
Step 1: Determine Total Time Worked for the Period
To start doing payroll, you’ll need to figure out how much time each employee has worked for the period. For hourly employees, this will be total work hours (and minutes if you want to pay exact amounts). For salaried staff, it’ll be a set number of hours agreed upon at the time of hire (like a standard 40 hours, regardless of actual hours worked). You’ll also need to have selected a pay schedule at this point. This schedule means you should know if you’re paying employees weekly, biweekly, monthly, etc.
If you need help choosing a pay schedule, check out our article that walks you through everything small business owners need to know.
Total Work Time for Salaried Employees
You should pay your salaried employees the same amount per pay period (unless you have a nonexempt salaried position and are legally required to pay out overtime worked).
Upon hiring a new employee, you’ll determine a set annual salary and a guaranteed number of hours for which they will be paid. When an exempt employee is hired at an annual salaried rate, they are expected to work a minimum of 40 hours each week. They can work more, but should know that they will not be compensated extra for it. Since their work time is typically fixed, most employers don’t require their exempt employees to track their time.
Tip: If you’re looking to use payroll software, check if there is an autopilot feature that automatically calculates payroll each period (without you having to do anything). Paychecks for salaried employees are the easiest to automate because their hours worked and pay rate stay the same.
Nonexempt Salaried Employees
The exemption to that rule, however, is nonexempt salaried employees. Although not as common, some employers will pay their nonexempt employees a salary, meaning a guaranteed amount each week, along with any overtime they work.
The nonexempt part of the position means these employees fall under federal labor law protection. The employer expects employees to work the set minimum number of hours each week, but if they exceed those hours, they must be paid at an overtime rate for them. This requires time tracking to manage successfully.
Total Work Time for Hourly Employees
Calculating total work time for hourly employees is a little more involved than it is for salaried workers but not too complicated. Essentially, you’ll add all of the hours and minutes an employee worked for the pay period.
For example, let’s assume that an hourly employee has worked various hours throughout the week from Monday through Saturday and none Sunday. Let’s calculate those hours and minutes to get the total hours worked for the period.
This employee’s total work time for the week:
8.67 + 8.17 +8.75 + 8.75 + 7.08 + 2= 43.42 hours
Some employers are stricter about the time their employees clock in and out (4 p.m. vs 4:05 p.m.), so calculations are easier. Nevertheless, if you find yourself needing to convert minutes for payroll, there are plenty of online resources to help.
Tip: If you’d rather skip the manual calculations and minutes to decimals calculations, check out our time card calculator. You can enter hours worked and breaks taken each day and it will calculate the total hours worked for you automatically.
Step 2: Calculate Gross Pay (Before Deductions & Taxes)
Once you know how many hours you’ll be paying per employee, you can calculate gross pay. Gross pay is the total pay an employee earns before taxes and other deductions are subtracted, or more simply put, their pay rate multiplied by time worked.
For example, we will calculate Jenny’s earnings for the week. She’s an hourly employee who is paid $15 per hour, and she worked 35 hours this week. Her gross pay is $525.
$15 X 35 hours = $525
Step 3: Determine Your Payroll Deductions
Legally, you have to subtract payroll deductions from an employee’s gross pay before determining their final payout. We suggest compiling a full list of the deductions each employee has and whether those deductions are pre-tax or post-tax. One thing to keep in mind is that in this article, we are separating taxes from payroll deductions.
Non-tax payroll deductions can include numerous items, such as:
- Insurance premiums: Health, dental, vision, life insurance
- Retirement contributions: 401(k), 403(b), IRA accounts
- Child support payments: Legal draft of your employees’ check that’s usually initiated by the state in which their child lives
- Wage garnishments: Court-ordered garnishments of an employee’s paycheck when they don’t pay their debts; third-party debtors can sue to hold them liable
- Union dues: Membership fees for being part of the union
We just listed a few, but there are plenty more that may be unique to your employees or company. For instance, some companies provide benefits like low cellphone rates for employees joining their company phone plans. This might require you to include employee phone charges on your business’ phone bill; if you wanted to recoup some of the money, you could charge them a low monthly cost (with their approval, of course) and deduct it from their paychecks.
You’ll need to add all payroll deductions together to get a grand total. Most deductions, like insurance, have premiums that are the same amount each month, though you may encounter some that are based on the employee’s pay for the period (retirement contributions).
For example, in pay-based cases, just multiply the percentage the employee wants withheld (say, 4%) by the gross pay amount (say, $850) to find the total you should withhold.
$850 x 4% (0.04) = $34
Step 4: Find the Sum of Payroll Taxes
You’ll need to find the total taxes your employees owe. This can be tricky without using a payroll calculator. Your employees should have completed a W-4 form upon hire; you can use this to help you figure out the percentage of their income that you need to withhold for federal, state, and local taxes. The IRS is also a good resource.
Here’s a list of payroll taxes you may have to track, withhold, and send to the appropriate agencies:
- Federal income taxes: Most employees are subject to this, unless they’re minors or are exempt because they earn too little.
- State income taxes: States like Florida and Texas don’t have a state tax, but many others do. Some are a flat percentage, and others charge tax based on the employees’ income level (if they earn more, you withhold a higher percentage).
- Local income taxes: Local taxes aren’t as common as state taxes. States like New York and California have several different ones, so be sure to withhold money for all that apply.
- Social Security: This is a 6.2% tax that goes toward each employees’ government retirement fund. Once an employee earns $132,900 in a year, it no longer applies. You are also responsible for paying 6.2% (in addition to what the employee pays).
- Medicare: This is a 1.45% tax that goes toward the government medical fund for seniors. There is no income cap on this one, and you must also pay a matching amount out of your business funds.
Federal, State, and Local Income Tax Rates
Deciding how much you should withhold in taxes is probably one of the most confusing parts of processing payroll. Income tax rates can vary depending on your worker’s W-4 information like marital status and the number of allowances they claim. Use the IRS withholding calculator to determine how much to withhold for federal income taxes.
As your business grows, calculating tax amounts manually can become a tall task. If you’re not ready for an all-in-one payroll software like Gusto, you may want to consider a free payroll software as an option.
When it comes to state income tax rates, you should expect to withhold around 10% or lower; however, if you are in a state like California or Hawaii, which traditionally have the highest state income tax rates, your employees could be responsible for paying from 11% to 13% of their income. There are a number of city and county taxes that may apply as well; for instance, if you operate in New York City or your employees live in Yonkers.
If you want to take a closer look at your state’s specific tax rates, check out our comprehensive state guides. (If your state is missing, then check back as we release new state guides weekly.)
Subtract Nontaxable Income Before Calculating Tax Amounts
Nontaxable income is important to consider when figuring employee taxes to withhold because you will need to exclude it from your calculations. This can include work-related amounts that the employee paid using their own money that you now need to reimburse. Be sure to deduct these amounts before calculating any taxes so you do not end up withholding too much.
For example, Fern’s gross pay for the week is $3,500. Of that, $350 is for a reimbursement she is receiving for a hotel stay that she paid on behalf of the company. Her state tax rate is 9%. She owes $283.50 in state taxes.
$3,500 gross pay – $350 in hotel reimbursement= $3,150 taxable income
$3,150 taxable income X 0.09 = $283.50
Employer Payroll Taxes and Other Payroll Expenses
In addition to the taxes you need to withhold (and remit) for employees, you are also responsible for payroll taxes. It’s not the most exciting part about being an employer but is necessary to avoid paying additional money in penalties and fees.
Here’s a list of taxes and other payroll-related expenses you are responsible for paying out of your business’ bank account:
- FICA taxes: These are the Social Security and Medicare taxes that employees pay. You’ll pay 6.2% of their income for Social Security and 1.45% for Medicare.
- Workers’ comp: Most states require employers to purchase workers’ comp insurance to protect employees in the event of an injury in the workplace. Rates vary, depending on factors like previous claims, length of time in business, industry, and so on.
- Unemployment taxes (or insurance): You may be liable for both state and federal unemployment insurance. This goes toward government funds from which money is distributed when employees aren’t working. The federal unemployment rate is 6%, but state rates vary.
- Family Leave Act premiums: Some states (like California and New York), require you pay money toward family leave insurance. This funds the accounts that pay employees when they take leave for big events (childbirth). Premiums can be less than $1 a month per employee.
- Disability insurance: Some states also require you pay into their disability fund. Rules and rates vary by state, but usually depend on factors like your total payroll amount.
Step 5: Subtract Deductions & Taxes From Gross Pay
To reach the employee’s final paycheck amount, you should start with the gross amount you calculated in step two. You’ll also need the total non-tax deductions and taxes calculated in steps three and four. At this point, you’ll simply deduct all withholding amounts from gross pay.
For example, let’s look at Jill’s gross pay. It’s $2,600 for a two-week period. Total non-tax deductions equal $343, and total tax deductions equal $440. Her net pay amount would be $1,817, so you would process a check or direct deposit in this amount.
Gross Pay – (Non-Tax Deductions + Tax Deductions) = Net Pay
$2,600 – ($343 + $440) = $1,817
If you follow these steps to calculating payroll, you should be able to avoid lawsuits from employees, IRS penalties from inaccurate and/or untimely tax payments, and all of the back-end work that goes into correcting payroll errors.
Even with all the tools needed, everyone makes mistakes from time to time. If you do happen to find that you underpaid an employee, you can use a retroactive pay calculator to quickly compute the amount you need to pay the employee so the situation is resolved.
Keep in mind though, you’ll also need to determine the tax impact to remain in compliance. Using payroll software, like Gusto, makes it easy, because all of the calculations (paycheck and taxes) are done for you.
Calculating payroll becomes more complex as you hire additional employees. Keep in mind, though, the steps are essentially the same. The ultimate goal is to pay employees and all applicable tax agencies the correct amount and on time. While some employers choose to calculate everything manually, others use online tools like payroll calculators and software. Whatever you use to help you calculate payroll, be sure to familiarize yourself with IRS tax rules and federal payroll laws so you avoid penalties.
You can always start out calculating payroll by hand and switch to an affordable payroll software like Gusto later. Once you finish Gusto’s setup process, you can easily enter work hours into the system and have all calculations done for you. If your team is paid the same amount each period, you can even set your payroll up on autopilot to process automatically. If you’re interested in seeing how it works, Gusto offers a free 30-day trial.