What Is Payroll? How to Calculate Payroll and Payroll Taxes

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Payroll is the process a business uses to pay its employees: tracking time worked, calculating gross pay, withholding taxes and other deductions, distributing net pay, and reporting and remitting the withheld and employer taxes to the government. The word also names the list of people a company pays and the total compensation it owes them, which is why “on the payroll” means employed by that company and why accountants speak of payroll as an expense line. In the United States, payroll runs within federal rules (the Fair Labor Standards Act and IRS employment tax rules) plus state and local wage and tax laws.

What Is Payroll?

As a process, payroll is the recurring cycle of calculating wages, overtime, bonuses, commissions, sick pay and vacation pay, then subtracting the right taxes and deductions before money reaches the employee’s bank account or paycheck.

As a record, payroll is the list of employees and what each is owed for a pay period, and for most businesses it is one of the largest operating expenses. Wages are generally deductible business expenses, so payroll reduces taxable income. The amount can change each pay period because of overtime, new hires, terminations, bonuses and other variables.

Payroll is limited to employees. Independent contractors are paid through accounts payable without tax withholding and handle their own self-employment taxes, so classifying a worker decides whether the payroll rules apply at all.

How Payroll Works

A payroll cycle repeats on a fixed schedule. Common pay frequencies are:

• Weekly: 52 pay periods a year
• Biweekly (every two weeks): 26 pay periods
• Semimonthly (twice a month, such as the 15th and last day): 24 pay periods
• Monthly: 12 pay periods

Within each cycle, the employer or its provider:

1. Collects hours worked for hourly staff and any changes (raises, bonuses, unpaid leave).
2. Calculates gross pay.
3. Applies pre-tax deductions, withholds taxes and applies post-tax deductions.
4. Pays employees by direct deposit or check.
5. Records the payroll in the accounting system: wages expense, taxes withheld, employer tax expense, and liabilities for amounts not yet remitted.
6. Deposits withheld taxes and employer taxes with the government on the required schedule and files the related returns.

Step 5 is where payroll becomes an accounting function. Taxes withheld from an employee’s pay are not company money. They sit on the balance sheet as a liability until the business deposits them.

How to Calculate Payroll

Every paycheck follows the same calculation order. The order matters because some deductions reduce the wages that certain taxes are calculated on, and others do not.

1. Calculate Gross Pay

Gross pay is total earnings before anything is taken out.

For hourly employees:

Gross pay = hourly rate × hours worked in the pay period (plus any overtime premium)

Under the FLSA, nonexempt employees earn overtime at 1.5 times their regular rate for hours over 40 in a workweek. Some states add daily overtime rules on top of the federal weekly rule.

For salaried employees:

Gross pay = annual salary ÷ number of pay periods in the year

A salaried employee earning $50,000 a year on a biweekly schedule has gross pay of $50,000 ÷ 26 = $1,923.08 per paycheck. On a semimonthly schedule, the same salary produces $50,000 ÷ 24 = $2,083.33 per paycheck.

Bonuses, commissions and tips reported by the employee are added to gross pay for the period in which they are paid.

2. Subtract Pre-Tax Deductions

Pre-tax deductions come out before certain taxes are calculated. Common examples:

• Traditional 401(k) and similar retirement plan contributions
• Employee-paid health, dental and vision insurance premiums under a cafeteria (Section 125) plan
• Health Savings Account (HSA) contributions made through payroll
• Flexible Spending Account (FSA) contributions
• Some group life insurance premiums

Not all pre-tax deductions reduce the same taxes. Traditional 401(k) contributions reduce wages subject to federal income tax, but they are still subject to Social Security and Medicare tax. Section 125 health premiums and FSA contributions generally reduce wages for both income tax and FICA.

3. Withhold Taxes

From the appropriate taxable wages, the employer withholds:

• Social Security tax at 6.2% of wages, up to an annual wage base
• Medicare tax at 1.45% of all wages, with no wage cap
• Additional Medicare tax of 0.9% on wages above $200,000 paid to the employee in a calendar year (employee only; the employer does not match it)
• Federal income tax, determined from the IRS withholding tables and the employee’s Form W-4
• State and local income taxes where they apply

Social Security and Medicare together are known as FICA, after the Federal Insurance Contributions Act; the combined employee rate below the wage base is 7.65%. The IRS offers an Income Tax Withholding Assistant for small employers who calculate federal withholding without software.

4. Subtract Post-Tax Deductions

After taxes are withheld, the employer subtracts deductions that do not reduce taxable wages:

• Roth 401(k) contributions
• Some life insurance and long-term disability premiums
• Union dues
• Wage garnishments (court-ordered child support, creditor garnishments, tax levies)
• Charitable contributions made through payroll

What remains is net pay, the amount the employee actually receives.

5. Add the Employer’s Share

The employee’s paycheck is only part of the cost. The employer also owes:

• A matching 6.2% Social Security tax and 1.45% Medicare tax on the same FICA wages
• Federal unemployment tax (FUTA): 6.0% on the first $7,000 of each employee’s annual wages, reduced by a credit of up to 5.4% for employers who pay state unemployment tax on time, leaving a net rate as low as 0.6%
• State unemployment insurance tax, at a rate and wage base set by each state and often tied to the employer’s history of layoffs and claims
• Any employer-paid benefits, such as a share of health premiums or a 401(k) match

Example of Payroll

The following hypothetical weekly paycheck uses assumed deduction and tax amounts to show the mechanics, not real withholding results.

Assumptions: hourly rate $25; 44 hours worked in the week; traditional 401(k) contribution of 5% of gross pay; Section 125 health premium of $40; federal income tax withholding of $90 (assumed result of the IRS tables and the employee’s W-4); state income tax of $30; union dues of $15; the employee is below the Social Security wage base and the FUTA $7,000 limit for the year.

Gross pay

• Regular: 40 × $25 = $1,000.00
• Overtime: 4 × ($25 × 1.5) = 4 × $37.50 = $150.00
• Gross pay: $1,150.00

Pre-tax deductions

• 401(k): 5% × $1,150 = $57.50
• Health premium: $40.00

Taxable wages

• FICA wages: $1,150 − $40 = $1,110.00 (the 401(k) contribution does not reduce FICA wages)
• Federal income tax wages: $1,150 − $57.50 − $40 = $1,052.50

Employee taxes

• Social Security: $1,110 × 6.2% = $68.82
• Medicare: $1,110 × 1.45% = $16.10
• Federal income tax (assumed): $90.00
• State income tax (assumed): $30.00

Post-tax deduction

• Union dues: $15.00

Net pay: $1,150.00 − $57.50 − $40.00 − $68.82 − $16.10 − $90.00 − $30.00 − $15.00 = $832.58

Employer cost for the week

• Gross wages: $1,150.00
• Employer Social Security match: $68.82
• Employer Medicare match: $16.10
• FUTA at the 0.6% net rate: $1,150 × 0.6% = $6.90
• Subtotal: $1,241.82, before state unemployment tax and any employer-paid benefits

For this one paycheck, the business owes the IRS $68.82 × 2 + $16.10 × 2 = $169.84 in FICA plus the $90 of federal income tax it withheld. Half the FICA came out of the employee’s pay; the other half is a direct company expense, so the employer spends more than $1,241 to deliver $832.58.

What Are Payroll Taxes?

Payroll taxes are calculated on wages, paid through the payroll system, and fund social insurance programs rather than general government spending.

Social Security applies only up to an annual wage base adjusted each year ($168,600 for 2024). Once an employee’s wages for the year pass the base, Social Security withholding stops for the rest of that year, so high earners see a larger paycheck late in the year.

Medicare has no wage cap. The employer must start withholding the employee-only 0.9% Additional Medicare Tax once wages pass $200,000 within the calendar year, regardless of the employee’s filing status.

Together, the employee and employer shares produce 15.3% of wages up to the Social Security base (12.4% Social Security plus 2.9% Medicare). Self-employed people pay both halves themselves through self-employment tax.

Unemployment taxes (FUTA and state unemployment insurance) are generally paid by the employer only, though a few states also collect a small employee contribution.

Income tax withholding is often grouped with payroll taxes because it moves through payroll, but it differs in one key way. It is the employee’s own income tax paid in advance, so the employer withholds it and remits it without matching it. The final liability is settled on the employee’s annual return, which is why withholding can produce a refund or a balance due.

Payroll Compliance and Legal Factors

The Fair Labor Standards Act (FLSA) sets federal minimum wage, overtime, recordkeeping and child labor standards. Enterprise coverage applies to businesses with annual gross sales or business of at least $500,000, and employees of smaller businesses can still be covered individually, for example when their work involves interstate commerce.

Exempt employees. Certain executive, administrative and professional employees who meet salary and duties tests are exempt from the overtime requirement.

Other industry laws. Some workers fall under separate federal rules. Railroad employees are covered by the Railway Labor Act, and many truck drivers fall under the Motor Carrier exemption from FLSA overtime.

Tipped employees. For employees who customarily and regularly receive more than $30 a month in tips, an employer may count part of those tips toward the minimum wage (a “tip credit”), but must make up any shortfall so tips plus cash wage reach the full minimum wage. Many states restrict or prohibit tip credits.

Federal filings. Employers report withheld income tax and both shares of FICA on Form 941, filed quarterly, and report FUTA on Form 940, filed annually. Taxes are deposited electronically on a monthly or semiweekly schedule that depends on the size of the employer’s past tax liability. At year end, each employee receives a Form W-2 showing wages and withholding, which also goes to the Social Security Administration. New hires complete a Form W-4 for federal withholding and Form I-9 for employment eligibility.

State and local rules add their own minimum wages, overtime rules, income tax withholding, unemployment tax filings, paid leave requirements and pay frequency laws, so an employer with staff in several states runs several sets of rules at once.

Ways to Run Payroll: In-House, Software or Outsourced

Manual payroll means calculating each paycheck from the IRS tables and filing forms by hand. It costs nothing beyond time, but the error risk rises with every employee and state added.

Payroll software handles the calculations, stores withholding tables, generates tax forms and often files and deposits taxes, usually for a monthly subscription, sometimes with a per-employee charge. It keeps salary and tax data inside the company but still takes staff time to enter hours, review runs and resolve exceptions. Growing companies sometimes move payroll into an enterprise resource planning (ERP) system tied to accounting and HR.

Outsourced payroll services take the employer’s hours and changes, calculate pay, withhold taxes, pay employees and file the returns.

Advantages of outsourcing:

• Ready-made reports that simplify accounting and tax filing
• Tracking of vacation, sick and personal time
• Less internal time spent on tax rules and deadlines

Disadvantages:

• Higher cost than doing payroll in-house, through flat monthly fees or tiered pricing
• People outside the company see salary and tax information
• Internal staff still handle employee questions and complaints when a check is wrong
• The employer can still face penalties for the provider’s errors, because legal responsibility for employment taxes stays with the employer

Limitations and Common Payroll Errors

The calculation is simple; the inputs are where payroll goes wrong. Frequent problem areas include:

• Worker misclassification: treating an employee as a contractor (or an exempt employee as nonexempt) can lead to back wages, unpaid overtime, back taxes and penalties.
• Wrong taxable wage base: applying a 401(k) deduction before calculating FICA, or failing to stop Social Security at the wage base, misstates both employee and employer taxes.
• Overtime errors: the regular rate used for overtime can include certain bonuses and shift premiums, not just the base hourly rate.
• Late deposits: withheld income tax and the employee share of FICA are “trust fund” taxes. If they are not remitted, the IRS can hold responsible owners or officers personally liable through the Trust Fund Recovery Penalty.
• Outdated employee data: a missing W-4 update, a new address in another state or an unprocessed garnishment changes what should be withheld.

Payroll as a figure also has analytical limits. Total payroll expense shows what a company spends on employees but says nothing about productivity, and a rise can reflect hiring, raises, overtime, bonuses or a one-time severance payment.

Payroll vs. Related Terms

Payroll vs. salary. Salary is a fixed amount one employee earns, usually stated annually. Payroll is the company’s whole process and total compensation cost, which includes salaries, hourly wages, overtime, bonuses, commissions and the employer’s payroll taxes.

Payroll vs. paycheck. A paycheck (or pay stub) shows one employee’s gross pay, deductions and net pay for one period. Payroll is the run that produces every paycheck plus the tax deposits and accounting entries behind them.

Payroll vs. HR. Payroll is fundamentally an accounting function, but many companies place it under human resources. Others keep it in finance, and large employers may have a dedicated payroll department.

Owners’ pay. Business owners are not always on payroll. A sole proprietor or the member of a single-member LLC taxed as a disregarded entity generally takes owner draws and pays self-employment tax, while owners of an S corporation or C corporation who work in the business are paid wages through payroll.

Payroll tax cut vs. payroll tax holiday. A payroll tax cut lowers the Social Security or Medicare tax withheld from paychecks, usually to support spending and stimulate the economy. A payroll tax holiday is a temporary suspension or deferral of collection. If it is a deferral, the taxes are still owed later, so the boost to take-home pay has to be repaid.

The Bottom Line

Any business with employees carries legal responsibility for calculating pay correctly and depositing withheld and employer taxes on time, even when a software vendor or outside service runs the work. Most errors come from inputs such as worker classification, taxable wage bases and stale employee data. Owners should budget for the employer's tax share on top of gross wages and check those inputs every pay period.