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How to set up a payroll process: 10 steps

Starting or acquiring a business is a rewarding experience, and your employees would likely agree. The reward they’re thinking of, however, is a steady paycheck.

As an employer you shoulder a lot of responsibility, especially when it comes to employee compensation. Not only do you have to figure out the proper way to pay your people, you have to withhold the appropriate taxes, deposit them and report them to the government.

Having a firm grasp on these responsibilities and why they are important will help you set up a payroll process that encourages accuracy and is easy to run.

Whether you have one employee or 1,000, creating a payroll process is the same.

Let’s walk through the 10 steps you need to take to get started.

1. Decide to do payroll yourself or choose a service provider.

Payroll processing is tedious and time-consuming, so choosing the right method for tackling it is a critical first step. You can choose to:

Using an automated payroll service can help you avoid hassles and headaches without being as costly as hiring an accountant. Most payroll services use automation to calculate wages, taxes and other withholdings properly and to generate and file tax returns.

2. Locate or apply for your tax ID.

No matter the payroll process you choose, before you can pay your employees, you must first obtain an employer identification number (EIN) from the Internal Revenue Service (IRS).

You can sign up for your EIN online or by phone using Form SS-4 if you don’t already have one.

Also, there are some states and local governments that require separate ID numbers in order to process taxes. Check your local requirements and make sure you have everything you need.

If you operate in multiple states, you will need to establish an account with each state in which you have employees so you can remit withholdings.

3. Gather W-4s from employees.

During the onboarding process, each new employee must fill out a Federal Income Tax Withholding Form (W-4) and Form I-9, which verifies identity and authorization to work in the US. Your obligation for federal income tax withholding will be based on the employee’s responses.  

Note: Federal and state agencies require certain documents to be retained for a specific period of time, and not having this information on file can lead to fines and penalties.

4. Verify employee classification.

Depending on their job duties, pay type and pay frequency, employees can be classified as:

  • Exempt
  • Non-exempt

Understanding the difference means knowing how to report income, withhold and pay taxes, and handle overtime for each group. If you’re unsure about the designation of any employee, seek the advice of a trusted HR professional.

Executive, administrative and professional exemption 

These are salaried employees who are not eligible for overtime compensation.

Be careful in using this distinction though – you can’t assign someone an arbitrary title to avoid paying them overtime if they don’t perform relevant duties. The U.S. Department of Labor keeps a close eye on employers in this regard, and penalties for misclassification and non-payment of overtime can be quite severe.

Non-exempt

This includes hourly employees who qualify for overtime compensation.

Remember that for hourly employees, overtime is generally 1.5 times the regular rate of pay for every hour worked beyond the standard 40-hour workweek. Depending on what state you’re in, these rules could vary to include daily overtime or other pay premiums.

In addition to obtaining deduction information and classification, to add employees to a payroll provider’s system, you’ll likely need:

  • Your employees’ names, addresses and social security numbers
  • Employees’ bank account information (for direct deposit)
  • Your payroll register (if acquiring an existing business with payroll history)

Independent contractor

Outside consultants are often hired to assist with specific projects, and are responsible for paying most of their own payroll taxes. However, they’re required to fill out a Form W-9 and submit it to you.

Note: If you don’t control an individual’s day-to-day activity, a specific one-time job is done and you are issued an invoice or a bill for the work they performed, the individual may be treated as an independent contractor. But there are many things to consider in this fact-intensive analysis. If you have any questions about whether a person is properly identified as an independent contractor, please consult a lawyer experienced in wage and hour matters.

5. Set your pay cycles.

Your state may have laws in place regarding how often you must pay your employees. Many employers favor a biweekly model, which is the best choice for organizations operating in multiple states. Other options include semi-monthly (e.g., the first and fifteenth of the month) and monthly.

From a payroll compliance standpoint, besides accurately classifying your employees, setting up your pay periods correctly is the most important decision you’ll make.

After you research and determine your pay periods, you’ll need to decide if you’ll offer direct deposit, which is preferred by most companies and employees because it:

  • Optimizes timely pay
  • Helps employees avoid banking fees
  • Allows you to keep funds in your account slightly longer

6. Understand the different employment tax withholdings.

Not all taxes are created equal. Knowing which ones you will be required to deduct from your employees’ pay – and where the money is supposed to go – is of vital importance in your payroll process.

Like all other business owners, you must collect federal payroll taxes for:

  • Federal income tax withholding
  • Social Security
  • Medicare

Federal income tax varies from employee to employee and is based on how many exemptions each one claims on his or her federal W-4 form. Since rarely are two employees’ incomes and exemptions equal, you must make careful calculations for each employee you have.

Your employees may also be responsible for taxes other than federal – such as state, school district, county and municipal taxes – and it’s your responsibility to collect them.

More than 40 states currently have state income tax. If you have employees who live in different areas or different states, then your employees’ taxes may differ from person to person.

7. Plan how you’ll track hours worked and time off.

Consider how you’ll collect or transfer timecard data into your payroll process and how you’ll handle things like overtime and paid time off (for holidays, vacations, sick days and personal days).

You may find that several government agencies have different record retention rules regarding payroll data.  You should review federal, state and local rules and retain information accordingly. 

8. Calculate payroll, and don’t forget deductions.

Whether you have hourly or salaried employees, you must figure out who is getting paid what amount.

Once gross pay is calculated for each employee, subtract:

  • The federal withholding based on their W-4 Form
  • Then state and local taxes (if applicable)
  • Then Social Security and Medicare taxes

Next up, consider any “fringe benefits,” such as:

  • Health insurance
  • Life insurance
  • A retirement plan
  • An employee stock purchase plan

These contributions, or voluntary payroll deductions, must be properly taken out of employee paychecks with either pre-tax or post-tax dollars, depending on the classification of the benefit being paid for.

Non-voluntary deductions include garnishments and child support payments. These government-mandated deductions, if you don’t comply with them, can result in costly penalties.

9. Test and run your first payroll.

Now that you have all your information calculated and collected, you can run your first payroll and actually pay your employees.

It’s wise to begin with a trial run (or two) before your employees’ real payday, so you can double check your calculations and make sure everything seems right.

If you’re generating the payroll, you’ll enter the numbers yourself, depending on the system you’ve chosen. If you’re outsourcing this task, you’ll hand over the pertinent information to whomever is handling the payroll process.

10. Remit and report payroll taxes to the proper authorities. 

To complete each payroll process, you must deposit the taxes you withheld and report them to the IRS and your state tax department (if applicable).

There are also several payroll tax reports you are responsible for submitting to local, state and federal entities at different times throughout the year and W-2s to generate each year for employees.

Using a payroll service helps you automate these responsibilities.

Don’t forget to keep track of your tax payments and filings for three years (or longer if your state requires it).

Correct and consistent payroll

Ten steps are all it takes to establish a reliable payroll process for your new business. Automating the process will ensure your company remains in compliance with complex tax laws and government regulations, and your employees are paid consistently and correctly.

Want to know more about how a company like Insperity can help you tackle your HR to-do list? Download our complimentary e-book: HR outsourcing: a step-by-step guide to professional employer organizations (PEOs).



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