How Does Payroll Processing Work?

A company’s payroll is normally processed by its HR personnel, either by HR generalists or dedicated payroll specialists. However, it’s also possible for a company to outsource this processing function to a third-party payroll service provider (PSP). This is particularly common when expanding to a new international location and wanting to streamline back-office functions. For example, it is common for global businesses that set up a Wholly Foreign-Owned Subsidiary in China to outsource payroll. 

In either case, payroll processing can be broken down into three distinct stages: pre-payroll activities, active payroll process, and post-payroll activities. Here’s how each of these stages works:

1. Pre-payroll activities

Pre-payroll activities include everything necessary to set up and manage a payroll process. These actions are normally performed by payroll managers in conjunction with the VP of Finance or even the chief financial officer (CFO) of a company. Here are the most common activities needed to set up a payroll process:

• Obtain Employer Authorization: In most countries businesses need to register with the authorities as an employer before they can onboard team members to payroll.  In the United States, for example, this is called the employer identification number (EIN). This is in addition to any tax ID number and business registrations which recognize your business as a legal entity. The EIN allows your business to pay taxes and withhold taxes from your employees.
• Register for Social Security: It’s critical to register your business with the social security authorities (the Social Security Administration (SSA) in the US) so that you can hire employees legally. Registration allows you to deduct contributions from your employees’ salaries and pay your mandatory employer contributions to social security programs.
• Choose a pay period: You’ll need to decide how often to pay your employees. You may be able to choose from daily, weekly, bi-weekly, semi-monthly, or monthly periods. However, this period might be pre-set by local laws or enshrined in collective agreements. Longer pay periods benefit employers by allowing them to save the resources needed to process payroll frequently. Shorter periods benefit employees by giving them quicker access to their wages.
• Set a payment method: A business will need to choose how it will pay its employees. Since actual cash payments are highly impractical and difficult to trace, companies normally choose to pay by direct deposit into employees’ accounts, by check, or using pay cards. In some countries, paying in cash is not even permitted. 
• Set payroll policies: A company’s payroll policies are highly influenced by labor laws, which determine how and how often employees need to be paid. However, it may also need to set its own punitive rules (lateness, absences, etc.) or incentives (bonuses, commissions, etc.), which will help define how much each employee’s gross pay is in each pay period.
• Implement a payroll system: You’ll need to choose a system for collecting and recording data and calculating pay. These days, this is often done using payroll software. The payroll system will either be implemented in-house by HR staff or by a third-party PSP.
• Collect data: You’ll need to collect the personal information from your employees (account numbers, tax IDs, social security numbers, etc.) from your employees so you can pay them. You’ll also need to set up a system for reporting their hours worked so you can pay them accurately.

Active payroll process

Once a payroll system is in place and management decisions are in place, actual payroll processing can be performed regularly. The main activities involved in processing payroll regularly include:

• Validating data: A system of checks and balances will allow your payroll staff to cross-check the data they receive about hours worked, overtime, bonuses, benefits, and deductions. Before they can do their calculations, they need to ensure this data is correct, or staff will be under- or overpaid. 
• Calculating gross pay: An employee’s gross pay is how much they should receive for the hours they worked during the pay period at their standard rate of pay.
• Determining additions: If an employee works overtime, earns a bonus, needs to be compensated for out-of-pocket expenses, or deserves an allowance, these amounts need to be calculated and added to gross pay.
• Determining deductions: Employers are normally responsible for withholding tax and social contributions from each employee’s salary. Court-ordered wage garnishments may also need to be withheld, and these amounts are subtracted to produce the net pay amounts that each employee should be paid.
• Issuing payments of net pay: Once you’ve calculated net pay, you need to issue these payments to all employees. This entails issuing paychecks in the employee’s name, issuing a pay card, or transferring funds to their bank account.
• Issuing payslips: Employers are legally required to issue payslips, also called pay stubs, to their employees for every pay period. These pay slips show each employee their pay breakdown and let them check its accuracy.

Post-Payroll activities

While the active payroll process is the main focus of payroll processing, that’s not all there is to it. Once pay has been issued to employees, there are still several activities that payroll professionals need to do to complete the process.

• Paying taxes and social contributions: Employees’ tax and social security deductions will have already been calculated so now it’s time to submit these payments to the appropriate authorities. This includes the contributions that employers must make as well. Payroll staff send these payments and submit reports to the relevant government agencies.
• Keeping records: Payroll staff are responsible for keeping all the data for processing payments and producing records of them for future reference. Payroll software usually stores all of these records automatically, but you should also back up this data to make sure it doesn’t get lost or corrupted.
• Producing internal reports: The finance department of every company needs to have accurate payroll figures in order to make their calculations and decisions. Payroll staff, therefore, need to produce reports showing payroll totals and breaking down expenses accurately.
• Auditing: It’s crucial to occasionally audit payroll to ensure that it’s being performed correctly. Overpaying employees can be a big source of lost revenue for any business. Likewise, underpaying employees or making incorrect tax and social security contributions can lead to fines or even legal action. 
• Monitoring compliance: New laws and regulations may require you to make changes to your payroll process. It’s important for payroll staff to keep abreast of any new laws that could affect how and how much employees get paid.