If you’re like many business owners, the mere thought of setting up payroll may seem like an insurmountable task. After all, there are a lot of things to figure out, and numerous micro-tasks associated with each that must be completed before you can run payroll for the first time. The good news is that with a good understanding of how the payroll system works, and a clear outline of the steps required to set things up, it’s a lot easier than you probably think.

Here’s everything you need to know about how to set up payroll for your business.

How does the payroll process work?

While setting up payroll requires several steps – some of which will take some time depending on where you are in that process – payroll itself is actually quite straightforward. All you need to do is:

  1. Calculate the pay of each employee based on the number of hours worked
  2. Process deductions
  3. Make the payment, either electronically or by cutting an actual check

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How to set up your payroll

Setting up payroll involves collecting information, as well as making important decisions about your business and your employees.

1. Gather all the essential payroll information

This means you’ll need to apply for an Employer Identification Number (EIN) from the IRS. This unique number identifies your business, and is required for both tax reporting and sending related information to the government. In order to pay federal taxes, you’ll also need to register for an Electronic Federal Tax Payment System (EFTPS) account.

In addition, you’ll need:

  • A state new hire reporting account
  • Workers’ compensation insurance
  • And depending on your location, a local or state tax ID number

Besides registering for these accounts, you’ll need to collect relevant information from your employees. They’ll need to complete the Personal Allowances Worksheet (Form W-4) so that you can calculate the amount of federal income tax withholding to deduct from their wages. They may also need to fill out a state Form W-4, depending on the location of your business. Workers who are considered independent contractors will need to fill out a Form W-9, a request for taxpayer identification number and certification.

2. Determine how everyone will be paid

In setting up your payroll process, you’ll also need to make several important decisions regarding your employees and how they will be paid.

To start, you need to figure out if the people who work for you should be considered employees or independent contractors. This is an important distinction to make, as incorrectly identifying workers can result in IRS penalties. The IRS suggests looking at the entire relationship between you and the person to make this a determination, based on three major factors:

  • Behavioral: Does the company have a right to control what the workers do and how he or she does his or her job?
  • Financial: Does the company control the business aspects of the workers’ job, such as how the worker is paid, who provides supplies and whether expenses are reimbursed?
  • Relationship: Is the relationship ongoing? Is the work that is performed a key aspect of the business? Is the worker offered benefits? Is there a written working contract?

Once you make that determination for each of your workers, you then need to see if your employees qualify for exemption status.

  • To be exempt from overtime wages, an employee must earn a salary, have certain job duties, and earn a minimum of $23,600 per year. Employees who do not meet these criteria are nonexempt and must be paid for any overtime hours worked.

Next, you have to decide how you’ll pay your employees:

  • Exempt employees must receive a salary
  • Nonexempt employees can be paid either a salary or hourly wages
  • Less common payment options include commissions and by the piece.

In addition, you’ll need to decide:

  • How frequently employees will get paid. Common pay periods include weekly, biweekly, semimonthly, and monthly.
  • Whether you’re going to offer optional employee benefits such health insurance, disability insurance, and/or retirement plans.

3. Decide whether you’re going to process payroll in-house or outsource it

Once you decide what types of wages to pay, pay rates and the frequency of payments, the next major decision you’ll have to make is determining how you’re going to run payroll. Some business owners choose to run it manually, while others use an online payroll service or outsource the payroll processing to an accountant or top payroll agencies.

If you have a small number of employees, you may be able to run payroll yourself. With more employees, however, it could wind up being a very time-consuming process.

Payroll software can help automate the payroll process and save valuable time. A few of the most popular online payroll services include Gusto, Intuit Full Service Payroll, and Paycor Perform.

Many business owners use Professional Service Organizations (PEOs), which aid small businesses in managing human resources and payroll. While the services rendered can be on the expensive side, they provide employees with added benefits including paid vacations and employee assistance programs. Popular PEOs include Paychex, Justworks, and TriNet.

Once you’ve finally worked through everything outlined above, you’re finally ready to run payroll.

How to run payroll

  • To begin, you’ll need to calculate the number of hours worked by your employees. You can keep track of how many hours employees spend working using attendance software, or by requiring employees to write down when they start and finish working – and then manually counting the hours.
  • You then have to calculate gross pay by multiplying the hours worked by the hourly rate. Overtime hours, in the case of nonexempt employees, will be multiplied by the overtime pay rate of the employee, which is 1.5 times the regular hourly rate. Once you add the results together, you’ll have the gross pay for that employee.
  • The next step is to convert gross earnings into net pay by processing all the necessary deductions, including payroll taxes, federal unemployment taxes, and Social Security, as well as contributions to healthcare and retirement plans (if applicable).  To calculate an employee’s net pay, you’ll simply subtract the total of these deductions from the gross pay.
  • Once you have calculated net payment amounts for all employees on payroll, you can then process everything. Before you do, however, be sure to double-check your calculations if you did them manually, and your inputs if you used payroll software.

Paying your employees

You have a few different options available when it comes to actually paying your employees:

  1. You can manually write or print payroll checks
  2. You can deposit the funds directly into their bank accounts

For the latter, this means that you’ll need to obtain bank account details for each employee, however, as well as ensure your payroll bank account is adequately funded when everything is being processed.

For employees without bank accounts, you can use payroll cards.

The benefits of payroll software

Payroll software makes the process of paying your employees much more simplistic and streamlined. Once you sign up for an account, you’ll simply add in basic information about your business and tax information, link your payroll bank account with the software, select your pay frequency and payday, and sign the necessary company forms to authorize the payments.

Once the setup process is complete, it’s simply a matter of adding employees, inputting the number of hours worked by each, and running the software. It will automatically calculate the gross and net pay, and deliver the payment to each employee through direct deposit.

How to handle payroll taxes

Primary payroll taxes include federal income tax, state income tax (if applicable) Social Security, Medicare, and unemployment taxes. You’ll be able to calculate the amount of taxes that need to be withheld based on the information listed on your employees’ Form W-4.

Once you successfully determine the amount of taxes to withhold, you must then file specific tax forms with the IRS and deposit the money withheld to the government. Federal unemployment taxes should be deposited quarterly, while FICA taxes should be deposited either semi-weekly or monthly depending on your total tax liability in the past four-quarter period.

You’ll also need to report Federal income, Medicare, and Social Security taxes every quarter to the government on Form 941. Federal unemployment taxes should be reported on Form 940.

It is important to regularly file taxes on time to avoid getting fined by the IRS. If you need more information about payroll taxes, visit the IRS website, or contact a local tax agency.

How workers pay taxes

Employees will pay two main types of federal taxes, which collectively are known as the Federal Insurance Contributions Act (FICA). These are figured out by taking the employee’s earnings into account and also what they filled out on their Form W-4.

  • You are required to hold a part of Social Security taxes from employees’ wages, and you also pay a matching amount of this. For 2022, the Social Security payroll tax rate is 6.2% of the first $147,000 of wages. Wages in excess of that are not subject to Social Security tax. In 2023, the rate remains the same, but the taxable earnings increased to $160,200.
  • The other component of an employee’s FICA taxes is the Medicare tax. The 2022 rate is 1.45%, and that rate did not increase in 2023. Unlike Social Security taxes, though, there is no wage limit for Medicare taxes; it is figured on a dollar-for-dollar basis.

Workers who are considered independent contractors will need to figure these taxes out on their own. Additionally, they may be subject to self-employment taxes as well, depending on their own situation.

How to handle year-end taxes

At the end of each calendar year, you are required to prepare and file tax forms with the IRS not only for your business but also for each of your workers.

  • Those who are considered independent contractors will receive a 1099-MISC Form. This must be provided to all independent contractors by January 31 of the year following payment. Independent contractors have the responsibility of determining and filing their own taxes with the IRS, as taxes will not be taken out of their checks during payroll.
  • Those who are considered employees will need to receive a Form W-2. These forms will include their income, Social Security and Medicare tax that was withheld for the entire year in question.


Setting up – and running – a payroll system demands that you make thoughtful decisions about your business, as well as your employees. By following the steps outlined here, however, you’ll skip the learning curve that many small business owners face when they first begin the process.

The true keys to success lie in being thoughtful and thorough in your approach and double-checking everything for accuracy.  Trust us, the extra time you spend now setting things up the right way will save you countless hours of headaches down the road.