How to run payroll: setup, options, and compliance

Executive overview

Many small businesses treat payroll as an afterthought until a mistake triggers penalties. Payroll is a legal obligation from the moment you hire your first employee. You have three options: DIY, hire an accountant, or use a payroll service provider. Each has a distinct cost-reliability tradeoff.

The right payroll option depends on your headcount, risk tolerance, and budget — but the setup steps are the same regardless.

Three payroll options

• DIY: cheapest, suitable for small teams early on, but error-prone and unscalable as headcount grows
• Accountant: most accurate and compliant; most expensive, whether in-house or outsourced
• Payroll service provider: middle ground — more reliable than DIY, cheaper than an accountant; most integrate with an HRIS to automate forms, time tracking, and tax filing

Setting up payroll: three steps

1. Register for an EIN — the IRS requires an Employer Identification Number to file taxes; some states also require a separate state/local ID
2. Collect employee W-4s — determines each employee's filing status and dependents, used to calculate withholding; distribute before first payday
3. Choose a pay schedule — four options: monthly, semi-monthly, bi-weekly, weekly; bi-weekly is recommended for most businesses because the FLSA calculates overtime weekly and most insurance premiums are monthly

Additional setup considerations:

• Workers' compensation insurance is mandatory in every state except Texas
• Decide on benefits to plan pre-tax deductions
• Open a dedicated payroll bank account separate from your general business account

Running payroll: five steps

1. Calculate hours and gross pay — exempt (salaried) workers: annual salary ÷ pay periods; non-exempt (hourly): hours × rate, plus overtime at 1.5×; include stipends, bonuses, tips
2. Deduct benefits and withhold taxes — subtract pre-tax deductions (health premiums, HSA, 401k) first; then withhold federal, state, and local income tax, Social Security, and Medicare based on W-4; finally subtract post-tax deductions (Roth IRA, garnishments)
3. Pay employees — net pay via direct deposit, check, or cash; most states require a pay stub detailing hours, rate, deductions, and withholdings
4. Pay and file taxes — deposit payroll taxes monthly or semi-weekly; file Form 941 quarterly (employer share of federal taxes); file Form 940 annually (FUTA unemployment tax); furnish W-2s to employees each year
5. Maintain records — federal law requires payroll records for at least 4 years (IRS) and wage records for 2 years (Department of Labor); records must include EIN, payment amounts and dates, employee SSNs, W-4s, tax deposits, and copies of filed returns