How payroll works: From timesheets to direct deposit

From an employee’s point of view, getting a paycheck may look simple: Money appears in their bank account every other week (or at another regular cadence), and that’s that. But behind that deposit, there’s a chain of calculations, approvals, payments, and filings that the employer needs to handle every pay cycle.

For a founder making their first few hires, the payroll process can feel especially opaque. There’s sensitive data to collect and organize, along with wages, taxes, and other information that needs to be calculated and reported correctly. Understanding how the process works can help you pay employees reliably and build a financial process that holds up as your team grows. Here we dive into what you need to know to get started.

Payroll processing is the recurring process businesses use to calculate employee compensation, withhold required taxes and deductions, pay employees, and document those transactions.

How it works

The payroll process looks like this:

1. Gather employee and compensation information.
2. Calculate each employee’s hours worked (if applicable) and earnings.
3. Calculate gross pay.
4. Factor in taxes and deductions.
5. Review payroll.
6. Send employee payments.
7. Submit tax deposits and filings.
8. Update your records.

For more details on how to run payroll, read our step-by-step guide to payroll.

Taxes and reporting

Payroll procedures cover more than just whether everyone gets paid on time. For U.S. employers, payroll also carries tax and reporting obligations, such as withholding federal income tax from employee wages, withholding and paying Social Security and Medicare taxes, and paying applicable unemployment taxes.

A reliable payroll process also helps you:

• Pay employees accurately and consistently.
• Withhold and remit the right taxes.
• Meet federal, state, and local requirements.
• Maintain payroll records.

For more information on payroll tax, read our plain-English payroll tax guide for business owners.

So, how does payroll work? The process begins long before payday. Here are the typical steps in the payroll process.

1. Choose a payroll schedule

Your payroll schedule determines how often employees are paid and sets the rhythm for everything that follows, from timesheet deadlines to tax calculations.

Common payroll schedules include:

• Weekly: 52 paychecks per year (This is common for hourly teams but requires more frequent processing.)
• Biweekly: every two weeks, or 26 pay periods per year.
• Semimonthly: twice per month (such as the 15th and last day), totaling 24 pay periods
• Monthly: 12 paychecks per year, with fewer runs but longer gaps between paydays

Choose a cycle that fits your cash flow, workforce, and administrative capacity, and confirm what the relevant state wage-payment rules are before finalizing.

Once you’ve set a schedule, stick with it. Employees plan bills and other expenses around predictable paydays.

2. Collect employee payroll information

Before you can process payroll, you’ll need accurate employee information. For new hires, this typically includes identifying details and federal Form W-4, which determines federal income tax withholding. Depending on location, you may also need state withholding forms or other onboarding documents.

You’ll also need:

• Salary or hourly wage
• Direct deposit information
• Benefit elections
• Payroll deductions
• Paid time off (PTO) balances
• Work location
• Bonus or commission terms

If you’re working from compensation information, tax forms, or banking details that are incorrect, you could end up processing a paycheck that’s incorrect, even if your calculations are correct.

3. Track employee time and earnings

Next, determine what each employee earned during the payroll cycle. For salaried employees, this is usually straightforward. For hourly workers, accurate payroll depends on accurate time records. Employers covered by the Fair Labor Standards Act must keep wage and hour records for nonexempt employees.

Payroll inputs may include:

• Regular hours
• Overtime
• Paid time off
• Sick leave
• Bonuses
• Commissions
• Tips
• Other forms of compensation

Reimbursements may also be included, though they’re often handled differently for tax and accounting purposes. And keep in mind that missed or inaccurate timesheets lead to payroll errors.

4. Calculate payroll

Once you’ve finalized the inputs, you can calculate what each employee should receive. Start with gross pay (the employee’s total earnings before taxes and deductions).

From there, subtract required withholdings, such as federal and state income tax, Social Security and Medicare taxes, benefits, and retirement contributions. Federal income tax withholding is based on the employee’s Form W-4 and IRS rules. Employers also pay their own share of payroll taxes, including Social Security and Medicare.

After all deductions have been taken out, you’ll arrive at net pay (the amount the employee actually receives). Here’s the formula for calculating net pay:

Gross pay − taxes and deductions = net pay

This number should always be reviewed before payments are sent.

For more information on calculating payroll deductions, read our payroll deductions guide for employers.

5. Review and approve payroll

A payroll review is your last chance to catch errors before employees are paid. Check for any new hires or terminations, and review hours worked, pay rate changes, bonuses, deductions, tax withholdings, and total payroll versus prior periods. Also confirm that you have enough cash to cover the run.

In a small startup, the founder may handle this step. As the company grows, payroll is often split between a preparer and an approver.

Remember to flag anything unusual. If payroll normally runs $45,000 but suddenly reaches $60,000, understand why before approving it.

6. Pay employees

After you’ve reviewed and approved payroll, it’s time to send employees their net pay. Common payment methods include direct deposit, paper checks, and payroll cards. Direct deposit can simplify the process, since it’s a way to initiate payments electronically.

Your payroll provider or financial institution may need payment information several business days before payday, so build your processing deadlines backward from the payment date. Your payroll calendar should show when timesheets are due, payroll gets reviewed, payments are initiated, and employees get paid.

7. Deposit payroll taxes and file required reports

Payroll doesn’t end when employees are paid. Employers must also deposit withheld payroll taxes and their own employer taxes.

The federal deposit schedule that your business needs to follow will depend on tax liability, and most employers use Form 941 to report income tax withholding and Social Security and Medicare taxes each quarter. State and local payroll taxes may also apply.

At year-end, employers issue Form W-2 to employees and file copies with the Social Security Administration, generally by January 31. These deadlines should be built into your ongoing payroll process, rather than treated as a year-end task.

8. Maintain payroll records

After payroll is complete, keep clear records of what was paid and why. This typically includes:

• Payroll registers
• Employee tax forms
• Pay statements
• Time records
• Compensation changes
• Benefits deductions
• Payroll tax deposits and filings

Retention requirements vary by record type and jurisdiction. The IRS generally requires employers to keep employment tax records for at least four years, and local wage-and-hour laws may impose additional requirements.

Good records can help you resolve employee questions, support your accountant, and provide a paper trail, if you need to correct an error later.

Payroll mistakes are often small process gaps that compound, such as an outdated salary, missed timesheet, forgotten bonus, or overlooked deadline.

Common payroll problems include:

• Entering incorrect employee information
• Processing payroll too late
• Miscalculating hours or overtime
• Missing compensation changes
• Applying incorrect deductions
• Missing payroll tax deadlines
• Keeping incomplete payroll records
• Changing payroll schedules inconsistently
• Skipping the final payroll review

Establishing clear ownership can prevent many of these issues. Your team should know who collects inputs, reviews and approves payroll, and confirms that tax filings and payments are complete.

You can process payroll manually, but it can quickly become time-consuming as your team grows. By using payroll software, you can automate payroll processes, including wage calculations, tax withholding, direct deposits, reporting, and employee access to pay information. Many tools also integrate with benefits, time tracking, HR, and compliance workflows, tools, and systems.

Using automation doesn’t mean you’re removing the need for oversight. Instead, it shifts your role (or your team’s roles) from doing calculations to reviewing inputs, rules, and exceptions.

A reliable payroll process should eventually become boring: Payday arrives, employees get paid, and you don't have to think much about it.

Payroll software can take much of the manual work out of the process, and connected financial tools can give you a clearer view of the cash needed to fund it. To do so, Mercury integrates with payroll and HR platforms like Gusto, Deel, and Rippling, and payroll providers can be funded directly from a Mercury checking account using supported payment methods. This helps founders tie payroll into the broader financial system they already use to run their company. Learn more about how Mercury can help.