How to do payroll: A step-by-step guide for small business owners

Processing payroll is a task that has to be right every single time. Leave overtime off a paycheck, and you’ll hear about it within hours. Miss a federal tax deposit and the IRS can charge you a penalty — and  the notice might not arrive until weeks after you’ve moved on to the next pay cycle. Although the payroll process can seem complicated at first, you’ll follow the same basic steps every pay period. 

This guide will walk you through the essentials of how to do payroll for a small business and how small businesses stay compliant with payroll laws in the US — including choosing payroll software, setting up deductions and calculating gross pay, and figuring out your company’s direct-deposit schedule.

Processing payroll typically follows the same five steps every cycle. You’ll: 

1. Calculate what each employee earned.
2. Withhold the right taxes and deductions.
3. Pay the employee the remainder.
4. Send the withheld amounts to the correct tax agency.
5. Log everything you’ve done.

If you miss a step, the rest of the process will fall apart. If you make a mistake while calculating a deduction, for example, you’ll throw off the paycheck and your tax filing. Software can automate most of this, but it’s still important for you to understand how each step works, so you can spot potential errors before they become compliance risks.

If you’re figuring out how to start payroll for a small business, a few things need to be in place before your first payroll run. Here’s what you’ll need.

An employer identification number (EIN)

Your employer identification number (EIN) is how the IRS tracks your business’s tax filings. If you don’t have one yet, here’s how to get an EIN. It’s free and usually only takes a few minutes. 

State tax accounts

Most states require you to register separately for state income tax withholding (where applicable) and unemployment insurance.

Worker classification 

Decide whether each worker is an employee or an independent contractor. This isn’t optional paperwork. Misclassifying workers can trigger back taxes and penalties. 

A pay schedule

A pay schedule could be weekly, biweekly, semimonthly, or monthly. Some states legally require a minimum pay frequency, so check your state’s rules before you pick one.

Payroll policies

Before your first employee starts, you should have established payroll policies that address overtime rules, PTO accrual, and deduction structures.

Employee forms

You’ll need a completed Form W-4 and Form I-9 from every new hire. 

Most of the work involved in managing payroll happens before you process your first paycheck. Once these pieces are in place, processing payroll each cycle can take minutes, instead of hours. Here’s how to set up payroll for small businesses.

Step 1: Collect Form W-4 from each employee

This tells you how much federal income tax to withhold from their paycheck.

Step 2: Decide how you’ll pay employees

Direct deposit is faster and cheaper to administer than paper checks, though you’ll need employees’ bank details and a few days’ lead time to set it up.

Step 3: Set up benefits and deductions

Health insurance, retirement contributions, and any other pre- or post-tax deductions need to be configured before your first pay run.

Step 4: Choose how you’ll actually run payroll

You’ve got options for how to actually run payroll: You can do it manually, hire a payroll service, or use payroll software built for small teams. If you’re comparing options, check out Mercury’s payroll tools. If you bank with Mercury, you can also set up payroll directly from your account.

Once you’ve finished setting up everything you need to run payroll, the rest will become so routine that you’ll forget you ever wondered how to process payroll. It all starts with a few basic calculations. 

Step 1: Start with gross pay 

For hourly employees, multiply hours worked by their rate. If a nonexempt employee works more than 40 hours in a workweek, you’ll generally need to pay overtime at 1.5 times the employee's regular rate, according to the Fair Labor Standards Act (FLSA). 

For salaried employees, divide their annual salary by the number of pay periods. Add any bonuses or commissions earned during that pay period. Although supplemental wages may have special withholding rules, they're still considered taxable compensation.

Step 2: Figure out any relevant payroll deductions

To calculate payroll deductions, start by subtracting pre-tax deductions, like 401(k) contributions, health insurance premiums, and similar benefits. Many pre-tax deductions, such as traditional 401(k) contributions and certain employer-sponsored health insurance premiums, will reduce the employee’s taxable income for federal income tax purposes. The tax treatment varies by deduction.

Step 3: Calculate payroll tax withholdings 

Calculating payroll tax withholdings usually involves these steps. You’ll probably need to:

• Determine federal income tax withholding, based on the employee's Form W-4.
• Calculate Social Security and Medicare taxes.
• Figure out any applicable state or local income tax withholding.

Payroll software can help with this step. But if you're doing your payroll manually, be sure to check current IRS and state tax tables.

Note: Employers and employees are each responsible for paying 6.2% for Social Security up to the $184,500 wage base, and 1.45% each for Medicare, without a cap. Once the employee's wages go over the wage base for Social Security, you’ll both get to stop paying that tax for the year — but you’ll both still need to pay Medicare tax.

Step 4: Subtract any post-tax deductions

Post-tax deductions might include wage garnishments or charitable contributions. Once you've subtracted those amounts, you're ready to issue net pay.

Step 5: Issue net pay 

This is the employee's take-home pay — the amount that actually lands in their account or appears on their paycheck.

Learning how to do payroll yourself makes sense in certain circumstances, especially if you only have a handful of employees, use simple pay structures, and have time to personally double-check your calculations. To do so, you’ll need to:

• Track hours. 
• Calculate withholdings by hand or with IRS tables.
• Cut payments.
• File tax deposits on schedule.
• Keep records for at least four years.

If you’re just starting to figure out how to do payroll manually, you should know that there are some risks. Employer tax rates change, deposit deadlines are strict, and miscalculations can trigger an underpayment penalty. 

As your headcount grows past a few employees, so will the number of hours you spend manually running payroll each cycle. And this time cost will likely start to outweigh the amount you’d pay for payroll software. If that trade-off sounds familiar, automating payroll might make more sense for you.

With biweekly payroll, you’ll pay employees on the same day every two weeks. That works out to 26 pay periods a year, as compared to 52 pay periods for weekly payroll, 24 for semimonthly, or 12 for monthly. 

It’s not uncommon for the question, “How does biweekly payroll work?” to trip people up. Here’s what to remember:

• Semimonthly: This means twice a month (such as the 1st and 15th, for example, with pay dates that shift around weekends). 
• Biweekly: This means every two weeks on the same weekday, so it occasionally results in three paychecks in one month, instead of two. 

Most employers learning how to manage payroll for a small business choose to run payroll biweekly because it lines up cleanly with hourly time tracking.

How long it takes to process payroll will vary, depending on several factors, including your company’s size and whether you use a manual system or automated software. Payroll software automates the calculation and issuing steps and sometimes reduces payroll processing from several hours to just minutes, depending on the provider. Manual payroll, by contrast, typically takes more time and could leave less room to correct errors if an issue needs to be fixed before payday.

To understand how to do payroll for small businesses, you’ll need to master the nuances of a few key areas. These are as follows.

Minimum wage and overtime

Federal, state, and sometimes city minimum wage rules can all apply, and you’re required to abide by whichever rules result in the highest pay for employees. 

Worker classification

Revisit how each worker is classified periodically, especially as roles change within your company.

Payroll tax deposits

The IRS and most states require you to deposit withheld taxes on a set deposit schedule — either monthly or semiweekly, depending on your tax history during the lookback period. For information on the rates you’re responsible for, read this breakdown of the three main types of employer payroll taxes: Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and State Unemployment Tax Act (SUTA) rates.

State and local requirements

State and local requirements vary widely. So, be sure you understand all the requirements that apply to your business. This will help you run payroll without risking penalties. State business tax liabilities may include payroll-adjacent requirements that go beyond what the IRS requires.

Paystub rules

Many states require you to provide a paystub with specific details on every payment. These can include the employer’s name and address, pay period and payment dates, gross and net wages, total hours worked, and more. Anyone asking, “How does payroll work?” will need to pay close attention to these requirements.

Year-end forms

You’ll send W-2s to employees and the Social Security Administration, and you’ll send 1099s to contractors. Both of these forms are due by January 31 each year. 

To keep your business payroll compliant, make sure to prepare thoroughly for tax season alongside your payroll calendar every year, since deposit deadlines and filing deadlines often overlap.

Imagine you have an hourly employee working 40 hours per week at $25 per hour with no overtime. This person contributes 5% of their pay to a 401(k).

Here’s how their paycheck would break down:

• Gross pay: 40 hours x $25 per hour = $1,000
• 401(k) contribution: $1,000 x 5% = -$50
• Federal income tax withheld: Based on the employee’s W-4 and IRS withholding tables, you calculate that they owe -$95.
• Social Security (6.2%): $1,000 x 6.2% = -$62
• Medicare (1.45%): $1,000 x 1.45% = -$14.50
• Net pay: $1,000 − $50 − $95 − $62 − $14.50 = $778.50

As noted earlier, as the employer, you’ll also owe a matching Social Security and Medicare contribution, plus FUTA and SUTA. None of that comes out of the employee’s paycheck; it’s a separate employer cost on top of wages.

When you’re managing payroll, you’ll need to stay on top of all the details. Using payroll software can help keep you on track of them —  along with this checklist:

• Choose a pay schedule that matches your state’s requirements.
• Decide whether you want to pay employees via direct deposit or check.
• Collect W-4 and I-9 forms from every employee.
• Calculate gross pay, deductions, and taxes each cycle.
• Check deposit deadlines and pay employees on time. 
• Follow the required schedule for depositing withheld taxes. 
• File your quarterly and year-end payroll tax reports on time.
• Review your payroll process for errors or changes each cycle.
• Check federal and state tax rates every year, since these could change.
• Keep payroll records for at least four years.

Payroll mistakes rarely stay small. Missing a deposit or misclassifying a worker can become a problem that compounds the longer it goes unnoticed. Using payroll software can help your team prevent expensive mistakes and keep employees happy, too. Ready to explore your options? Check out Mercury’s payroll tools today.