How to conduct a payroll audit — and what to look for

Handling payroll might sound pretty straightforward: You simply need to pay the right people the right amount at the right time. But doing that consistently, without errors, involves a lot of moving parts. That’s because a business is always in motion. Employees join and leave, salaries change, staff members might earn a commission or work overtime, and benefits and tax withholding rates change. Payroll software can automate many of these calculations and payments, but it still relies on accurate inputs.

A payroll audit compares your payroll system with employee records, bank activity, tax filings, and books so you can catch discrepancies before they become bigger problems.

A payroll audit is the process of reviewing your company’s payroll records and processes to confirm that you’ve paid employees accurately, handled taxes and deductions correctly, and that payroll transactions match your financial records.

Auditing payroll means tracing the entire payroll process, from assessing the employees who need to be paid to tracking the cash leaving your bank account to, finally, reviewing the expenses that have been recorded in your general ledger.

When you conduct a payroll audit, here are some examples of what you could uncover:

• Former employees who are still active in payroll
• Incorrect salaries or hourly rates
• Missing or duplicate bonuses and commissions
• Incorrect hours or overtime
• Benefit or payroll deduction errors
• Incorrect tax withholding
• Payroll transactions that don’t reconcile with your bank account or books
• Missing or late tax filings and payments

If you’re newer to payroll, start by learning how payroll works, including how to calculate gross pay and withholding taxes, as well as how to issue net pay.

Payroll errors have an immediate impact. Whereas an accounting mistake elsewhere in your business ecosystem might sit unnoticed until month-end, when an employee is underpaid or sees the wrong deduction on their paycheck, they’re likely to notice right away. Conducting regular audits can help you catch those errors, as well as confirm that payroll reflects changes that have happened elsewhere in the company. For example, changes to staffing (like hiring new staff or terminations) and changes to pay (like raises and bonuses), mean the payroll needs to be updated. Also look for updates to benefits and worker classifications that could impact payroll.

Audits can also catch compliance issues. U.S. employers generally have responsibilities for withholding, depositing, and reporting federal income, Social Security, and Medicare taxes, as well as paying federal unemployment taxes, when applicable.

The need for doing consistent reviews will grow with your team. It’s easier to spot an unexpected payment when you have five employees with similar compensation structures, for instance. But when you have 50 employees who live across multiple states and have varying pay structures and benefits plans, discrepancies become harder to see.

There’s no required schedule for when you should do an internal payroll audit. You can include a basic payroll reconciliation in your regular financial close, for example, and run a more comprehensive audit annually.

Consider more frequent reviews during periods of rapid hiring, after switching payroll providers, or when your team rolls out other major changes that impact payroll.

Gather the records that show what you should have paid employees, as well as records of what you actually paid.

Depending on your business, you might need these records:

• Employee roster
• Offer letters, agreements, and compensation records
• Timesheets and paid time off (PTO) records
• Bonus and commission approvals
• Benefits elections
• Payroll registers
• Employee withholding forms
• Payroll tax filings and payment records
• Bank statements
• General ledger

The Internal Revenue Service (IRS) requires employers to keep employment tax records for at least four years after the tax becomes due or is paid, whichever is later. The Department of Labor also requires employers subject to the Fair Labor Standards Act to maintain certain wage and hour records for nonexempt employees.

With those records in hand, you can work through the payroll audit checklist below.

Use the steps below to trace payroll from employee records through payments, taxes, and your general ledger.

1. Verify everyone on your payroll

Start with your employee roster. Compare it with your payroll register to confirm that every active employee appears in payroll and that former employees are no longer receiving regular payments.

Pay particular attention to people who joined or left during the period you’re reviewing. Check their start and termination dates and verify any prorated salary, final wages, PTO payout, or other compensation. Look for duplicate employee profiles or payments, too.

2. Check employee classifications and payroll information

Confirm that each worker is correctly classified as an employee or independent contractor and, for employees, as exempt or nonexempt (where applicable). Classification affects wage-and-hour requirements and how you handle taxes.

Check the information that drives payroll, including tax information, salary or hourly rate, and department. Focus on new employees, recent changes, and records that don’t match your HR or accounting systems.

3. Review salaries, wages, bonuses, and other compensation

Compare the compensation in your payroll system with source documents, such as offer letters, compensation change approvals, and bonus or commission records.

Be sure to check these factors, too:

• Salary or hourly rate
• Raises and their effective dates
• Bonuses and commissions
• Other taxable compensation
• One-time or off-cycle payments

For any compensation change, trace the amount back to an approval, such as an official email or letter, rather than treating the payroll record itself as the source of truth.

4. Verify hours worked, overtime, and PTO

For hourly and other nonexempt employees, compare payroll against approved time records. Check regular hours, overtime, PTO, sick leave, and other time that affects wages. Investigate unusual changes between pay periods or hours that don’t match the underlying time records.

(As noted earlier, federal recordkeeping rules require covered employers to maintain records related to nonexempt employees’ hours and wages. The Department of Labor generally requires you to retain payroll records for at least three years.)

5. Check benefits and payroll deductions

Compare deductions with employee elections and supporting records. This may include health insurance premiums, retirement contributions, FSA or HSA contributions, and other deductions.It’s important to check these benefits and deductions, since small discrepancies can add up when they repeat across employees and pay periods.

To learn more about the ways common deductions can affect a paycheck, read our guide to payroll deductions.

6. Review payroll tax withholding and employer contributions

Check that payroll reflects employees’ current withholding information and correctly calculates applicable employer payroll taxes.

At the federal level, employers generally need to withhold federal income tax and the employee portion of Social Security and Medicare taxes. Employers also pay their share of Social Security and Medicare taxes and, when applicable, federal unemployment tax. State and local requirements vary.

Want to dive deeper? Our guides to payroll taxes and employer payroll tax rates cover the major components in more detail.

7. Reconcile payroll with your bank account and general ledger

To reconcile your accounts, compare what your payroll system says happened with the movement of actual cash. Match your payroll register against withdrawals from your business bank account. Depending on your bank, the employee net pay, taxes, benefits, and payroll fees may appear as separate transactions.

Then, compare payroll with your general ledger. Confirm that you’ve recorded wages, employer payroll taxes, benefits, and other payroll expenses in the correct accounts and periods.

You should be able to follow the same dollars across these three places:

Payroll records → bank activity → general ledger

If these three places don’t reconcile, find the difference. Common causes include:

• Timing differences
• Incorrect journal entries
• Duplicate payments
• Returned payments
• Payroll adjustments

8. Check payroll tax filings and payments

Finally, confirm that your team not only calculated payroll taxes, but also deposited and reported them. To do so, compare your payroll reports with tax payments and returns for the same period. Depending on your business, this could include federal Forms 941 and 940, as well as applicable state and local filings. Also, check that the payments cleared your bank account and the amounts agree with your payroll records.

Your payroll provider may automatically handle filings and deposits for you, but it’s still worth verifying periodically that the amounts and filings match your records.

Some discrepancies may be due to simple timing differences, but others could signal a payroll process that needs attention. Keep an eye out for repeating errors. If you’re making the same manual correction every pay period, look upstream at the payroll setup or workflow causing it.

If you find a payroll error, start by defining the scope:

1. Identify who the error affected.
2. Determine which pay periods are involved.
3. Check to see whether the error affects employee pay, taxes, benefits, accounting records, or several of these things.
4. Trace the error to its source. That could be an incorrect salary, missed termination, unpaid bonus, or incorrect general ledger entry, for example.
5. Correct the underlying record first, then address the effects. Depending on the error, that could mean issuing additional wages, handling an overpayment in accordance with applicable law, correcting a journal entry, amending a tax filing, or something else. For tax or compliance errors, your accountant, payroll provider, or tax professional can help determine the required correction.
6. Document the error, its cause, and how you fixed it. If the same issue has happened before, change the process that allowed it to recur.

To conduct an effective payroll audit, focus on the points where errors commonly show up: who gets paid, how much you pay them, what gets deducted, what gets sent to tax authorities, how much cash leaves the bank, and how those transactions appear in your books.

If you’re still setting up your process, read our guide on how to do payroll for a small business for a step-by-step process. If you don’t use a dedicated payroll platform, here’s what to know about paying employees without formal payroll software. As your team grows, you can automate more of your payroll process while keeping review and approval for the areas that need human judgment.

Doing regular payroll audits can help you identify — and fix — errors and ensure that your payroll process is working well. When you’ve got a smooth-running payroll system, you’ll have few surprises to deal with and better insight into your finances as your company grows.

^{This article is for informational purposes only and does not constitute legal, tax, investment, or financial advice. Founders should consult their own legal and financial advisors before making important financial decisions.}