What is payroll tax? A plain-English guide for business owners

Hiring your first employee is an exciting milestone — and it also comes with real, recurring financial obligations: payroll and payroll taxes. 

To understand the ins and outs of payroll taxes, you’ll need to get informed about federal and state rules, withholding requirements, deposit schedules, tax forms, and penalties (if you miss a deadline). For many founders and early finance operators, this process begins with a straightforward question: What even is payroll tax?

In this article, we’ll break down what payroll tax is, how it works for employers, and what you need to know to stay compliant as your team grows.

“Payroll tax” refers to taxes that employers must withhold, pay, or remit because they have employees on payroll. It isn’t just one tax, but rather it’s a category of wage-related taxes with different rules, rates, and responsibilities. Payroll taxes are collected to fund government assistance programs, including Social Security and Medicare.

The cost of payroll tax is split evenly between employees and employers.

Payroll taxes fall into three categories:

1. Employee-paid taxes: These are taxes that the employer withholds from the employee's paycheck and remits. This includes federal income tax withholding. 
2. Employer-paid taxes: These are costs the business pays in addition to gross wages. They include federal unemployment tax (FUTA) and, often, state unemployment tax.
3. Shared taxes: These are costs that the employee and employer share. Examples include Social Security and Medicare taxes. Employees pay these taxes through withholding, and employers pay a matching amount.

Reminder: When budgeting to hire a new employee, keep in mind that the business costs extend beyond their salary alone. You’ll also need to budget for employer payroll taxes, benefits, payroll software, workers’ compensation, and other costs.

You might be wondering, “How much is payroll tax?” To calculate this, you’ll need to understand both what taxes your employees are responsible for (through withholding) and what taxes you’re responsible for as the employer. 

Withholding

As an employer, you’ll withhold certain taxes from the employee’s wages, then remit that money to the government. (So, for employees, withholding reduces their take-home pay.) 

Employer cost

At the federal level, the main employer payroll tax costs in 2026 include:

• Social Security: 6.2% of wages up to the wage base of $184,500 per employee
• Medicare: 1.45% of all wages, with no wage base limit
• FUTA: 6.0% only on the first $7,000 of wages per employee

Employee cost

Employers and employees split the cost for certain payroll taxes. At the federal level, employees are responsible for paying these taxes (at the same rate as employers):

• Social Security: 6.2% of wages up to the wage base of $184,500
• Medicare: 1.45% of all wages, with no wage base limit

Example: How to calculate payroll tax

Wondering how to calculate payroll tax? Here’s an example.

Sample scenario: An employee earns $5,000 in gross wages for a pay period. 

Before paying the employee, the employer will withhold certain taxes from their paycheck for that pay period. These withholdings may include federal income tax, plus the employee’s share of Social Security and Medicare.

The employee’s tax share

The employee’s take-home pay is $5,000 in gross wages minus any tax withholdings and other deductions, such as health benefits.

For Social Security and Medicare, the employee’s share of these taxes would be: 

• Social Security tax: $5,000 × 6.2% = $310
• Medicare tax: $5,000 × 1.45% = $72.50

The employer’s tax share

The employer also owes its own payroll taxes for that same paycheck. In this example, the employer would likely owe:

• Social Security tax: $5,000 × 6.2% = $310
• Medicare tax: $5,000 × 1.45% = $72.50
• FUTA: until the employee reaches the annual FUTA wage base
• State unemployment and payroll taxes: as applicable, based on local requirements

Takeaway: A $5,000 paycheck will involve multiple cash movements to cover wages and various tax requirements. So, it's important to plan for this process and the associated business costs before payday rolls around.

One common misconception is that your payroll tax deposit schedule is based on how often you run payroll. It isn’t.

An employer’s payroll tax deposit schedule is generally based on the amount of employment tax that the business reported during what the IRS calls a “lookback period.” The IRS will determine whether an employer needs to deposit payroll taxes on a monthly or semiweekly basis, depending on the amount of taxes that the business reported during that timeframe. For most businesses, the payroll tax lookback period is the 12-month period from July 1 of two years ago through June 30 of last year.

In general, employers that reported $50,000 or less in employment taxes during the lookback period will be considered monthly depositors, and employers that reported more than $50,000 in employment taxes during the lookback period will be considered semiweekly depositors.

There’s also a $100,000 next-day deposit rule to factor in: If an employer accumulates $100,000 or more in employment tax liability on any day during a deposit period, they must deposit by the next business day.

Depositing and reporting are related, but they aren’t the same thing: 

• Depositing: Employers are required to deposit federal income tax withholding, Social Security taxes, and Medicare taxes according to their required deposit schedule. Deposits are payments made during the quarter. 
• Reporting: Reporting is how you tell the IRS what happened. 

Businesses will likely need to report local and federal taxes, depending on the company’s size and location, using these forms:

• Federal tax forms: Most employers report federal payroll taxes quarterly using Form 941, Employer’s Quarterly Federal Tax Return, but some small employers may be eligible to file Form 944, Employer’s Annual Federal Tax Return instead.
• State tax forms: State agencies may have their own filing requirements and payment schedules. 

Remember: Payroll tax filings are one part of a broader tax calendar, so it can help to build a year-round process for gathering records, reconciling accounts, and preparing for tax season.

Payroll taxes can be complex, especially for new companies. Here are a few common mistakes. 

Misclassifying workers

For tax purposes, employees and independent contractors are treated differently. For instance, for workers who are classified as employees (or should be), the business may be responsible for payroll taxes, wage rules, and benefits obligations.

Missing deposit deadlines

Payroll tax deposits are time-sensitive. Filing Form 941 at the end of the quarter doesn’t replace the need to deposit taxes during the quarter, too.

Forgetting to file state taxes

Federal payroll tax is only part of the picture. State unemployment tax, state income tax withholding, and local payroll taxes might also apply.

Curious about what state taxes your company might be responsible for? Learn more in our article on state taxes for startups.

Confusing gross wages with total employer cost 

Hiring costs extend beyond an employee’s salary. Be sure to factor in employer payroll taxes and benefits, since these can materially change your budget.

Treating withheld taxes like working capital 

Employee withholdings should be handled with care. Your business will collect these funds to submit to tax authorities. Don’t be tempted to hold them as flexible company cash.

If you’re worried about other potential errors, read our guide to common financial pitfalls to avoid.

Before you run payroll, make sure the basics are covered with this checklist:

• Classify workers correctly: Decide whether each worker is an employee or independent contractor, based on your actual working relationship.
• Collect required forms: Employees generally need to complete Form W-4, so you know the correct amount of federal income tax to withhold from the employee’s paycheck.
• Withhold applicable taxes: Withhold federal income tax, employee Social Security and Medicare, and applicable state or local taxes.
• Budget for employer taxes: Plan for your employer share of Social Security and Medicare, FUTA, state unemployment tax, and any local payroll taxes.
• Confirm your deposit schedule: Confirm whether you’re a monthly or semiweekly depositor, and watch for the $100,000 next-day deposit rule as your payroll grows.
• File the right forms: Most employers use Form 941 quarterly for federal employment taxes. Some small employers might use Form 944, if directed by the IRS.

With the right knowledge and systems in place, managing payroll tax can become a routine part of running a healthy, scalable company.

For business owners, the goal here isn’t to become a payroll tax expert overnight, but to build a system that keeps every pay run accurate, every deadline visible, and every dollar accounted for before it leaves your business. 

Having the right financial setup can help make your day-to-day processes feel more manageable. Mercury helps companies bring banking, cards, and financial workflows into one place, giving finance teams more visibility into how money moves through the business. If you’re setting up payroll for the first time or looking to streamline your current process, explore payroll tools in Mercury’s software stack, learn how to set up payroll directly within Mercury, and see how Mercury’s acquisition of CentralHQ, an AI-native payroll, benefits, and compliance platform for startups, means expanded support for global teams and payroll workflows.

This article is for informational purposes only and isn't tax advice. Verify current rates with the IRS and your local state agencies, and consult a qualified professional for your specific situation.