What is a payroll and how is it calculated?

PayrollIn a functional accounting sense, "payroll" consists of an employer's activities related to the compensation it pays to its employees (payroll accounting, payroll tax return preparation, benefits administration).

However, the term "payroll" is also used broadly to refer to the dollar amount of an employer's liability for cash wages he must pay to his employees (as in "my company's total annual payroll is $100,000.") In this sense "payroll" refers to the employee compensation expense of a business.

Payroll for a given employee is calculated as follows:

1. Start with Gross Pay

For a salaried employee, gross pay equals the employee's flat salary per pay period.

For an hourly employee, gross pay equals the number of hours worked multiplied by his hourly rate. If the employee works overtime, or has more than one hourly rate, multiply the applicable hours by those special rates.

2. Subtract deductions from gross pay to arrive at the employee's net pay.

Some major deductions are:

Income taxes - Federal, State and Local, if applicable (also

called "withholding taxes")

Social Security and Medicare tax

Employee contributions to the state's

unemployment or worker's compensation

fund (if applicable)

Deductions for employee benefits (Medical/401(k)

plan contributions, etc.)

Wage garnishments (often calculated as a

percentage of gross salary)

3. After all deductions have been made, the amount left over is the employee's net pay.

This process is easily automated, and there are a variety of software packages to handle payroll processing.

There are also "widgets" and free websites that can be used in a pinch to calculate employee paychecks.

Large companies will usually want to use payroll service bureaus, such as ADP. They can also handle the various payroll tax reporting and deposit requirements, which can be quite complex.

There are different models for forecasting future payroll expense, but the simplest way is to multiply expected average headcount for the future period by the current average compensation rate, and then multiply the product by the average percent wage increase to be effective in the future period. But this assumes that the range of salaries is fairly evenly distributed among the current employees, and that future headcount will reflect a similar salary distribution range.