10 Costly Payroll Mistakes to Avoid

Payroll is tricky, and you’re bound to run into a few obstacles trying to get it right. Every year, American employers make payroll mistakes that cost their businesses and employees. Civil penalties assessed by the IRS during fiscal year 2021 pertaining to employment taxes totaled nearly $6.84 billion.¹ Time card and tax errors, miscalculated time punches, or incorrect gross-to-net calculations affect employee paychecks. In addition, mistakes in withholding (W-2 reporting) and publishing employee pay data can encourage payroll fraud. Affected employees may also leave negative public employer reviews if they have not received their paychecks accurately or promptly.

We want to help you keep your employees happy, ensure payroll compliance, and stay on the right side of the law. There are numerous things that can — and do — go wrong in the payroll sphere. Here we’ll cover 10 common payroll mistakes businesses make.

Not setting up automatic payroll deductions

Every worker should receive all wages due when calculating payroll taxes like FICA (Social Security) and FUTA (unemployment). However, the IRS has specific guidelines about how much money you should withhold from each paycheck based on how many exemptions employees claim on their W-4s. This step of processing payroll is crucial if you have a remote workforce or don’t use a full-time payroll department.

To make it easier for employees to save money, offer the option of setting up automatic payroll deductions. This allows employees to have a set amount of money removed from each paycheck and the remainder deposited into a savings or investment account. Save your employees the headache by arranging it for them. In addition, employees can save on their income tax bills because their money comes out before taxes.

Exempt versus nonexempt classification

In the U.S., employers aren’t required to pay employees a specific rate for gross wages. However, if you have a set salary or hourly rate for employees, keep that information up to date. Your staff members  are either classified as exempt or nonexempt employees. This designation determines whether they’re eligible for overtime pay and other compensation.

If you misclassify a worker as exempt when they should be nonexempt, you risk running afoul of federal laws. The Fair Labor Standards Act (FLSA) requires covered (nonexempt) employees to receive overtime pay for every hour worked beyond 40 in a workweek.² Unless exempt, covered employees must receive overtime wages at a rate not less than 1.5 times their regular pay rates.

To simplify, some small businesses pay their entire staff a salary. Treating everyone as exempt streamlines payroll records from an administrative perspective and can save the company money when paying employees. After all, exempt employees don’t receive overtime pay, and it’s easier to pay fixed salaries instead of tracking and paying for hours worked. But by automatically classifying everyone as salaried-exempt without considering their job duties, business owners risk violating federal and state wage-and-hour laws. The FLSA and states have strict rules for classifying employees, and states set their own minimum wage. Rules can be difficult to interpret, so when in doubt, defer to legal expertise to avoid misclassifying employees. Also know that independent contractors are not considered employees and are classified differently.

Payroll fraud

Payroll fraud happens frequently in small businesses. It can be committed by:

• Employers engaging in wage theft.
• Employees working in the payroll department.
• Third parties, such as cybercriminals, carrying out payroll diversion schemes.³

The impact can be especially damaging to small business owners, who typically are not financially equipped to withstand scams. To guard your small business against payroll fraud, implement strong internal payroll controls. Conduct routine payroll evaluations and audits, segregate payroll duties, provide cybersecurity awareness training, and promote ethical/legal payroll practices.

Timekeeping mistakes

Federal law doesn’t require use of a specific job-related timekeeping system. But it does mandate that all nonexempt employees be paid for all hours worked. If this is violated, the U.S. Department of Labor will pursue repayment from employers to pay back wages. Implementing a payroll software timekeeping system can help ensure accurate pay records and compliance and prevent common payroll errors such as this.

Leaving out PTO, bank holidays, and vacation time

When calculating your payroll, remember to factor in vacation days, bank holidays, and other types of paid time off. This is essential because it will help you meet your employees’ time-off needs and avoid potential payroll errors.

Omitting PTO or vacation can lead to costly mistakes in the payroll process. For example, if you accidentally leave out a week’s worth of vacation time from an employee’s pay, you could owe that employee a lot of money.

To avoid errors, make sure you understand your state and federal laws governing vacation and PTO. In addition, consult with an accountant or payroll professional, or use payroll software, to help you get it right. Or consider using a third-party payroll provider. They’ll tell you if an employee doesn’t have enough hours to use their paid time off. However you handle it, your goal is to avoid payroll tax-related issues and resulting penalties..

Common incorrect and illegal overtime calculations

Labor laws clearly outline that overtime should be paid at a minimum 1.5 times the employee’s regular pay rate for all hours worked over 40 in a workweek — but not if your state has laws that supersede this federal standard. Employers need to know the specific rules that apply to their state or jurisdiction, as well as those of remote employees. Another common mistake is misunderstanding how hours worked by mobile employees across time zones may be incorrectly tracked and counted. There are also special rules for salaried employees and those working on commission.

It’s essential to get accurate information about properly calculating overtime. Top common and illegal overtime errors include:

• Only using hourly wage to determine OT pay.
• Forgetting bonuses and other remuneration in OT calculations.
• Using mean work hours, regardless of the pay period.
• Not paying for OT without advanced authorization.
• Offering PTO to avoid paying OT.
• Setting employee expectations that allow or require them to work while clocked out.
• Misclassifying employees.

Miscalculating overtime can be costly to your business and employees, who may lose out on substantial pay they deserve. If you omit or undercut employee hours, you might expose your small business to wage-theft accusations.

Miscalculating deductions, benefits, or garnishments

One of the most common payroll errors is miscalculating deductions. To prevent this, calculate deductions before calculating gross pay to ensure accuracy.  Remember that some benefits, like health insurance, are subject to FICA taxes, while others, such as voluntary 401(k)s, are not.

You need to  have the correct tax forms on file and issue W-4s to employees. If not, you may be paying your employees too much and not withholding enough in taxes to be reported on federal, state, and local tax forms.

Staying on top of your employees’ filing statuses can prevent nasty fines. Remember, when you run payroll, double-check your calculations so you don’t overlook any necessary deductions. If you don’t have the time to calculate, consider an SaaS solution or hiring a payroll service to stay compliant with payroll laws.

Forgetting to include bonuses, wages, or overtime

When calculating and paying overtime, you may occasionally make mistakes that lead to employees being underpaid. The most common overtime calculation mistake is failing to include bonuses in the regular rate of pay. This can lead to employees being owed extra money for overtime worked.

While bonuses are standard in many companies, they can be tricky to calculate when paying employees. For example, you may have a bonus once or twice a year, and it could be enough to offset your net payroll calculations significantly.

Make sure you understand how your company handles bonuses. There are several different ways they can be paid out, such as end of the month, per paycheck, or sporadically. It’s also possible that your company gives bonuses in cash instead of salary increases (which would affect gross wages).

For tax purposes, bonuses are considered supplemental income. This means employers don’t need to deduct employment taxes since they’re not part of an employee’s regular paycheck. However, employers must report any bonus payments made during the calendar year on their W-2. Hence, your employees need to understand their total earnings and income taxes owed by tax day.

Not setting aside enough money to cover payroll

Not setting aside enough money to cover payroll can lead to bounced checks, missed payments, and other financial problems. Forget to pay your employees on time, and you can expect employee dissatisfaction and even lawsuits. Affected employees may also start looking for other employment.

In line with your payroll schedule, have enough money saved each month to cover the expenses. This includes wages, benefits, bonuses,overtime earned, and employer tax obligations

But be careful not to overspend on employee hours. This can lead to financial instability and even bankruptcy.

Depositing employment taxes late

Most small businesses pay employees different amounts at different times. This can make managing payroll and cash flow challenging as payroll processing and employees’ pay stubs may differ from pay period to pay period.

Still, it’s critical to meet every tax deadline so you don’t incur penalties. Not being prepared for when government collects payroll taxes is among the most common payroll mistakes. To avoid it, carefully track employment tax due dates and routinely deposit money for this purpose so you’ll have the funds to pay on time.

Payroll mistakes can be costly for your business

Payroll and tax errors are costly. Payroll takes time, but devote the necessary attention to your payroll system to avoid preventable errors. If you discover that something about payroll management is off, ask yourself:

• Do I have all the correct employee information and data?
• If not, what’s missing from my payroll and why?
• Have I made any payments to these employees in error (vacation or sick days)?

The more mistakes you make, the more susceptible you, and potentially your employees, are to penalties and IRS audits.

If you don’t like maintaining payroll records, consider a good payroll software or hiring a professional. Knowing that an expert is handling it and you’re paying employees and tax agencies correctly, on time, can deliver peace of mind.

1 Internal Revenue Service Data Book, 2021, Publication 55–B, Washington, DC, May 2022 ( https://www.irs.gov/pub/irs-pdf/p55b.pdf )

2 Overtime Pay, U.S. Department of Labor

3 Business Email Compromise The $26 Billion Scam, FBI Internet Crime Complaint Center