How to do payroll for small businesses in 8 easy steps

Learning how to set up payroll might not be the most glamorous part of running a small business but getting it right matters. A clunky process can lead to unhappy employees, tax headaches, and even legal trouble.

After all, payroll systems do more than just issue paychecks. They calculate wages, deduct taxes, and generate accurate pay slips. Many can handle bonuses, holiday pay, expenses, and end-of-year reporting as well.

The good news? Setting up a payroll system for your small business is not as complicated as it sounds, especially if you break it down into manageable steps. In this guide, we’ll walk through exactly how to do payroll for a small business.

Step one: Determine employee classification

Employee classification is the system used to categorize how each employee works for your business. This affects everything from payroll taxes and benefits to legal responsibilities and reporting requirements.

Before adding anyone to your payroll system, you’ll need to determine which category they fall into:

• Full-time employees: Typically work a set number of hours per week (e.g., 35-40) and are eligible for benefits like paid time off, health insurance, and retirement plans. As an employer, you’re responsible for withholding income taxes and contributing to Social Security and Medicare.

• Part-time employees: Work fewer hours than full-time employees and may receive limited or no benefits, depending on company policy and local regulations. Their tax obligation is generally the same as full-time employees.

• Freelancers or independent contractors: Handle freelance work on a project or contract basis, which means they’re not on the regular payroll system. Businesses usually don’t withhold taxes for freelancers; instead, they’re responsible for reporting and paying their own taxes.

Misclassifying workers can lead to penalties, back taxes, and compliance issues.¹ When in doubt, consult IRS guidelines or speak with a payroll professional to ensure your bases are covered.

Step two: Obtain an employer identification number (EIN)

Before you start hiring employees or running payroll, you need to get an employer identification number, or EIN.

Essentially, an EIN is a unique nine-digit number issued by the IRS to identify a business for tax purposes, much like a social security number does for individuals. You’ll use it to handle just about any official payroll documentation.

Getting an EIN is simple and free. Most businesses apply online through the IRS EIN application portal. In many cases, you’ll receive your EIN soon after submitting the form.²

To apply, you’ll need to provide basic information about your business, including:²

• Your business’s legal name and structure (LLC, sole proprietorship, corporation, etc.)

• The name and taxpayer ID of the person responsible for the business

• Your business address and contact info

• The reason you’re applying (e.g., hiring employees, starting a business)

Once you have your EIN, keep it safe and accessible. You’ll need it for everything from payroll setup to tax filings and year-end reporting.

Step three: Choose a payroll system

There’s no one-size-fits-all when it comes to payroll solutions. The right setup depends on the size of your business, the number of employees, and how hands-on you want to be.

Naturally, some choose to outsource to a payroll company for small businesses. Others prefer to manage everything in-house using payroll software.

Here’s a quick breakdown of the pros and cons of each approach:

• Payroll software: A good choice for businesses that want to stay in control and save on costs. Most platforms are easy to use and come packed with helpful features like automated tax calculations, direct deposit, and pay slip generation. But keep in mind that managing payroll in-house still takes time and attention to detail. One missed deadline or incorrect tax filing can quickly turn into a costly headache.

• Payroll service providers: A payroll company for small businesses can take the burden off your plate. These companies manage tax filings, employee payments, year-end forms, and more. It’s typically more expensive than software, but it saves time and most processes can be handled by professionals.

Step four: Collect employee information

In order to pay your employees, you’ll need to gather some information from them, including their full legal name, address, and social security number — all of which you should have on file in their employment record. You’ll also need their bank details (for direct deposit) and employee classification (e.g., full-time, part-time, or freelance).

Employees must also complete a W-4 tax withholding form. This is an IRS document that determines how much federal income tax should be withheld from an employee’s paycheck. It reflects their filing status and any personal allowances or dependents they claim.

Once you’ve collected all this information, make sure to:

• Review it for accuracy before entering it into your payroll system.

• Keep records up to date, especially if employees move, change filing status, or update their banking information.

• Store all employee data securely to comply with privacy and data protection laws. This includes using encrypted systems and limiting access to authorized personnel only.

Step five: Choose your payroll schedule

Your payroll schedule determines how often employees get paid, and is one of the first decisions to make when setting up payroll.

Here are some common payroll schedules, along with their pros and cons:

• Weekly: Employees are paid once a week, typically on the same day (like every Friday). This schedule is great for hourly workers or businesses with a lot of shift work. It keeps cash flow moving for employees but requires more payroll runs, which means more admin time and higher processing costs.

• Bi-weekly: Employees are paid every two weeks, resulting in 26 pay periods per year. It’s a popular middle ground — frequent enough to keep employees happy but less demanding than weekly payroll. Just keep in mind that some months will have three pay periods instead of two, which can affect budgeting.

• Semi-monthly: Employees are paid twice a month, usually on set dates like the 15th and the last day of the month. It lines up neatly with many monthly accounting tasks and benefit deductions. The downside? Paydays can fall on weekends or holidays, which may require manual adjustments or delays.

• Monthly: Employees are paid once a month. This is the simplest and most cost-effective option for employers but it’s often the least favored by employees, who may struggle to manage expenses with such infrequent pay.

Step six: Calculate employee payroll

Now, it’s time to run the numbers. Employee pay is typically based on either an hourly wage or a set salary — but that’s just the beginning.

You’ll also need to account for:

• Overtime: Any hours worked beyond the standard 40-hour work week. In most cases, overtime must be paid at 1.5x the regular hourly rate. This applies to non-exempt employees under federal labor law. Not tracking this correctly can lead to back-pay claims or penalties.³

• Bonuses or commissions: These may be performance-based or seasonal and must be added to regular pay calculations.

• Payroll deductions: Deductions are where payroll calculations can start to get a bit more complex. For every paycheck, you’re required to withhold the correct amounts for several types of taxes.

Uncover more accounting tips that’ll keep your payroll accurate and compliant.

Step seven: Set up direct deposit or paychecks

Once you’ve calculated payroll, the next step is actually paying employees. There are a number of different options, including:

• Direct deposit: Wondering what is direct deposit? It’s an electronic transfer that moves money straight from your business bank account to your employee’s bank account. It’s fast, reliable, and reduces the risk of fraud. Employees appreciate the convenience, and there are typically little to no fees on their end. However, employers may face setup or transaction costs depending on their bank or payroll provider.

• Pay cards: These work like prepaid debit cards. Wages are loaded onto the card each pay period, and employees can use them to make purchases, withdraw cash, or check balances. Pay cards are useful for employees without traditional bank accounts and are entirely paperless. But both employers and employees may face small fees for transactions or card maintenance.

• Paper checks: This old-school option is still used by some businesses, especially if employees prefer them or if direct deposit isn’t feasible. However, they’re slower to process, cost more to print and deliver, and come with a higher risk of being lost or stolen.

Step eight: File payroll taxes

Once your team is paid, there’s one final (and very important) task: filing payroll taxes.

Every business is responsible for calculating and submitting taxes based on what’s been withheld from employee paychecks. These filings usually happen monthly or quarterly, depending on your business size and location.

Here’s a breakdown of what you’ll need to handle:

• Federal payroll taxes: This includes federal withholding based on each employee’s W-4 form, plus your share of Social Security and Medicare contributions (also known as FICA taxes).

• State taxes: Most states require income tax withholding, though a few don’t. Some states also have additional employer contributions, like unemployment insurance.

• Local taxes: Depending on where your business operates, you might also need to file city or county payroll taxes.

Timeliness matters. Late filings or incorrect payments can lead to steep penalties and interest charges. And once you fall behind, it’s hard to catch up, especially as a small business.

So, if you’re managing payroll in-house, it’s smart to:

• Use payroll software that automates tax calculations and filings: Many platforms can calculate federal, state, and local tax liabilities, generate the correct forms, and even submit payments directly to the IRS or state tax authorities. This reduces the risk of human error and saves hours of manual work.

• Set reminders for due dates, or better yet, create a payroll tax calendar: Different taxes are due on different schedules (monthly, semi-weekly, quarterly), and missing even one deadline can result in costly penalties. Consider adding reminders to your calendar or using task management tools to stay ahead of filing dates.

• Double-check tax rates and thresholds regularly: Federal and state rates can change each year, so build the habit of checking for updates. If you’re using software, make sure it’s updated with the latest tax tables.

• Keep copies of all payroll tax filings and payment confirmations: Store these digitally in a secure, well-organized location in case you’re audited or need to reference them for future filings.

• Consult a CPA or tax attorney, especially if your team spans multiple states: Multi-state payroll can get tricky fast. An expert can help you follow all the right rules for payroll laws and regulations in each location.

• Reconcile your payroll reports regularly: Take the time to make sure everything lines up. It can be easy to fix a small issue now rather than uncover a big one months later.

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Learning how to do payroll for a small business may seem overwhelming at first, but once you’ve broken down the process into these clear steps, it becomes far more approachable.

For some small businesses, especially those with limited time or resources, outsourcing the whole process to a specialist may be an easy way to do payroll. Others may prefer to take control and use payroll software to manage everything in-house. Both are valid approaches — it simply depends on the structure and needs of the business.

What matters is having a system that ensures employees are paid accurately and on time while also staying compliant with tax and legal requirements. Getting payroll right not only helps avoid penalties and stress but also builds trust with your team and sets a strong foundation for growth.

Now that you know how to do payroll, it’s time to fine-tune the rest of your business finances. Explore these money management tips.