A payroll system runs a repeating cycle: it collects each worker’s time and pay information, calculates gross earnings, subtracts mandatory taxes and voluntary deductions, sends the net amount to the employee, and then deposits the withheld taxes with the IRS and files the required reports. Understanding how payroll systems work means understanding that cycle and the legal deadlines wrapped around each step. Miss a piece and the penalties start small; ignore the obligation entirely and it becomes a felony.
What Has to Be in Place Before the First Paycheck
A business cannot run payroll without an Employer Identification Number. The IRS issues the nine-digit number for free through its website, and every future tax deposit, quarterly return, and W-2 is tied back to it.1Internal Revenue Service. Get an Employer Identification Number
Each worker then has to be classified correctly, and the classification happens on two axes. The first is employee versus independent contractor. The IRS weighs behavioral control, financial control, and how the two parties view the relationship.2Internal Revenue Service. Independent Contractor (Self-Employed) or Employee? The Department of Labor applies a related “economic reality” test asking whether the worker is economically dependent on the business or genuinely running their own operation.3U.S. Department of Labor. Notice of Proposed Rule: Employee or Independent Contractor Status Under the Fair Labor Standards Act Classifying an employee as a contractor to skip withholding creates liability with both agencies.
The second axis, for actual employees, is exempt versus non-exempt under the Fair Labor Standards Act. Non-exempt workers get overtime; exempt workers do not. The line depends on duties and on a minimum salary. After a federal court vacated the higher thresholds from a 2024 rule, the DOL is enforcing the 2019 level of $684 per week, or $35,568 annually.4U.S. Department of Labor. Earnings Thresholds for the Executive, Administrative, and Professional Exemption From Minimum Wage and Overtime Protections Under the FLSA Anyone earning below that is non-exempt no matter what their job title suggests.5U.S. Department of Labor. Fact Sheet 17C: Exemption for Administrative Employees Under the Fair Labor Standards Act (FLSA)
Onboarding then produces the paperwork the payroll system needs. Form I-9 verifies identity and work authorization, and the employer must physically examine the employee’s documents within three business days of the first day of work.6U.S. Citizenship and Immigration Services. I-9 Central Form W-4 tells the employer how much federal income tax to withhold; an employee who never submits one is withheld at the single rate with no adjustments.7Internal Revenue Service. Form W-4 – Employee’s Withholding Certificate (2026) Bank routing and account numbers are collected for direct deposit, and federal law requires the new hire to be reported to a state directory within 20 days.
Calculating Gross Pay
Every payroll run starts with gross pay, the amount earned before any deduction. For an hourly worker, the system multiplies hours worked by the hourly rate. A salaried employee gets a fixed slice of the annual salary each period: 26 slices for biweekly, 24 for semi-monthly, 12 for monthly.
For non-exempt employees, the FLSA requires overtime at one and a half times the regular rate for every hour past 40 in a single workweek.8U.S. Department of Labor. Fact Sheet 23: Overtime Pay Requirements of the FLSA Federal law does not require overtime for weekend or holiday work by itself; the trigger is exceeding 40 hours in the week. Some states impose stricter rules, including daily overtime thresholds, and the payroll system has to apply whichever standard is tougher.
What Gets Withheld From the Employee’s Check
Once gross pay is set, the system subtracts the taxes the employee owes. These deductions are not optional.
FICA is the biggest piece for most workers. Social Security is 6.2% of gross wages up to an annual cap of $184,500 in 2026, after which the withholding stops for the rest of the year. Medicare is 1.45% with no cap and applies to every dollar earned.9Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
High earners pay an extra 0.9% Medicare surtax on wages above $200,000 in a calendar year. The employer must begin withholding the surtax once a worker’s year-to-date pay crosses $200,000, regardless of the employee’s filing status.10Internal Revenue Service. Topic No. 560, Additional Medicare Tax The final tax liability may look different when the employee files, but the payroll system uses the flat $200,000 trigger.
Federal income tax withholding is the other major line. The amount depends on the employee’s W-4, their earnings, and the IRS withholding tables. It is graduated rather than flat, so higher pay pushes portions of income into higher brackets. Most states run their own income tax withholding on top, with state-specific rates and forms.
What the Employer Pays on Top
The pay stub shows only half of FICA. The employer matches every dollar withheld: another 6.2% for Social Security up to the same $184,500 cap and another 1.45% for Medicare. The true combined FICA rate is 12.4% for Social Security and 2.9% for Medicare, split evenly between worker and business.9Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
Employers also owe federal unemployment tax under FUTA. The gross rate is 6.0% on the first $7,000 of each employee’s annual wages, but paying state unemployment tax on time earns a 5.4% credit that drops the effective FUTA rate to 0.6%, or a maximum of $42 per employee per year.11Internal Revenue Service. FUTA Credit Reduction State unemployment insurance rates run anywhere from under 1% to over 9% depending on the state, the industry, and the employer’s layoff history.
Voluntary Deductions and the Net Amount
After the mandatory taxes come the deductions the employee chose. These usually include 401(k) or similar retirement contributions and premiums for employer-sponsored health, dental, or vision insurance. Many are pre-tax, which means they lower the taxable base before federal income tax and FICA are calculated. A $500 monthly traditional 401(k) contribution reduces the worker’s taxable gross by that amount each pay period.
What survives all of this is net pay, the number that actually lands in the employee’s account. The payroll system prints a pay stub alongside each payment showing gross earnings, every individual deduction, and the resulting net. Even where state law does not require a stub, providing one is standard practice, since it gives both sides a clean record if a dispute comes later.
How the Payment Reaches the Employee
Direct deposit through the Automated Clearing House network is the dominant method. The employer sends the payroll file to the bank, which routes each net amount to the account the employee provided at onboarding. The run typically has to be approved and submitted a couple of business days before payday to give ACH time to process the transfers.
Paper checks are still available, especially for workers without bank accounts, and payroll software generates them with the same pay-stub breakdown attached. Payroll cards, prepaid debit cards loaded each period with net pay, sit between the two options for unbanked workers who want electronic access to their wages without opening a checking account.
When an employee leaves, federal law does not require the final paycheck to be handed over immediately; it can wait until the next regular payday.12U.S. Department of Labor. Last Paycheck Many states impose tighter deadlines, and some require same-day payment on termination. Ignoring the state rule gets expensive quickly.
Depositing the Withheld Taxes and Filing Reports
Withholding money is only half the obligation. Those funds have to be deposited with the IRS on a set schedule. If total tax liability during a four-quarter lookback period was $50,000 or less, deposits follow a monthly schedule and are due by the 15th of the following month. Above $50,000, the schedule shifts to semi-weekly with much shorter deposit windows.
Late deposits carry escalating penalties. One to five days late is 2%. Six to fifteen days is 5%. Beyond fifteen days it reaches 10%, and if the deposit still is not made after an IRS notice, it climbs to 15% of the unpaid amount.13Internal Revenue Service. Failure to Deposit Penalty The higher rate replaces the lower one rather than stacking on top of it.
Deliberate nonpayment is treated as a different kind of problem. Willfully failing to collect or pay over employment taxes is a federal felony punishable by a fine of up to $10,000, up to five years in prison, or both.14Office of the Law Revision Counsel. 26 USC 7202 – Willful Failure to Collect or Pay Over Tax
On the reporting side, most employers file Form 941 each quarter (due April 30, July 31, October 31, and January 31) to report wages and withheld taxes. Form 940, filed annually by January 31, reports FUTA wages and tax.15Internal Revenue Service. Employment Tax Due Dates By that same January 31 deadline, every employee must receive a Form W-2 summarizing the prior year’s total earnings and all taxes withheld.16Internal Revenue Service. Form W-2 and Other Wage Statements Deadline Coming Up for Employers
Keeping the Records
Two retention rules apply to payroll records, and the longer one controls in practice. The FLSA requires basic payroll records (employee identification, daily and weekly hours, pay rates, and total wages) for at least three years from the last date of entry.17eCFR. 29 CFR Part 516 – Records to Be Kept by Employers The IRS requires all employment tax records for at least four years after the fourth-quarter return for that year is filed.18Internal Revenue Service. Employment Tax Recordkeeping Keeping everything for four years satisfies both.
The records matter most when something goes wrong. In a wage dispute, an employer without time-and-pay records is at a serious disadvantage, and courts tend to credit the employee’s account when the employer cannot produce documentation. In an IRS audit, missing records can turn a small discrepancy into an assumed deficiency. Storage costs almost nothing next to the cost of not having the paperwork when someone asks for it.