Payroll processing is the recurring cycle a business runs each pay period to pay its workforce and settle the taxes that come with those wages: collect hours, calculate gross pay, withhold federal and state taxes plus any other deductions, pay employees their net pay, and then deposit and report the withheld taxes to the IRS on schedule. Every step has a deadline attached, and missing one usually costs money.
What Happens in Each Pay Cycle
A pay cycle is the fixed interval at which employees are paid — weekly, bi-weekly, semi-monthly, or monthly. Inside every cycle, the same sequence repeats:
- Gather hours worked for hourly employees and confirm salaried employees’ status.
- Calculate gross pay, including overtime where it applies.
- Subtract federal and state tax withholdings and any other deductions.
- Pay each employee their net amount.
- Deposit the withheld taxes with the IRS on the required schedule.
- File the quarterly and annual returns that reconcile what you withheld and paid.
The rest of this article walks through each of those steps and the rules that govern them.
Classifying the Worker Before You Start
Payroll only applies to employees. Independent contractors handle their own taxes and are paid without withholding. Getting this wrong is expensive: under Section 3509 of the Internal Revenue Code, a business that misclassifies an employee as a contractor without a reasonable basis owes 1.5 percent of the worker’s wages for income tax withholding plus 20 percent of the employee’s share of Social Security and Medicare taxes. If the business also failed to file the required information returns, those rates double to 3 percent and 40 percent.1Office of the Law Revision Counsel. 26 U.S. Code 3509 – Determination of Employer’s Liability for Certain Employment Taxes
The IRS weighs behavioral control, financial control, and the type of relationship to decide whether a worker is a common-law employee.2Internal Revenue Service. Employee (Common-Law Employee) If you’re uncertain, either party can file Form SS-8 to request an official determination.3Internal Revenue Service. About Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding
Calculating Gross Pay
Gross pay is what an employee earns before any deductions. For salaried workers, divide the annual salary by the number of pay periods in the year. For hourly workers, multiply hours worked by the hourly rate.
Hours over 40 in a single workweek must be paid at 1.5 times the regular rate for hourly, non-exempt employees.4eCFR. Part 778 Overtime Compensation Whether a salaried worker owes overtime depends on exempt status. Under the currently enforced federal standard, a salaried employee generally must earn at least $684 per week ($35,568 annually) and perform qualifying executive, administrative, or professional duties to be exempt.5U.S. Department of Labor. Earnings Thresholds for the Executive, Administrative, and Professional Employee Exemptions Anyone below that salary or outside those duties is non-exempt and earns overtime.
What Gets Withheld
Once gross pay is set, three categories of withholding come off the top.
FICA taxes. Social Security tax is 6.2 percent of gross wages up to the annual wage base, which is $184,500 in 2026. Medicare tax is 1.45 percent of all wages with no cap.6Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates7Social Security Administration. Contribution and Benefit Base An additional 0.9 percent Medicare tax applies to wages above $200,000 in a calendar year for a single filer ($250,000 for married filing jointly). The employer withholds this additional amount but does not match it.8Internal Revenue Service. Understanding Employment Taxes
Federal (and usually state) income tax. The federal amount is set by what the employee entered on Form W-4 — filing status and any adjustments.9Internal Revenue Service. About Form W-4, Employee’s Withholding Certificate Most states also require state income tax withholding; a small number do not tax wage income at all.
Other deductions. These include health insurance premiums, retirement contributions, and court-ordered garnishments. For ordinary consumer debts, federal law caps the garnishment at the lesser of 25 percent of disposable earnings or the amount by which weekly disposable earnings exceed 30 times the federal minimum wage.10Office of the Law Revision Counsel. 15 USC 1673 – Restriction on Garnishment Higher limits apply to child support, federal student loans, and tax debts.
Bonuses, commissions, and other supplemental wages have their own federal withholding rule: a flat 22 percent as long as total supplemental wages for the year stay at or below $1 million, and 37 percent on anything above that.11Internal Revenue Service. Publication 15 (2026), (Circular E), Employer’s Tax Guide Social Security and Medicare still apply as usual.
What remains after all of this is net pay.
What the Employer Owes on Top
Payroll isn’t just what comes out of the employee’s check. The employer owes its own share.
The employer matches the employee’s 6.2 percent Social Security and 1.45 percent Medicare contributions dollar for dollar, which is why the combined FICA rate is 15.3 percent of each employee’s wages up to the wage base.6Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
Under the Federal Unemployment Tax Act, the employer also pays 6.0 percent on the first $7,000 of wages paid to each employee per year. Employers who pay state unemployment taxes on time generally get a 5.4 percent credit, dropping the effective FUTA rate to 0.6 percent. Employees pay no FUTA.12Internal Revenue Service. FUTA Credit Reduction13Internal Revenue Service. Topic No. 759, Form 940 – Employer’s Annual Federal Unemployment (FUTA) Tax Return
Every state runs its own unemployment insurance program funded by employer contributions. Wage bases range from $7,000 to over $70,000 depending on the state, and new employer rates typically fall between roughly 1 percent and 4 percent. Your rate adjusts over time based on how many former workers file claims.
Depositing Withheld Taxes on Time
Withheld taxes don’t stay in the business’s account. They get deposited with the IRS, most commonly through the free Electronic Federal Tax Payment System.14Internal Revenue Service. EFTPS: The Electronic Federal Tax Payment System Your deposit schedule depends on how much you reported during a lookback period:
- Monthly schedule: if you reported $50,000 or less, deposit each month’s accumulated taxes by the 15th of the following month.
- Semi-weekly schedule: if you reported more than $50,000, deposit taxes on wages paid Wednesday through Friday by the following Wednesday, and taxes on wages paid Saturday through Tuesday by the following Friday.
If your liability hits $100,000 or more on any single day, the deposit is due the next business day regardless of your usual schedule.15Internal Revenue Service. Notice 931 – Deposit Requirements for Employment Taxes
Late deposits carry escalating penalties: 2 percent if 1–5 days late, 5 percent if 6–15 days late, 10 percent if more than 15 days late, and 15 percent if the tax is still unpaid after the IRS issues a demand notice.16Internal Revenue Service. Failure to Deposit Penalty
Filing the Quarterly and Annual Returns
Depositing isn’t reporting. Form 941 reconciles what you actually withheld and paid each quarter — federal income tax, Social Security, and Medicare, plus the employer’s matching share.17Internal Revenue Service. About Form 941, Employer’s Quarterly Federal Tax Return The deadlines:
- Quarter 1 (January–March): due April 30
- Quarter 2 (April–June): due July 31
- Quarter 3 (July–September): due October 31
- Quarter 4 (October–December): due January 31 of the following year
If you deposited all taxes for the quarter on time and in full, you get an extra 10 days to file.18Internal Revenue Service. Instructions for Form 941
FUTA is reported separately on Form 940, filed annually by January 31.19Internal Revenue Service. Employment Tax Due Dates
At year’s end, every employee receives a Form W-2 showing their total wages and taxes withheld. For tax year 2026, W-2s must reach employees by February 1, 2027.20Internal Revenue Service. General Instructions for Forms W-2 and W-3
Paying Employees and Handling Final Paychecks
Most employers move net pay by direct deposit through the ACH network, which transfers funds electronically into employees’ bank accounts.21Nacha. How ACH Payments Work Others use printed checks with an attached stub, or offer payroll cards to workers without bank accounts.
When an employee leaves — resignation, layoff, or termination — the employer owes a final paycheck for all earned but unpaid wages. Federal law does not require immediate payment, but many states set their own deadlines that can be as short as the employee’s last day of work.22U.S. Department of Labor. Last Paycheck Miss the state deadline and you can owe penalties or additional wages.
How Long to Keep Payroll Records
Two agencies set the retention rules, and the longer one governs in practice.
The IRS requires all employment tax records — Forms W-4, deposit receipts, quarterly returns — kept at least four years after the tax becomes due or is paid, whichever is later.23Internal Revenue Service. How Long Should I Keep Records?
The Fair Labor Standards Act requires payroll records with total wages and hours worked each week for at least three years, and supporting documents like time cards and work schedules for at least two years.24U.S. Department of Labor. Fact Sheet 21 – Recordkeeping Requirements Under the Fair Labor Standards Act (FLSA) Because the IRS four-year rule runs longest, many employers keep everything payroll-related for at least four years and satisfy both.