How does payroll work?

As an employer, payroll will be one of the most essential aspects of what you do. The process starts as soon as you hire your first employee and requires regular management to keep it running smoothly.

A solid payroll system is key in ensuring your company is successful and your employees remain happy. Paying staff correctly and on time helps to build a well-respected and positive company culture.

Not only is getting payroll wrong likely to be one of the biggest frustrations for an employee, but payroll is also an essential part of keeping your business legally compliant, for example paying taxes. Failure to run an effective payroll can leave you with hefty fines from HMRC.

The six key steps of payroll processing are:

1. Keeping track of hours
2. Calculating wages and salaries
3. Tax deductions
4. Filing returns with HMRC
5. Creating payslips
6. Paying employees

We understand that for employers, payroll can seem really daunting and difficult. In this guide, we’ll help you understand the basics and weigh up different options for payroll management.

How to do payroll

The following steps need to be carried out on or before pay day each week or month.

1. Keeping track of hours

This step will only be relevant if you have employees who are paid hourly. In order to ensure they receive the correct amount on pay day, you’ll have to collect in all timesheets (HR software collates them automatically) and calculate their wages according to the number of hours they’ve worked in that pay period.

Make sure to remind your workers to fill in their timesheets when needed. It’s also a good idea to check over them periodically to ensure employees are recording their hours correctly. You can also keep an eye on Working Time while doing this, by ensuring they take the breaks they need.

2. Calculating wages/salaries

The next step is to calculate an employee’s gross pay, which will be done slightly differently according to whether they are paid by the hour or receive an annual salary (a fixed amount per pay period).

Pay includes bonuses, commission, holiday pay, sick pay and shift allowances.

3. Tax deductions

To find an employee’s net (final) pay, you’ll need to deduct tax from their gross pay, the most common deductions being Income Tax and National Insurance. You may also need to take off student loan repayments, pension contributions and child maintenance payments.

The amount of tax deducted will be worked out using the employee’s tax code and National Insurance category letter, which are generated by HMRC. As an employer, you’ll need to pay a National Insurance contribution on each employee’s earnings above £166 a week.

Automatic enrolment into a pension scheme is now a legal requirement for businesses, meaning all employers have to provide and pay into a workplace pension scheme for eligible employees.

4. Filing to and paying HMRC

The next step involves reporting all payments and deductions to HMRC, and then paying them. This is essential for keeping you compliant with employment law.

You’ll have to report everything to HMRC in the form of a Full Payment Submission (FPS). You’ll be able to do this automatically through payroll software. When you set this up you’ll need your PAYE reference and Accounts Office reference, which HMRC will have sent to you after you registered as an employer.

If you don’t send an FPS on or before your employees’ pay day, HMRC will send you a late filing notice and may even charge a penalty, unless you have a valid reason for reporting late.

As part of your reports, you should tell HMRC if any employee circumstances change, for example if someone new joins or an individual reaches State Pension age.

Your report will tell you exactly how much tax and National Insurance you owe to HMRC, which you’ll then have to pay to them each month. If you expect to pay less than £1,500 a month, you can arrange to pay quarterly instead.

5. Create payslips

Now that you’ve calculated all the necessary deductions, you’ll be able to produce payslips for your employees. These should show:

• pay before deductions (gross pay)
• amount of deductions
• pay after deductions (net pay)
• number of hours worked, if relevant

6. Pay your employees

With all these calculations and reporting done, you’re all set to pay your employees on pay day!

Payroll management

When it comes to payroll management, you have three options. Depending on the type and size of business you have, one of them may be an obvious solution for you. We’ve weighed up the pros and cons of each method below.

Manual payroll system

Some business owners still choose to do their own payroll by hand, as it affords more control over the process. However, this method brings many problems, not least because it leaves you open to manual errors, which can lead to fines from HMRC.

If employees receive the incorrect amount on pay day, especially if it happens more than once, they’re likely to become really frustrated, which will often impact their work and productivity. In the worst case it could result in a resignation and leave you with a gap, and a recruitment headache.

Doing payroll manually will also take up a lot of your time with gathering timesheets, doing calculations and making tax deductions – time which would be better spent running your business.

Outsourced accounting services

Outsourcing your payroll to a professional accountancy will save you a lot of time, but it may also end up costing a lot of money. This could prove a problem long-term, especially for smaller businesses.

However, an accountant will be able to process your payroll a lot more quickly and efficiently than doing it yourself manually. They’re also highly unlikely to make any errors in calculations, easing your worries about potential penalties for incorrect payments.

Payroll software

By far the most reliable, accurate and cost-efficient method of processing payroll is to do it through payroll software. The payroll software benefits are numerous. It’s easy to use, housed securely in the cloud and usually only requires an affordable monthly fee.

It also saves on hours of admin by pulling numerous processes together in one place. Good payroll software will automatically update an employee’s rate of pay with any bonuses, changes of hours, pension, sick pay and maternity/paternity leave adjustments.

Payroll software should also connect to HMRC automatically to send over all payroll data every pay period. Payslips can be accessed by employees on the software, which will notify them when they’re ready to view.

The content of this blog is for general information only. Please don’t rely on it as legal or other professional advice as that is not what we intend. You can find more detail on this in our Terms of Website Use. If you require professional advice, please get in touch.