What are payroll expenses? A complete guide for businesses

Your payroll expenses include much more than your employees’ salaries. They also encompass payments to independent contractors and other monthly costs associated with payroll, including taxes, software, and more. Whether your business is small or large, understanding your payroll costs is essential to both your bottom line and to staying compliant with tax laws.

In this article, we walk through the components of payroll expenses and share some tips for managing your payroll process effectively.

What’s considered a payroll expense?

In addition to gross salaries and wages, payroll expenses consist of several other components, including tax withholdings, benefits withholdings, and costs related to payroll services. Here’s the breakdown:

Employee salaries and wages

Employers must pay employees and contractors for the services they perform. Salaries and wages are usually the largest component of payroll expenses for employers.

State and federal income tax withholdings

A percentage of every employee’s pay gets withheld to cover state and federal income taxes. Employees must fill out IRS Form W-4 and the state equivalent where necessary to determine their tax rates.

FICA tax withholdings

FICA is a federal payroll tax that funds Social Security and Medicare benefits. Employees must pay 6.2% of their gross wages to Social Security and 1.45% to Medicare, totaling 7.65% in payroll tax withholdings. Your business needs to match this 7.65% rate, which counts as a business payroll expense.

Unemployment tax withholdings

A small amount of every employee's paycheck goes toward financial assistance programs that benefit the unemployed through the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA).

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At the federal level, the first $7,000 of a worker’s gross wages gets taxed at 6%. Depending on whether wages are subject to SUTA taxes, your business can receive a tax credit of up to 5.4% for the federal program, which reduces the FUTA tax to 0.6%.

Benefits withholdings

These funds get earmarked for employee benefits. Businesses generally only have benefits withholdings for full-time workers, but some companies also offer benefits to part-time staff. Some of the most common employee benefits include:

• Healthcare coverage, including health insurance, dental, vision, etc.
• Paid leave, including PTO and sick days
• Retirement plans, including 401(k) plans and similar investment vehicles
• Life insurance premiums
• Workers’ compensation
• Childcare

Payroll processing expenses

Depending on how you categorize your business expenses, you might consider payroll processing to be a payroll expense. These would include any costs related to payroll processing services, including payroll software, online payroll services, processing fees, or support from a third-party payroll specialist.

Payroll expenses for independent contractors

Employers must also include payments to freelancers and independent contractors in their payroll expenses. However, it’s important to note that you don’t have to withhold any of an independent contractor’s gross income.

A worker’s classification determines how your business handles tax withholdings for them. If the worker is an employee, you’re responsible for the payroll expenses above. In contrast, independent contractors are responsible for their own tax withholdings and don’t receive benefits from the business, so your only payroll expense is the contractor’s gross wages.

How to calculate payroll expenses in 5 steps

Projecting your business’s total payroll costs can help you set a budget and allocate cash for upcoming expenses. You can follow these five steps to calculate payroll:

1. Collect income tax forms from your employees

When a new employee starts at your company, they must complete IRS Form W-4. This tells your business how much money to withhold from the employee’s paycheck for income taxes. The employee will indicate their allowances, tax filing status, and other factors to determine their tax withholdings. New employees will also need to submit the equivalent state form where applicable.

2. Calculate gross pay

Begin your calculation with your employees’ gross wages, excluding all withholdings. Your payroll period will determine how much of an employee’s wages you pay on each payroll date.

For example, let’s say you have a biweekly payroll. If an employee receives $50/hr and works for 40 hours each week, they receive a gross pay of $4,000 per pay period. You can then calculate annual payroll costs and break them down into monthly, quarterly, or weekly costs as needed.

3. Calculate net pay

Net pay is the amount an employee receives after all payroll deductions. To calculate net pay, use the employee’s gross wages, the information they provided on Form W-4 (and the equivalent state income tax form), and their benefits elections.

Using the same example from above, let’s say the employee withholds 15% for federal income taxes and 5% for state income taxes. You also deduct 7.65% for FICA taxes and $100 for the employee’s healthcare elections. Based on the employee’s $4,000 gross wages per period, their net pay would be $2,794 per payroll period.

4. Add payments to independent contractors

To get an accurate view of your total payroll expenses, you need to include any payments to independent contractors as part of your payroll calculation. This tends to be easier than calculating payroll for employees since you only need to consider gross pay. However, it can sometimes be a bit trickier to project total payroll expenses for contractors over a given period depending on their contract terms.

5. Determine other payroll processing expenses

As discussed above, you might consider payroll processing to be a payroll expense based on how your business categorizes these expenses. Include the costs you incur for any third-party payroll services, payroll software, processing fees, or other payroll expenses as part of your total calculation.

Making payroll tax journal entries

Posting payroll tax journal entries is crucial for accurate financial bookkeeping. You can use three types of entries to organize your payroll costs:

1. Accrued payroll: Accountants should debit accrued earnings and credit wages payable. These entries should take place during their corresponding pay periods.
2. Accrued payroll in cash: Cash payments debit your wages payable account and credit your cash position
3. Income taxes withheld: Your company records liabilities for the amount you withhold in income taxes. Once your business pays withheld taxes, cash decreases with a credit, while tax liabilities decrease with a debit.

Strategies for managing payroll expenses

Keeping your payroll expenses organized makes it easier to create accurate budgets and pay everyone on time. These are some of the strategies you can use to ensure paydays go smoothly:

Automate payroll

Investing in payroll processing software helps make payroll less time-consuming and minimizes the risk of human error. Payroll systems reduce your investment in outsourcing these kinds of tasks to payroll specialists. Automated payroll software also helps you keep up with changes in tax laws.

Avoid overstaffing

If you bring on more workers but productivity stays the same or there’s not enough work to keep your existing team busy, it may be time to reexamine your strategy. Consider how hiring a new worker would increase productivity in the long run. You should also determine whether the additional cost is worth the marginal increase in the company’s output.

Monitor overtime pay

Non-salaried employees may get extra pay if they work for more than 40 hours a week. While you can’t avoid overtime entirely, you can look for ways to keep it manageable. Consider implementing a preapproval process or hiring more workers to split the workload.

Retain talented employees

It costs more money to replace an employee than it does to retain top talent. New employees want the current market rate, and you have to invest time into training them. And remember, posting job listings, reviewing applications, interviewing candidates, and everything else that comes with a job search all take time.

Meanwhile, giving an existing employee a raise—and offering more competitive benefits—can keep them on board. You can keep payroll and productivity in a good position by retaining your best workers.

Borrow capital

Borrowing money to cover payroll expenses isn’t sustainable in the long run. However, accessing a business loan, line of credit, or working capital can alleviate cost pressures during slower business cycles and ensure your workers get paid. You can then repay the debt once your business gets into its busier months.

Simplify your payroll expense management with Ramp

As a small business owner, payroll expenses can be difficult to manage on your own. You have to calculate the gross pay for each employee, determine how much to withhold from every paycheck, and comply with state and federal regulations.

Ramp has you covered if you need help with managing payroll costs. You can stay on top of all your business expenses with Ramp's all-in-one expense management software. We integrate with QuickBooks, NetSuite, Xero, Square Payroll, and other accounting software to help you close your books faster and maintain accurate financial statements.

Give Ramp a try and see why our customers save an average of 5% a year.