Payroll Basics: What Every Small Business Owner Needs to Know Before Running Payroll
Running payroll for the first time comes down to five repeatable steps. Here's each one, in order, with the withholding math spelled out so the number on the paycheck actually makes sense.
By Antoine Joseph · Payroll & Contractors · 8 min read
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If you've never run payroll before, the paperwork can make it look more complicated than the math actually is. Payroll comes down to five steps, done the same way every pay period: calculate gross pay, apply withholdings, land on net pay, pay the person, then file what the government requires. Here's each step, with the numbers spelled out.
Gross pay vs. net pay
Gross pay is what an employee earned before anything gets taken out — hourly rate × hours worked, plus overtime, tips, commissions, or bonuses. Net pay is what actually lands in their bank account after every withholding is subtracted. The gap between the two is where most first-time payroll confusion comes from, so it's worth walking through in order.
The 5 steps, in order
- 1Calculate gross pay. For hourly employees: rate × hours, plus any overtime (typically 1.5× the regular rate past 40 hours/week under federal law). For salaried employees: their annual salary divided by the number of pay periods.
- 2Withhold federal income tax. Based on the employee's W-4 (filing status and any adjustments they claimed) and the IRS withholding tables for your pay frequency.
- 3Withhold FICA tax. A flat 7.65% of gross pay: 6.2% for Social Security and 1.45% for Medicare. You as the employer match both, so FICA actually costs you 15.3% of gross pay in total. Social Security tax stops once an employee's year-to-date wages hit the annual wage base — $184,500 for 2026 — though Medicare keeps applying to every dollar earned above that.
- 4Withhold state/local tax and other deductions. State income tax (if your state has one), plus any pre-tax benefits (health insurance, retirement contributions) and post-tax deductions (wage garnishments, voluntary deductions) the employee has set up.
- 5Pay net pay, then file. What's left after every withholding is net pay — the amount that actually gets deposited or handed over. Separately, you're responsible for depositing the withheld taxes (plus your employer match) with the IRS on a schedule based on your total tax liability, and filing quarterly (Form 941) and annual (W-2, Form 940) payroll tax returns.
A worked example
An hourly employee works 40 hours at $22/hour: gross pay is $880. FICA withholding is 7.65% of that, or about $67.32. Assume federal income tax withholding of roughly $70 based on their W-4, and no state income tax. Net pay comes to roughly $742.68 — and separately, you as the employer owe a matching $67.32 in FICA on top of the $880 you paid out.
Payroll isn't the same as paying a contractor
Everything above applies to W-2 employees, where you're required to withhold and remit taxes on their behalf. If the person doing the work is an independent contractor, none of this withholding happens — they're responsible for their own taxes, including quarterly estimated payments. Getting this distinction wrong is a real compliance risk: see 1099 vs. W-2: Is Your Worker a Contractor or an Employee?
What you're required to keep on file
- Payroll records (hours, pay rate, gross/net pay, withholdings) for at least 3 years, per the Fair Labor Standards Act
- Employment tax records for at least 4 years, per IRS guidance
- Each employee's signed W-4 and I-9, on file for the duration of employment plus applicable retention periods
- Copies of every payroll tax deposit and quarterly/annual filing you submit
Common first-time mistakes
- Missing the Social Security wage base and continuing to withhold it after an employee's wages cross the annual limit
- Treating a worker as a contractor to skip payroll withholding, when the actual working relationship makes them an employee
- Depositing withheld taxes late — the IRS penalty schedule for late payroll tax deposits starts at 2% and climbs quickly
- Forgetting the employer match exists — FICA isn't just withheld from the employee, you owe an equal amount on top
Sources
- IRS Publication 15 (Circular E), Employer's Tax Guide — official federal withholding, deposit, and reporting rules
- Social Security Administration, 2026 COLA Fact Sheet — the official 2026 Social Security wage base and tax rates
- U.S. Dept. of Labor, FLSA Recordkeeping (Fact Sheet #21) — federal payroll record retention requirements
Frequently Asked Questions
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