How to Do Payroll: Step-by-Step Guide for Small Businesses (2026)

Updated March 2026 · 20 min read · 1,000 monthly searches

Before You Run Payroll: Setup Checklist

Before processing your first payroll, you need:

• EIN (Employer Identification Number): Apply at IRS.gov — free, instant online
• State employer registration: Register with your state tax agency and unemployment office
• Employee W-4 forms: Determines federal income tax withholding
• State withholding forms: Varies by state (some use the federal W-4)
• I-9 verification: Confirms employee eligibility to work in the US
• Direct deposit authorization: Bank routing and account numbers
• Pay schedule decision: Weekly, bi-weekly, semi-monthly, or monthly

Step 1: Calculate Gross Pay

Hourly Employees

Key rules: overtime kicks in at 40 hours/week (federal). Some states have daily overtime rules (California: over 8 hours/day).

Salaried Employees

Step 2: Calculate Tax Withholdings

Federal Income Tax

Use the employee's W-4 and IRS Publication 15-T (tax withholding tables) to determine the amount. In 2026, the process is:

1. Start with gross pay for the period
2. Subtract pre-tax deductions (401k, health insurance, HSA)
3. Apply the W-4 adjustments (additional withholding, credits)
4. Look up the withholding amount in the IRS tables

FICA Taxes (Social Security + Medicare)

Additional Medicare: 0.9% on wages over $200,000 (employee only, no employer match).

State & Local Taxes

Varies enormously by state. Nine states have no income tax (TX, FL, WA, NV, WY, SD, AK, TN, NH). Some cities (NYC, Philadelphia) have local income taxes too.

Step 3: Calculate Deductions

After taxes, subtract voluntary deductions:

• Health insurance premiums (usually pre-tax)
• 401(k) / retirement contributions (pre-tax traditional, post-tax Roth)
• HSA / FSA contributions (pre-tax)
• Life insurance (group term over $50K is taxable)
• Garnishments (child support, tax levies, student loans — mandatory, not voluntary)

Step 4: Calculate Net Pay

Example calculation:

• Gross pay: $2,500.00
• Federal income tax: -$287.00
• State income tax: -$112.00
• Social Security (6.2%): -$155.00
• Medicare (1.45%): -$36.25
• Health insurance: -$200.00
• 401(k) (6%): -$150.00
• Net pay: $1,559.75

Step 5: Pay Your Employees

Methods of payment:

• Direct deposit: Most common, most efficient. ACH transfer to employee bank accounts.
• Paper checks: Still used by ~10% of businesses. More expensive and slower.
• Pay cards: Prepaid debit cards for employees without bank accounts.

Regardless of method, provide a pay stub showing gross pay, all deductions, and net pay. Most states require this by law.

Step 6: Pay Employer Taxes

Besides matching FICA, employers must pay:

• FUTA (Federal Unemployment): 6.0% on first $7,000 per employee (credit of up to 5.4% for state UI = effective rate of 0.6%)
• SUTA (State Unemployment): Rate varies by state and your claims history (typically 1-5%)
• Workers' Compensation: Required in most states, rates vary by industry and risk

Step 7: File Payroll Tax Returns

Payroll Software Comparison

The Advisory Angle: Payroll as a Revenue Stream

For bookkeepers looking to grow into advisory, payroll is a natural expansion:

• Payroll processing: $150-$500/month per client depending on size
• Payroll setup & migration: One-time fee of $500-$2,000
• Compliance review: Quarterly audit of payroll practices — $200-$500/quarter
• Compensation benchmarking: Help clients set competitive pay — high-value advisory
• Benefits optimization: Review and recommend benefit packages — advisory gold

Payroll creates recurring revenue AND opens doors to higher-value conversations about compensation strategy, labor cost management, and workforce planning.