Knowing how payroll software works makes good business sense, whether you’re self-employed or managing a growing team. While these tools save hours of administrative work, they still require a solid foundation of employee and company information, meaning you’re still responsible for entering the right details before that first pay run.
What you’ll learn
What you’ll learn
Key takeaways
- Businesses use payroll software to automate the process of calculating wages, withholding taxes, and paying employees or contractors
- Full-service systems automatically handle tax filings and compliance, reducing the risk of potential IRS or state penalties
- Modern payroll tools integrate with time tracking, HR, and accounting software, so you can manage back-office tasks in one platform
- Before any software can automate tax filings and payments, along with employee withholdings, deductions, and direct deposits with each pay run, you’re responsible for adding details like employee pay rates, state and local tax info, unemployment insurance rates, and employee deductions
Whether you’re hiring your first employee or managing a growing team of gig workers, you might be wondering: Can’t I just use a spreadsheet? While that’s a common starting point, it gets complicated as your headcount grows. In this guide, we’ll cover what payroll software actually does, clear up common misconceptions, and show how automating these moving parts simplifies payday.
What payroll software is
Whether cloud-based or installed to your desktop, investing in software should take the complexity out of paying your team. It’s not a magic wand — but it is a highly intelligent organizer that helps you enter and track employee and 1099 data so your payroll process runs smoothly from day one. Here’s why:
- Centralized hub: A good system houses all your team’s data in one place, easily organizing a mixed roster of full-time employees and 1099 contractors. You’ll need to enter the initial details — like pay rates, tax withholdings, and how PTO accrues—but once that baseline is set, the software automatically applies your rules to the natural course of paying people.
- Compliance calculator: You probably don’t need to know exactly how every employee is taxed. But you do need to enter their home address correctly, because that’s how they’ll be taxed. The software will also make it very easy for you to keep your SUI rate up to date (or if you need to label someone as exempt, you can do this as well).
- Time saver: As you add more and more employees, trying to calculate every deduction manually, while in theory, it’s possible, but will you realistically have time (or want) to do this each pay period?
What payroll software is not
While software handles a lot of the math, human oversight is still key. Don’t expect:
- Replacement for accurate data entry: A payroll service is only as good as the data you give it. Let’s say you’re doing business in Arizona—the state has its own minimum wage, and cities like Tucson and Flagstaff have their own local rates, too. It’s up to you to enter those exact local details and pay rates when you bring an employee on board.
- A system you can completely ignore: Even the best software needs occasional input from you to stay accurate. For instance, state unemployment insurance (SUI) rates change annually. When the state mails (or emails) your new rate, you’ll need to log in and update your payroll account so your business stays compliant.
- Immune to changing legislation: More and more states are making required leave a thing, and no business owner is ever going to say keeping up with payroll is less complicated than it used to be. While most providers follow federal and state legislation updates, employers are still responsible for keeping up. Note that OnPay does offer proactive state-by-state compliance alerts you can sign up for as part of an HR add-on upgrade.
The takeaway is that any tool is only as good as the data that’s entered into it (and there’s always moving parts to monitor).
Basics of payroll software
If you’re upgrading from a spreadsheet, you are probably wondering which features actually move the needle for your day-to-day operations. It typically comes down to core functions working together in the background:
- Employee self-service portals: Software isn’t just for the employer. Many give your workers more control over their data through their own logins to view pay stubs, download end-of-year tax forms, and update their direct deposit information. And it keeps them from knocking on your door every time they need a past pay stub or document. Some software tools provide lifetime access even if the employee or contractor is no longer working with you.
- Automation of gross-to-net calculations: One of the main reasons why employers use software is that it automatically handles the math involved in calculating gross pay (total earnings before deductions), then accurately subtracts and allocates federal, state, and local taxes, as well as other deductions, to arrive at the final net pay.
- Direct deposit and payment generation: Once net pay is calculated, the system can directly deposit funds into employee and contractor bank accounts. And for those who prefer physical checks, there are providers that can generate printable paychecks, often with pay stubs.
- Tax compliance and filings: Some businesses also use payroll tools because they help with managing documentation like Form 941 (Employer’s Quarterly Federal Tax Return) and Form W-4 (Employee’s Withholding Certificate), ensuring they are correctly filled out and submitted on time. For an employee’s W-4, many payroll tools let employees complete the form through an online portal, send reminders when needed, and let you track their progress as part of the onboarding process.
Out of the box, look for:
Employee self-service portals
- Workers get personal logins to view pay stubs and download year-end tax forms
- Employees can easily update their own direct deposit information
- Some tools offer lifetime access for both current and former team members
Gross-to-net calculations
- Automatically handles the math for calculating gross pay before deductions
- Accurately subtracts and allocates federal, state, and local taxes
- Determines final net pay without the need for manual spreadsheet formulas
Direct deposit payments
- Directly deposits final net pay into employee and contractor bank accounts
- Generates printable paychecks for workers who prefer physical payment
- Includes detailed pay stubs alongside every generated payment
Tax compliance and filings
- Manages documentation like the Employer’s Quarterly Federal Tax Return (Form 941)
- Tracks Employee’s Withholding Certificate (Form W-4) completion during onboarding
- Ensures required tax forms are accurately filled out and submitted on time
To get a sense of why it’s so critical for a small business owner to establish a formal payroll system before they pay their first employee, we spoke with Peggy James, a CPA, small business consultant, and frequent OnPay contributor.
“It’s a lot easier to get the details right before you start than it is to clean things up after the fact.”
— Peggy James, CPA and OnPay contributor
Peggy explains that while it requires a lot of initial administrative work to set up payroll correctly, once that baseline is established, making routine updates — like adjusting for (SUI) rate changes — should be straightforward. However, when a business chooses to wing it with a manual spreadsheet, it can lead to avoidable structural errors that cost significant time and money to fix down the road.
How payroll calculations work in small business software
Understanding what’s actually happening during the wage calculations can help illustrate why employers go the software route.
Determining gross pay and overtime
- Gross pay is the total amount an employee earns before any deductions. For hourly employees, the software multiplies their hourly rate (or rates, if multiple) by the number of regular hours worked.
- If overtime hours are involved, it applies the appropriate overtime rate (typically 1.5 times the regular rate for hours over 40 in a workweek, though state laws can vary).
- For salaried employees, gross pay is simply their agreed-upon salary for the pay period.
Managing deductions and withholdings
Once gross pay is determined, the software applies deductions and withholdings without you having to build pivot tables in spreadsheets.
- Pre-tax deductions: These are subtracted from gross pay before taxes get calculated, reducing the employee’s taxable income. Examples include contributions to health insurance premiums, 401(k) plans, or flexible spending accounts (FSAs). Any tool you purchase should run these numbers as part of the service.
- Post-tax deductions: These are taken out after taxes have been calculated. Examples include garnishments (court-ordered payments), union dues, or certain charitable contributions.
- Tax withholdings: These are mandatory deductions for federal income tax, state income tax (if applicable), and FICA taxes (Social Security and Medicare). Again, any software provider should automatically withhold each deduction so you don’t have to. If there’s an extra fee for this, or a company’s site fails to mention that it’s part of what the product does, it’s probably time to keep researching other vendors.
Calculating net pay (the “take-home” amount)
After all deductions and withholdings are applied, the remaining amount is the employee’s net pay – which is the actual take-home money they receive after all the appropriate deductions are accounted for.
How payroll taxes work in small business software
Payroll software acts as a powerful compliance engine, but accurate data is the fuel that keeps it running. Once you enter your specific details — like your SUI rate, employer deductions, and retirement plan contributions — you can be confident that all necessary payroll taxes will be correctly calculated, withheld, and paid.
Employee tax withholdings
For each employee, the software calculates and withholds:
- Federal income tax: Based on the employee’s W-4 form.
- State income tax: If your state has one, also based on state-specific withholding forms.
- Local taxes: Some cities or counties have their own income taxes.
- FICA Taxes (Social Security and Medicare): Employees pay a portion of these taxes, which fund Social Security and Medicare programs.
Did you know? New hire reporting is required by law
Almost all states require you to report new hires to a specific state agency shortly after joining your team. This varies depending on where you operate. For example, Florida requires reporting to the Department of Revenue, while Utah uses the Department of Workforce Services.
The good news? Most full-service payroll systems handle this communication for you automatically. At OnPay, we report new hires every Friday for clients, but you should always confirm this feature is included when evaluating different software providers.
Employer-paid tax contributions
As an employer, you also have tax obligations. The software helps you manage:
- Employer’s share of FICA taxes: You match the employee’s contribution to Social Security and Medicare.
- Federal Unemployment Tax Act (FUTA): This is a federal tax that helps Uncle Sam fund unemployment benefits.
- State Unemployment Tax Act (SUTA): State-level unemployment taxes, which vary by state and for the most part, change annually.
Automated tax filing and payments
One of the biggest benefits of signing up for a third-party platform is knowing that it’s automating your tax filing and payments. It prepares and submits required forms like:
- Form 941 quarterly
- Form 940 annually (for FUTA)
- W-2s and W-3s at year-end
Part of spending on tools is also having peace of mind that tax payments are made to the correct federal and state agencies on time – this should not be something you have to do manually once you are paying for software (or a service provider).
What specific payroll reports or data points generated by software are most valuable to you as a CPA, and how do you use that data to help an SMB run a better business?
“One of the reports I use most often is some version of a payroll journal report, which usually gives me what I need to post the journal entries needed to record payroll transactions.”
— Peggy James, CPA and OnPay subject matter expert
On the tax compliance side, Peggy also finds annual summary reports incredibly helpful. Financial teams use this specific data to cleanly break down total payroll expenses by category, separating standard employee wages from employer-paid tax contributions so they can be accurately reported on the company’s year-end tax return.
Five basic steps of the payroll process
While software takes care of a lot, having a basic understanding of the payroll process keeps you firmly in control of your business.
Employee setup and onboarding
- Before you can pay an employee, there’s certain info you’re going to need. This includes their W-4 form (for federal tax withholdings), I-9 form (to verify employment eligibility), and direct deposit information so you can distribute wages to their bank account.
Entering time and earnings
- For hourly employees, you’ll need to input their hours worked. Many payroll systems integrate with time-tracking software, automatically syncing this data so you don’t have to enter each person’s hours.
- For salaried employees, their regular earnings are typically pre-filled. But you’ll also enter any commissions, bonuses, or other special earnings for the pay period (if there are other pay items).
Reviewing the pay run
- This is where a second set of eyes comes in. Before finalizing anything, the software allows you to review a summary of the entire pay run – take advantage of this. You can check gross pay, deductions, taxes, and net pay for each employee. This is your chance to catch any errors before funds are distributed.
Approving and distributing funds
- Once you’ve reviewed and approved the pay run, the software takes over. It initiates direct deposits to employee bank accounts, or generates checks for printing. This step is usually irreversible once approved. You could probably correct if needed in a future pay period, but dedicated time for reviewing each pay run to be sure everything is right is worth adding to your calendar.
Post-payroll reporting and recordkeeping
- After payroll is complete, the software generates reports. These can include payroll summaries, tax liability reports, and employee earnings statements. It also maintains records of all payroll activity, which you may need one day for compliance or an audit. For example, federal requirements make it a rule to keep payroll records for around four years.
Comparing options: Manual vs. software
Many small business owners start by managing payroll manually, often using spreadsheets like Excel. While this might seem cost-effective initially, it’s important to understand the significant differences and risks compared to dedicated payroll software.
Here’s a comparison of manual payroll (like using Excel) versus full-service payroll software:
| Aspect | Manual payroll (e.g., Excel) | Payroll software |
| Accuracy | Prone to human error in calculations and data entry. | High accuracy with automated calculations and validations. |
| Compliance | Requires constant manual research and updates for tax laws. | Automatically updates tax rates and ensures compliance. |
| Time savings | Very time-consuming, especially with more employees. | Significantly reduces time spent on payroll processing. |
| Tax filings | Must be done manually, increasing risk of missed deadlines. | Automates tax form generation and electronic filing. |
| Direct deposit | Not typically supported; requires manual bank transfers. | Offers direct deposit, often with no extra effort. |
| Recordkeeping | Manual organization, susceptible to loss or disorganization. | Secure, digital recordkeeping with cloud-based access to reports. |
| Integration | Limited to no integration with other business tools. | Integrates with time tracking, accounting, and HR software. |
| Penalties | Higher risk of IRS/state penalties due to errors or delays. | Lower risk of penalties due to automated compliance. |
Is Excel a payroll software?
No, Excel is a spreadsheet program, not software for paying employees. Now, while you can use it to track hours and even perform some calculations, it lacks the automation, compliance features, and security of a dedicated system.
Using spreadsheets, you’d be responsible for manually updating tax rates, calculating all withholdings, generating pay stubs, and filing all tax forms yourself. So you could probably set up Excel for this purpose, but may take a lot of work.
We asked Peggy about the operational hurdles she comes across when a new client tries to manage payroll manually with formulas rather than using a dedicated service.
“There are a few places where things can go wrong. One is garbage in, garbage out: the output of the spreadsheet is only as good as the data input.”
— Peggy James, CPA and OnPay subject matter expert
Formulas represent another massive point of failure for manual trackers. Peggy warns that if an error is accidentally built into a cell formula, that mistake is often carried over silently from pay period to pay period. By the time a professional catches it, there’s a massive compliance mess to clean up.
Furthermore, running payroll through a spreadsheet means committing yourself to manually preparing and submitting complex payroll tax returns and employee W-2s yourself — tasks that are notoriously easy to get wrong if you are not an expert.
Know what payroll software does so you can decide
Knowing what happens behind the scenes helps you realize the true value of moving away from manual spreadsheets. The right investment not only saves you hours of administrative work, but it also keeps you compliant with state and federal laws. Now that you know what to look for, you’re ready to find a service that fits your needs. Our team is here to help you along the way!
Take a tour to see how easy payroll can be.
Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.