How to Calculate Total Payroll Cost and Pay Employees Correctly

Paying employees accurately and efficiently is a critical part of running a successful business. Not only does proper payroll management ensure that your team is compensated fairly, but it also helps businesses stay compliant with federal, state, and local tax laws. Without accurate bookkeeping and data tracking, payroll miscalculations can lead to costly penalties and financial instability. 

In this guide, we’ll break down the key components of payroll costs, including taxes, benefits, payroll withholdings, and how much of your business’s revenue should be allocated to payroll. We’ll also highlight the importance of accurate accounting and financial management in ensuring smooth payroll operations.

The Importance of Good Data Practices and Accounting 

Before diving into payroll calculations, it’s important to stress that accurate payroll depends on good bookkeeping and financial records. If your business doesn’t track employee hours, salaries, and benefits properly, it becomes impossible to: 

• Pay employees the correct amounts 
• Accurately estimate payroll taxes 
• Stay compliant with IRS and state tax regulations 
• Ensure payroll expenses align with business revenue 

This is why a well-maintained accounting system, like QuickBooks Online or a professional bookkeeper, is essential for any business. Payroll should never be calculated based on assumptions or outdated financial data.

Understanding Payroll Costs: Taxes, Benefits, and More 

When budgeting for payroll, business owners need to account for more than just the employee’s base salary or hourly wage. The true cost of an employee includes mandatory payroll taxes, benefits, and other expenses. 

Federal, State, and Local Payroll Taxes 

Example Payroll Cost Breakdown

Let’s say a business pays an employee a $10,000 monthly salary. Here’s how the actual employer cost adds up:

• Base Salary: $10,000
• Employer Social Security Tax (6.2%) = $620
• Employer Medicare Tax (1.45%) = $145
• FUTA = $42
• SUTA (Assume 3%) = $300

📌 Total Employer Cost: $11,125/month ($10,000 salary + $1,125 in payroll taxes)

This doesn’t include employee benefits, which add additional costs.

Employee Benefits and Additional Costs 

Beyond salary and taxes, businesses must account for employee benefits, which may be required for full-time employees under federal and state laws. 

Common Employee Benefits: 

• Health Insurance: Typically $500-$1,000 per employee per month 
• Retirement Contributions (401k match): Around 3%-6% of salary 
• Paid Time Off (PTO): Paid vacation, sick leave, and holidays 
• Workers’ Compensation Insurance: Varies by state and industry 

Using the $10,000 salary example, adding a $600 monthly health insurance premium and a 3% retirement match ($300) brings the total employer cost to approximately $12,025 per month. 

What Are Payroll Tax Withholdings? 

While employers pay certain payroll taxes, they also withhold taxes from an employee’s paycheck before issuing payment. These withholdings include: 

1. Federal Income Tax: Based on IRS tax brackets (determined by the employee’s W-4 form). 
2. State & Local Income Tax: Varies by state. Some states (like Texas and Florida) have no income tax, while others (like California) have high rates. 
3. Social Security & Medicare (FICA Taxes): The employee also pays 6.2% Social Security and 1.45% Medicare (just like the employer).

For a $10,000 salary, an employee’s paycheck after withholdings could look like this: 

• Gross Pay: $10,000 
• Federal Income Tax (Assume 22%) = $2,200 
• State Income Tax (Assume 5%) = $500 
• Employee Social Security (6.2%) = $620 
• Employee Medicare (1.45%) = $145 
• Net Pay: $6,535 (after taxes withheld) 

The business must send the withheld taxes to the IRS and state tax agencies on behalf of employees. 

What Percentage of Income Should Go to Payroll? 

The percentage of revenue allocated to payroll varies by industry. Generally, businesses fall into two categories: 

1. Service-Based Businesses (Higher Payroll Costs): 

○ Payroll typically accounts for 50%-60% of total revenue. 

○ Example: Restaurants, consulting firms, law offices, and agencies rely heavily on labor. 

2. Product-Based Businesses (Lower Payroll Costs): 

○ Payroll expenses usually range from 20%-30% of revenue. 

○ Example: Manufacturing, e-commerce, or retail businesses have higher Cost of Goods Sold (COGS) instead. 

Here’s how payroll costs break down for different industries:

A business making $1 million in revenue should budget payroll based on industry standards to maintain profitability.

Final Thoughts: Why Good Accounting Is Critical for Payroll 

Payroll is one of the largest expenses for any business, and miscalculations can be costly. Without accurate bookkeeping, business owners risk: 

• Underpaying employees, leading to legal issues. 
• Overpaying taxes, reducing profitability. 
• IRS audits and penalties for payroll tax mistakes. 

At LedgerFi, we help businesses track payroll expenses, ensure compliance, and optimize payroll spending to maximize profits. 

Need help managing payroll for your business? Contact LedgerFi today for expert bookkeeping and payroll support!