When you bring on a new employee at your small business, one of the key concepts to master in understanding how payroll works is the difference between gross pay and net pay. On the surface, the difference is straightforward, but get into the details, and things get complicated.
How you handle gross and net pay has many business implications. You need to understand how to handle the two to comply with federal, state, and local regulations since it’s your company’s responsibility to ensure proper employee taxes are collected and paid to the government.
You also need to be prepared to answer employee inquiries about the differences. Imagine a young employee collecting the first paycheck of their career. They may have questions why they received less than what they are supposed to be paid.
What is gross pay?
Gross pay, called gross wages or gross income, is the salary or hourly rate an employer pays an employee. Gross pay reflects what the employee earns before deductions, such as local, state, and federal taxes.
For example, if an employer pays a salary of $52,000 per year to an employee, that $52,000 amount is referred to as the employee’s gross pay.
Gross pay also includes any other payment made by the employer to the employee, such as imputed income.
If the employee earned overtime pay, that amount is added to the gross pay. The same applies to vacation time payment, commissions, bonuses, reimbursements for business expenses, sick pay, and holiday pay.
These additional payments from an employer are added to the gross pay whenever they take place.
What is net pay?
Net pay, or net income, is the money an employee receives as payment for their work. It’s called take-home pay. Net pay equals gross pay minus various deductions subtracted from the gross pay amount.
These deductions are grouped into two parts: mandatory and voluntary.
The law mandates certain deductions be taken from an employee’s paycheck. Federal, state, and local taxes are the most common of these. However, employers don’t have to address taxes for contract workers.
Wage garnishments, amounts withdrawn from an employee’s pay as ordered by a court, are another deduction example.
Voluntary deductions are those requested by the employee. Typical voluntary deductions include amounts taken to pay for small business health insurance, to fund a retirement account, and to pay union dues. Some of these payments can occur before taxes are taken out.
Different rules apply to these mandatory and voluntary deductions. And withholding amounts may vary between employees, based on various factors such as their W-4 withholdings.
The overall net income formula, however, is the same. Here’s how to calculate it:
(Gross pay) - (Pre-tax deductions and nontaxable wages) - (Payroll taxes) - (After-tax deductions) = Net pay
Gross pay vs. net pay: What's the difference?
Gross pay is the amount to factor into a business budget as the income paid to employees even though their net pay will be less. You determine the proper amounts for both gross and net pay by referencing an employee’s gross pay.
Gross pay serves as the foundation for an employee’s payroll calculations. You use it to calculate tax payments and an employee’s overtime. Hence, it’s an important number in the payroll world. Once you know gross pay, you can determine net pay.
As mentioned, net pay is an employee receives after all deductions are removed from gross pay. It’s what they have to deposit in their bank account. If an employee is paid $52,000 in gross pay, the sum they actually receive is less, depending on the amounts and number of deductions subtracted from gross pay.
Since you deduct taxes from gross pay based on an employee’s W-4 information, it’s wise to have employees review their W-4 form annually. They need to adjust for life changes such as marriage or having children, events which can reduce tax deductions.
Employees can forget to change their W-4 over time, so having them review it annually to ensure accuracy.
You'll encounter complex deductions, which can vary widely between employees, to determine net income. Purchase payroll software and you’ll streamline this process and ensure accuracy and compliance.
How to calculate gross income for an hourly employee
You calculate gross income differently for a salary vs. hourly employee. Follow this calculation for an hourly employee: take their hourly rate and multiply it by hours worked in a pay period.
Add any further reimbursements you paid them. For instance, you must pay an employee overtime if work exceeds 40 hours in one week. The federal overtime rate mandates a minimum hourly rate in overtime pay equivalent to one-and-a-half times the employee’s regular hourly rate.
This overtime pay must then be added into the gross pay amount. Note that states vary in terms of overtime pay, so check your state’s overtime requirements.
If an employee, hired for $20 an hour, works 45 hours in a one-week period, the gross pay earned for that time is $20 x 40 hours = $800, plus five hours of overtime pay. Overtime hours would be at 1.5 times the employee’s $20 hourly fee, which is $30.
So the overtime pay calculation is $30 x 5 = $150, which brings the gross pay for that week to $950 ($800 regular hours + $150 overtime pay).
How to calculate gross income for a salaried employee
Gross pay per paycheck is calculated differently for salaried employees. First determine how many pay periods exist in a year. If salaried employees receive biweekly pay on a specific day, such as Friday, then there are 26 pay periods in the year. If you pay weekly, say every Friday, then you have 52 pay periods.
Once you determine the number of pay periods, divide the employee’s salary by the number of payroll periods to obtain the gross pay amount for each paycheck.
For example, if you have 26 pay periods, and you pay a salaried employee $52,000 per year, you calculate gross pay like this: $52,000 / 26 = $2,000 per paycheck.
Then you add additional payments, such as reimbursements for business expenses, to the gross pay. While most exempt employees (employees exempt from overtime or minimum wage pay) don’t receive overtime, federal law requires salaried employees making less than $684 per week to be eligible for overtime pay.
The bottom line
As you can see, the concepts of net pay and gross pay are foundational to understanding how to do payroll. Whether the payroll function falls under the responsibilities of a specific payroll department or a payroll clerk, it’s a critical part of your overall small business bookkeeping.
You need to understand the important differences between gross pay and net pay for better oversight of your business expenses and legal compliance.