8 Types of Payroll Fraud and 5 Ways to Prevent It

People go to great lengths to steal from their employers. A quick Google search brings up the most sensational stories, including one about the Illinois town treasurer who thieved more than $50 million over two decades that later became a documentary.

But not every clandestine business embezzlement is as elaborate. It could be happening right under your nose if you’re not paying close attention.

Overview: What is payroll fraud?

Payroll fraud is a breach in the payroll process that allows someone or a group of people to siphon cash from a business for an improper reason.

It’s not only sinister, but it’s more ubiquitous in small businesses than you might think. A 2020 report by the Association of Certified Fraud Examiners (ACFE) found that payroll fraud cases are two times more prevalent in small businesses than in large enterprises.

Both employees and business owners commit payroll fraud. Owners and executives perpetrate 20% of all occupational fraud schemes and cause more monetary damage than employee swindlers, the CFE report says.

Here are the most common types of payroll fraud and how you can protect your business from suffering the same violations.

8 types of payroll fraud

Let’s step into the fraudsters’ heads to understand how they redirect money to themselves through the payroll process.

Padded timesheets

Many hourly employees self-report time worked using timesheets. At the end of every week, they submit the number of hours they worked each day, sometimes accompanied by notes of what they worked on. It’s a vulnerable target for wage fraud.

Employees sometimes pad timesheets, or add hours they didn’t actually work, to earn more money. A payroll administrator who’s cozy with the hourly employees might also edit timesheets to help their friends take home a bigger paycheck.

For example, Rick says on his timesheet that he worked from 8 a.m. to 5 p.m. on Monday. His computer’s records show he logged in at 8:30 a.m. and logged off at 4:30 p.m., meaning he padded his timesheet by an hour.

The fraud can get significantly more costly when the padded time triggers FLSA overtime.

Timesheets are vulnerable to payroll fraud because they rely on the honor system. It’s nearly impossible to dispute a timesheet unless there are corroborative measures in place, like logs that show when employees are working on their computers or cameras in your store.

Buddy punching

We’re not talking about when you see a Volkswagen Beetle and punch your friend in the arm. Buddy punching is when employees have coworkers clock in or out for them.

Say you own a small cafe. You leave at 6 p.m. one night to enjoy a date night with your spouse, entrusting your employees Jesse and Trish to handle things and close up at 9 p.m. It’s a slow night, which gives you some assurance that they’ll be fine without you.

After you head out, Jesse offers to close the cafe alone and punch out for Trish so she can go home early. She agrees, promising to return the favor next time, and leaves work two and a half hours early.

As a business owner, you’re caught paying for two employees when you got only one.

Ghost employees

A ghost employee is a fictitious employee who’s on your payroll register. While more common in larger businesses, ghost employees can exist at any organization without strong internal controls.

Payroll administrators are most often the puppeteers of ghost employee schemes. They’ll set up fake employees or continue to use a former employee’s name to pay themselves or a spouse by direct deposit.

Wage violations

Wage violations occur when an employee is paid less than the minimum wage or is not paid for working at a for-profit entity. These schemes violate the Fair Labor Standards Act, which regulates labor laws, minimum wage, and overtime pay.

An Economic Policy Institute study found that 2.4 million U.S. employees lose $8 billion each year due to minimum wage violations. Employees in the U.S. must be paid according to the highest minimum wage applicable to their work, but it’s clear that many employers shirk the law when paying their employees to line their own pockets.

Unauthorized bonuses

Conniving payroll administrators can do a lot of damage. Yet another payroll embezzlement popular among payroll administrators is disbursements of unauthorized bonuses.

Employees with wide-ranging payroll responsibilities can cover up extra payments by running an off-cycle payroll that doesn’t appear on the business’s payroll register. Unless you’re completing payroll reconciliations that compare payroll records to the general ledger, you may not notice the extra money walking out the door.

Unsanctioned raises

Similar to unapproved bonuses, unsanctioned raises happen when someone with access to payroll makes changes to employee hourly rates or salary.

A smart -- but malefic, to be sure -- payroll administrator would give slight pay increases over time to avoid raising the alarm when comparing payroll reports from successive pay periods.

Skipping payroll tax deductions

Schemers funnel more money into their pockets by not withholding income and payroll taxes from employee paychecks. That way, employees’ gross wages go straight into their bank accounts.

Involving the IRS in your payroll schemes is a bold move. You should catch missing payroll tax payments when you file payroll forms like Form 941 every quarter.

Worker misclassification

Business owners can commit payroll fraud just like anyone else. Employer payroll fraud often comes from paying workers as independent contractors and treating them like employees. While hiring contractors is legal and can help businesses get necessary work done, business owners need to play by the rules.

Behavioral control, financial control, and the worker-company relationship differentiate independent contractors from employees. For example, independent contractors generally work on their own schedules and use their own equipment to complete their jobs. Employees are bound to the employer’s set working hours and expect to be given all the equipment needed for work.

The line between independent contractors and employees can get blurry sometimes, which leads some business owners to misclassify workers by accident. Intentional or not, it’s still a payroll scheme that artificially lowers payroll liabilities and cheats workers out of perks only afforded to employees, like health insurance and unemployment benefits.

Unauthorized or fraudulent reimbursements

It’s standard in many industries to reimburse employees for expenses they incurred on behalf of the business. It’s not standard to grant reimbursements without verifiable proof of payment, however.

Say Bob, an employee in a plumbing business, goes to the hardware store to buy a tool necessary to complete a job. As the owner, you promise to reimburse him when he shows you a receipt.

Well, a week passes, and you ask him to show you a receipt so you can pay him back for the tool. He says he never got a receipt but shows you a $100 charge on his credit card statement from the hardware store. That’s good enough for you, so you pay him the $100, even though it sounds higher than you expected.

You might’ve just gotten swindled because you didn’t even bother to check the tool’s price on the hardware store’s website.

How to prevent payroll fraud in your small business

Payroll fraud is avoidable. Here are some fail-safes made to catch payroll fraud.

1. Conduct a payroll audit

A payroll audit looks for weaknesses in your payroll management system from top to bottom. Usually carried out by a business owner or trusted employee, an outside accounting firm could also carry out a payroll audit.

Through activities like payroll reconciliations and verification of employee direct deposit information, you might pick up on the ghost employees haunting your payroll records.

2. Make vacation mandatory

While you might appreciate an employee’s enthusiasm for the job, make sure all employees regularly take vacations.

Your payroll clerk, Chloe, has been paying herself unapproved bonuses for the past six months. Having her take a vacation will force you or another employee to run payroll, making it more difficult for her to cover up her payroll manipulation.

Keep a close eye on your business’s cash outflow, or cash leaving the company, when employees with financial responsibilities are on vacation. You might have a fraudster in your ranks if there’s an unexpectedly sharp decrease in outgoing cash.

3. Use time-tracking software with geofencing

Technology has made it easier to repel payroll fraud. Look for payroll software with a time and attendance feature that tracks the locations of your employees’ punches.

Software with geofencing features allows employees to clock in and out only when they’re within your business’s vicinity. They won’t be able to clock in while they’re still getting ready at home, for example.

RUN Powered by ADP and Paychex Flex both offer geofencing in their time and attendance functions.

4. Clearly distinguish employees from contractors

Straddling the line between employees and contractors sets you up for an IRS inquiry. Make it clear in the hiring process the classification for the role.

Once they’re at the firm, take special care not to treat independent contractors as employees by requiring that they stick to the same work schedule as your employees or undergo the same training. Check out our guide on independent contractors and employees.

5. Don’t make exceptions for reimbursement protocols

Remember the example above where Bob got reimbursed $100 for a hardware store purchase? He bought the tool he needed, but he also bought a gallon of paint for his home renovation.

Institute a policy with your employees that requires a receipt for reimbursement, with no exceptions. If you’re willing to bend a little, do your research to corroborate the item’s approximate cost before granting reimbursement.

Don’t get swindled

Start bulletproofing your payroll process now to deter payroll schemes from starting. Once the schemes start, they seem to go on for a while: The ACFE report found that payroll fraud schemes tend to go on for two years before getting caught.