Small Business

How to Set Up Payroll: A Small Business Guide

Reviewed by Unpack Money Research Desk · Updated October 28, 2026 · Our review process

Quick answer

Payroll setup has four parts: register as an employer, decide how and when you pay, collect the right data for each worker, and run a test payroll before real money moves. Most first-payroll mistakes are not software mistakes — they are missing registrations, wrong worker classification, or a pay schedule chosen without checking pay-frequency rules. Work through the steps in order, and do not run a live payroll until the checklist at the end is complete.

Step 1: Register as an employer

Federal registration. Apply for an Employer Identification Number (EIN) if you do not already have one — it identifies your business for federal employment-tax purposes. Confirm whether your business must also register for federal employment-tax reporting, and which forms and deposit schedule apply to your situation, from current IRS guidance for employers.

State and local registration. Register with your state's tax agency for income-tax withholding and unemployment insurance, and with any local tax authority that applies where your employees work — not just where your business is registered. Remote employees can create obligations in their own state. Check each relevant state agency's current employer-registration instructions; deadlines and account types vary by state and are deliberately not stated here.

Business accounts and insurance. Open a business bank account for payroll if you have not already, and confirm workers' compensation requirements in your state — some states require coverage through a state fund, others through a private carrier, and requirements vary by industry and headcount. Do not run payroll from a personal account.

Step 2: Classify every worker correctly

Employee vs. contractor. Misclassification is the costliest payroll mistake a small business makes. An employee is paid through payroll, with tax withholding and employer payroll taxes; a contractor is paid as a vendor, generally without withholding, and reports their own income. The distinction turns on control over the work, not on what you call the person or what they prefer. If a worker's status is unclear, get advice before the first payment — reclassifying later means back taxes, penalties and amended filings.

Exempt vs. non-exempt (for employees). For employees, confirm whether each role is exempt or non-exempt from overtime rules under current federal and state law. Non-exempt employees must be paid for overtime hours worked; exempt status depends on duties and pay, not on job title alone. Record the basis for each classification.

Step 3: Choose a pay schedule and pay method

Weekly payroll means more payroll runs and more per-run cost than monthly payroll. If you use a vendor that charges per run, frequency is a cost decision, not just a preference. See the table below ("At a glance") for the decisions to weigh.

Step 4: Collect worker data before the first run

For each employee, collect and verify: legal name and address, tax withholding information (current federal and state forms), direct-deposit details, start date, pay rate and pay type (hourly or salary), work location, and any benefit or deduction elections. For each contractor, collect a taxpayer identification form and payment details, and confirm the payment terms in writing. Store this data securely, with access limited to the people who run payroll — payroll data is a prime target for fraud.

Step 5: Choose payroll software — or a service

Whichever route you choose, confirm in writing: who files which taxes, who is responsible if a filing is late or wrong, and what happens to your data if you leave.

Step 6: Run a test payroll, then your first live payroll

First-payroll checklist. ☐ All employer registrations confirmed, with account numbers on file. ☐ Every worker classified (employee vs. contractor; exempt vs. non-exempt) with the basis recorded. ☐ Pay schedule, pay method and pay calendar set and communicated to the team. ☐ Withholding forms, direct-deposit details and pay rates verified for every worker. ☐ A test payroll run reviewed line by line: gross pay, each deduction, each employer tax, net pay. ☐ A named person responsible for each filing deadline, with a calendar reminder. ☐ Year-end forms (W-2 for employees, 1099 for contractors, as applicable) confirmed as included in your process.

Run the test with real data for one pay period. If any line does not reconcile, fix it before money moves — a wrong first payroll is harder to unwind than a delayed one.

Ongoing: the monthly payroll habit

Each period: review hours and pay changes, approve the run, confirm deposits and filings, and file the payroll reports in a single place. Each quarter and year-end: reconcile payroll totals against filings before they are submitted. Payroll is a system, not an event — the businesses that struggle are the ones that treat each run as a surprise.

At a glance

Pay schedule and pay method decisions

What this means for you

Payroll is a system, not an event. Register, classify, schedule, collect, test — in that order — and a wrong first payroll never gets the chance to happen. Educational only. This page is not legal, tax or financial advice. Employment-tax rules vary by state and change over time; confirm current IRS and state guidance, or consult a qualified professional, before running payroll. Unpack Money currently earns $0 affiliate revenue and has no approved affiliate programs.

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