Pay calculation is the formula that converts an employee’s income from gross to net. Gross income refers to income before deductions, and net income refers to what a worker takes home after deductions have been made. If we think of pay calculation as a formula, it’s (gross income) – (deductions) = net income.
Pay calculation is a vital aspect of HR. Whether your payroll is handled by an in-house accounts department, by software, or is outsourced to an accountant or payroll company, you must ensure that HR personnel at your organization understand pay calculation. Employees may have questions about their take-home pay, so you must know how to explain pay calculation to them.
There can be a significant difference between gross income and net income, and it’s important that you can help your workers understand exactly what will be ending up in their bank account each pay period and why.
As an employer, you should also consider whether the net income your employees receive following deductions is competitive. If it isn’t, your employees may look for work elsewhere. Ensuring that you provide a competitive net income can help you retain talent at your organization.
Best Practices for Pay Calculation
To calculate pay, you will need to consider whether your employee receives a set monthly salary, is paid hourly, or is compensated in some other way, such as by a college term or per project. Let’s take a closer look at each step of the pay calculation process and how to ensure best practice.
Prepare for payroll every pay period
Before you start calculating pay and running payroll, make sure that you have all the documents you need. You will need information about each employee, including any benefits they have signed up for and employee W-4 forms.
You will also need employee timesheets so you can see how many hours and overtime hours each employee has worked.
Calculate gross income
Gross income is calculated first. Comprised primarily of a worker’s salary or hourly wages earned, this can also include bonus pay, reimbursements for work materials or travel, commissions, and other sources of income, such as tips and incentive pay.
To calculate gross income for an hourly worker, multiply the number of hours worked in a pay period—which should be indicated by the worker’s time sheet—by the worker’s hourly wage. Then, add on bonuses, commissions, and any additional sources of income earned that pay period.
When calculating gross income, pay attention to overtime rules in your state. Depending on your location, overtime may count as time worked over 40 hours a week or over eight hours a day.
When calculating gross pay, keep regular pay and overtime pay separate since these will generally involve different rates. You will be adding in overtime as part of the pay calculation formula.
Let’s look at an example.
Let’s say you’re in a state where workers who work more than 40 hours a week earn time and a half. Your employee earns $15 per hour. Over the past month, your worker worked 40 hours for the first three weeks, but 45 hours in the fourth week. Overall, your employee worked 160 hours at regular pay and 5 hours count as overtime.
Those overtime hours will be paid at $22.50 per hour ($15 + $7.50). Gross income for the worker this past month would be $2,512.50 (160 x $15 + 5 x $22.50).
To calculate gross income for a salaried employee who is paid monthly, you will divide their annual salary by 12 to get a gross monthly salary. For example, if an employee earns $40,000 a year, then their gross monthly salary would be $3,333.33. Add on any commissions and additional income earned during the pay period for the employee’s full gross salary for the month.
Some salaried workers do not work the full year, and you will need to adjust your calculations to reflect that. For example, some universities and colleges pay some faculty members a set annual salary, but faculty may only work nine months of the year. If that’s the case, the employer will determine how gross salary will be calculated.
Some organizations divide a worker’s annual salary by 12 months and pay that worker a set amount each month—regardless of hours worked—plus any additional income.
At other organizations, the gross income is calculated by dividing the annual salary by the number of days the employee works per annum in order to calculate a daily rate. This daily rate is then multiplied by the number of days in a pay period.
So, if a member of staff at a college is paid $60,000 for nine months of work and there are 160 work days in that nine-month period, the daily rate is $375. If that employee works 20 days in a month, their gross income for that month would be $7,500 plus any additional income.
You should itemize all sources of income for every employee, so workers can see the breakdown. This breakdown is usually on their paystub.
Subtract deductions to determine net income
Once you have gross income determined for an employee, you need to establish their income deductions. This is money that will come out of gross pay as part of the pay calculation. Deductions can include any of the following:
- Garnishments ordered by a court, including custody payments
- Tax withholdings, including federal and state withholding, which can be calculated by looking at each employee’s W-4 or W-9 form
- Deductions for any benefits your employee has signed up for
- Federal Insurance Contributions Act (FICA) deductions for Medicare and Social Security
- Deductions made for charity
- Deductions made at the request of the employee to be placed in a savings or retirement account
Once you understand how many deductions an employee has, you subtract the total from their gross pay. This gives you the net income of the worker. For example, if a worker earned $5000 in the last month in gross pay but had $382.50 deducted for FICA, another $1100 deducted for taxes, and $89 deducted for work benefits, the worker’s take-home pay would be $3,428.50 ($5000-$382.50-$1100-$89).
Communicate with your employees about their pay and deductions
Explaining your pay calculation to your employees can help them understand where their money is going. It lets them double-check their pay and deductions. You should ensure that your workers’ pay stubs contain a detailed breakdown of their gross pay, with a line item for each deduction.
This way, employees can see how much they are paying in taxes and other items. They can check the numbers for themselves and decide if they want to adjust voluntary deductions if needed.
You may also want to create an online training video or a document as part of onboarding to help new employees understand deductions and pay calculation. This can help your employees plan their budget more accurately, since they’ll know how much money they will be taking home each pay period.
Pay calculation helps you deduct the right amounts from a worker’s total pay so they can be paid appropriately and is an essential part of running payroll.
To calculate pay, you subtract deductions from gross income in order to get to the net income. You must calculate pay effectively, considering the kind of worker and pay you are calculating, as well as any deductions that need to be made.
You should explain to your workers how their take-home pay is calculated and be prepared to answer any questions they might have.
Even if you outsource your payroll to an accountant or use software, knowing how pay calculation works is important and will help you to communicate with workers about their pay.
Looking at net pay after completing pay calculations allows you to compare the amount workers receive in their accounts to your state or city’s living wage.
You can then work to make sure your pay is competitive in your industry and your location in order to retain your top talent.