Running payroll accurately is arguably one of your most critical employer responsibilities. But even if you use a reliable payroll processing system, there’s room for user error. You might input numbers incorrectly, forget to add an employee’s pay raise, or fail to remove a terminated employee from your payroll. To combat these potential problems, conduct a payroll audit. A payroll audit is a periodic review of your payroll records, taxes, and processes to confirm accuracy, compliance, and to detect errors or fraud.
Regularly performing a payroll audit can alert you to mishaps early on. Learn about payroll audit procedures to catch mistakes and avoid IRS penalties, payroll fraud, tax filing corrections, and disgruntled employees.
What’s a payroll audit?
A payroll audit is an analysis of a company’s payroll records and processes to ensure accuracy and compliance with wage and hour laws and tax rules. Payroll audits typically verify active employees, pay rates, hours and wages, deductions, and tax withholdings and deposits. Audits can be internal (performed by you or your team) or external (performed by an independent accountant or government agency). Many businesses sample a subset of employees and pay periods to make the review efficient. Conduct a full audit at least once per year, and run mini-checks each pay cycle.
Generally, payroll audits are internal, meaning you or someone in your business conducts them. Performing internal audits can help you catch errors and prevent possible external audits later on.
After conducting the review, examine your payroll audit report. If necessary, make changes for future payroll processing. You may also need to retroactively make changes. For example, you might provide retroactive pay to an employee or remit more in taxes to the IRS.
Benefits of conducting a payroll audit
So, why should you conduct a payroll audit? The better question is, why shouldn’t you?
Conducting a payroll audit regularly can help you:
- Prevent payroll fraud by weeding out ghost employees or mismarked time cards
- Catch manual errors made when entering numbers into a system
- Improve payroll KPIs, like payroll accuracy rate
- Spot calculation mistakes if doing payroll by hand
- Realize you need to factor in a raise
- Remove terminated employees from your payroll
- Verify your tax withholdings are accurate
- Accurately account for paid or unpaid time off
- Compare hours paid to when employees clocked in
- Ensure you are compliant with employment laws (e.g., overtime pay)
- Confirm correct worker classification (e.g., employee vs. independent contractor) and proper exempt/nonexempt status
- Strengthen internal controls and create a defensible audit trail for regulators and lenders
If you fail to audit your payroll process, your small business can end up doling out excess money, breaking employment laws, and remitting incorrect tax amounts.
Let’s take a look at a made-up employer, Amy. Amy terminated an employee, Jenn, in March but forgot to remove Jenn from payroll. In December, Amy decides to conduct a payroll audit. She realizes that she never removed Jenn. Amy gave Jenn wages for nine additional months, totaling $19,000.
Payroll audit procedures
Use the following steps to get started on your payroll audit process.
Before you begin: Gather your records
Collect the documents you’ll need to speed up your audit:
- Employee list, status, hire/term dates, pay rates, job titles, and classifications
- Time and attendance records; PTO/leave balances and requests
- Payroll registers, pay stubs, and deduction summaries
- Tax filings and deposits (e.g., Forms 941, 944, 940, W-2, and state and local returns)
- Benefits elections and deductions (health, retirement, garnishments)
- General ledger payroll accounts and bank statements (or payroll account)
- Written policies (timekeeping, overtime, PTO) and any pay change approvals
Tip: For efficiency, consider sampling a representative set of employees and pay periods, then expand the sample if you find discrepancies.
1. Look at the employees listed on your payroll
Review your employees listed on your payroll. Verify that all of these employees worked for you during the time period. If more workers are listed on your payroll than you had working for you, you may have a problem.
Some employees commit payroll fraud by adding fake employees to payroll. Or, you may have forgotten to remove a terminated employee from your payroll.
Make sure that the list of employees on your payroll matches your employment records. Remove any employees who no longer work for you. You may need to dig deeper to find out why those employees are on your payroll. While reviewing, also confirm correct worker classification (employee vs. contractor) and that job status (full-time vs. part-time; exempt vs. nonexempt) is current.
2. Analyze your numbers
When conducting a payroll audit, you can’t avoid analyzing numbers. Running payroll is mostly numbers. Pay rate, hours worked, total pay for the period, and withheld taxes are some essential payroll numbers.
Examine each employee’s pay rate to ensure you paid the worker the correct amount. Make sure the pay rate is up-to-date and matches the employee’s record. If you gave the employee a raise or salary reduction, verify that you changed the pay rate on the applicable date.
Look into the hours the employee worked. Did they really work those hours during the pay period? Does your payroll system match what’s recorded in your time and attendance software? Did you provide overtime pay to nonexempt employees who worked over 40 hours in a workweek?
Also review:
- Overtime, double-time, shift differentials, and premium pay
- Bonuses, commissions, retro pay, and off-cycle checks
- Meal/rest break rules where applicable
- Rounding practices and time edits (ensure they comply with policy and law)
- Any deductions (benefits, garnishments) for accuracy and authorization
- Easy-to-access payroll reports
- Free USA-based support
- 3-step easy payroll process
3. Verify time is correctly labeled
Most employers give employees time off from work, with many providing paid time off (PTO). Do you provide time off? If so, make sure you or your employees properly labeled time when running payroll. That way, you can identify when an employee worked and when they didn’t.
If you provide a set number of paid time off, subtract it from the employee’s available time off. Be sure to label time off as vacation, personal, sick, bereavement leave, or whatever labels you use.
If your state or locality has paid sick leave or predictive scheduling laws, verify accruals, carryover, and usage align with those rules.
4. Reconcile your payroll
Next, look at your payroll. Compare your findings to other records to verify your totals match. If there is a discrepancy, closely examine your records to find out the problem.
Compare your payroll records to your business’s general ledger. The payroll expenses in your general ledger should match your payroll audit findings.
Next, you need to reconcile your payroll records with your bank statements. Compare the amounts listed in your payroll records to what was withdrawn from your account. Consider having a separate payroll account to make bank reconciliation easier.
Tie payroll liabilities (taxes, benefits, garnishments) to payment confirmations and settlement reports to ensure everything collected was remitted.
5. Confirm tax withholdings, remittance, and reports are accurate
Another critical payroll audit procedures step is verifying the accuracy of your employment taxes.
Make sure you withheld the correct amount of taxes from each employee’s wages. You must withhold federal income, Social Security, and Medicare taxes. You may also need to withhold state and local income tax. And, verify that remitted tax amounts are correct.
Compare the values on your payroll reports (e.g., Form 941) to your payroll records. Wages and tax withholding amounts listed on your payroll reports should match your payroll records.
Remember employer taxes and filings such as FUTA (Form 940), state unemployment (SUTA), and any local payroll taxes. At year-end, reconcile W-2 totals to the last Form 941 of the year and your general ledger before distributing W-2s.
After the audit: Document, correct, and prevent
- Document findings: Summarize discrepancies, amounts, root causes, and affected periods/employees.
- Correct promptly: Issue retro pay or recover overpayments (consistent with state law), amend tax filings and remit shortages, or request refunds/credits for overpayments.
- Prevent recurrence: Update policies, adjust role-based permissions, require approvals for pay rate changes, and schedule recurring mini-audits.
- Communicate: Let affected employees know what changed and why, and keep records in case of an external audit.
How often should you audit?
- Every pay run: Spot-check new hires, overtime, and tax withholdings.
- Quarterly: Reconcile payroll expense, liabilities, tax deposits, and benefit deductions to the general ledger and financial statements.
- Annually: Full audit of payroll policies, classifications, and year-end forms (Forms W-2 and 1099-NEC, if applicable).
Complex operations, multiple states, or frequent pay changes may warrant more frequent reviews or an external accountant.
Common red flags that trigger a payroll audit
- Late or missed tax deposits or filings
- Overtime spikes or payroll costs outpacing headcount
- Complaints about unpaid wages or misclassification
- High volume of manual check edits or off-cycle payments
- Inactive or terminated employees still being paid
- Mismatches between timekeeping and payroll reports
How payroll software can simplify your audit process
Payroll software helps you prevent and detect errors by centralizing data and automating checks.
With Patriot:
- Unified data: Sync time and attendance with payroll to reduce mismatches.
- Built-in calculations: Automate overtime, taxes, and deductions to reduce manual errors.
- Audit-ready reports: Run payroll registers, tax liability reports, and PTO balances in a few clicks.
- Role-based controls: Limit who can add employees, change rates, or approve time.
Start a free trial to streamline payroll and make audits faster and more accurate.
Payroll audit checklist
Take a look at our payroll audit checklist to make sure your process is thorough.
Here’s a simplified text version of the image above for easy reference:
- Verify active employee list (remove terms; confirm classifications)
- Analyze pay rates, hours, overtime, and all earnings
- Confirm PTO/leave is correctly labeled and accrued
- Reconcile payroll to general ledger, bank, and liabilities
- Validate tax withholdings, deposits, and filings (federal, state, local)
Frequently asked questions
A payroll audit is a structured review of your employee data, time records, pay, deductions, and taxes to ensure accurate pay and legal compliance.
Do spot checks every pay cycle, reconcile quarterly, and complete a full audit annually.
Your team runs internal audits to catch issues early; external audits are performed by third parties or agencies and may be triggered by red flags or complaints.
Small teams can complete a focused audit in a few hours to a few days, depending on scope and whether you sample or review records.
Payroll registers, time/attendance records, employee lists and pay rates, tax filings/deposits, benefit deductions, general ledger accounts, and bank statements.
Wrong pay rates, misclassified employees, unpaid overtime, deductions you failed to remit, incorrect tax withholdings, and ghost or terminated employees are common errors.
Yes! Integrated payroll and time tools reduce errors, centralize audit trails, and provide reports that make reconciliation faster.
Looking for an easy way to run payroll and conduct a payroll audit? With Patriot’s online payroll software, you can run payroll in three easy steps. Plus, access numerous payroll reports like time off balances, payroll details, and payroll tax liabilities. Streamline your payroll process with a free trial!
This article has been updated from its original publication date of April 15, 2019.
This is not intended as legal advice; for more information, please click here.
