How to Calculate a Payroll Budget: A Step-by-Step Guide

Calculating a payroll budget helps improve the financial stability of your business and avoid unexpected costs. Encountering surprise payroll taxes or overtime bills can put a strain on your cash flow, considering payroll is usually the largest expense. All of this can be a significant source of stress, especially for smaller businesses.

In this article, we’ll define a payroll budget and see what it includes. We’ll also teach you how to calculate it with precision by providing a step-by-step payroll planning guide with concrete examples. Finally, we’ll go through some tips on how to control payroll costs, when to update your budget, and what mistakes to avoid.

Key Takeaways

• A payroll budget represents the total cost of compensating workers over a specific period.
• The essential components that go into a payroll budget include gross wages, employer payroll taxes, benefits costs, bonuses, overtime, variable pay, contractor costs, and payroll service or software fees.
• To calculate a payroll budget, tally up all the components, determine a range to account for variables and different scenarios, and create a small contingency fund, if possible.
• Some of the mistakes you can make include forgetting employer taxes, ignoring the turnover, underestimating overtime, not updating your budget when needed, and using outdated tax rates.

What Is a Payroll Budget?

The payroll budget is a comprehensive estimate of all the costs associated with employee compensation over a specific period. It is usually calculated on a monthly, quarterly, or yearly basis. The budget includes more than just salaries, encompassing various taxes, benefits, and other expenses related to employment.

Efficient and accurate payroll budgeting helps businesses plan and optimize their cash flow, ensuring employers always have sufficient funds to pay their employees. Moreover, it ensures compliance with federal and state tax laws, avoiding potential issues and penalties.

Lastly, payroll budgeting plays a critical role in hiring decisions. When business owners have a clear look at their finances, they can forecast expenses ahead of time and know when to hire new employees, offer promotions, or expand their operations.

What Does a Payroll Budget Include?

The payroll budget includes every component related to employee compensation.

Here is a complete breakdown of payroll costs with key elements to consider when doing the calculations:

• Gross wages. This is the total amount employers pay their employees before any deductions are taken out of their paychecks. It includes salaries for exempt employees and hourly wages for non-exempt workers.

• Payroll taxes. Employers are responsible for paying several payroll taxes for their employees. These include partial payments for Social Security (6.2% of an employee’s wage) and Medicare tax (1.45% of an employee’s wage), federal unemployment tax (FUTA), and state unemployment insurance (SUI or SUTA).

• Employee benefits. These costs vary based on the benefits that the employer offers. They commonly include contributions to health, dental, and vision insurance, as well as retirement plans. There’s also paid time off (PTO), which includes vacation days, sick leave, and holidays.

• Overtime and shift differentials. Non-exempt workers are eligible for overtime pay that has a rate of at least 1.5 times their regular rate for every work hour over 40 in a week.

• Bonuses and commissions. Any type of incentive pay in the form of bonuses and commissions must be taken into account when creating the payroll budget.

• Contractor costs. If a business works with independent contractors, the fees associated with hiring and paying them go into the payroll cost calculation, even if these aren’t traditional employees.

• Costs of payroll software and service. This encompasses any costs associated with processing payroll, whether an employer uses specialized software or a third-party service.

How to Calculate Payroll Budget in 6 Simple Steps

Now that you know what elements to consider when calculating your payroll budget, let’s go through a six-step process that will help you do it quickly and accurately.

#1. Estimate Gross Wages

The first step involves calculating an estimate of the total gross wages for all your employees for a specific period. However, there’s a difference between hourly workers and salaried employees, which is outlined in the table below:

You should also take into account any planned new hires or raises during the budget period, especially if you’re looking at a longer timeframe. This can help you avoid underestimating the total gross wage cost by accident.

To ensure accuracy and make this step easier, you can create a list of all employees with their respective pay rates.

#2. Calculate Employer Payroll Taxes

Next, you want to use the wages that you’ve calculated for your employees to determine your payroll tax burden. Check the current regulations and rates regarding federal and state taxes to ensure accuracy.

In 2025, the rate for Social Security is 6.2% on employees’ gross wages up to the annual limit of $176,100, while the rate for Medicare is 1.45% without a wage limit. Federal unemployment tax (FUTA) has a rate of 6% on the first $7,000 of each employee’s wages.

FUTA tax rate can be reduced with a tax credit by up to 0.6%, depending on how much the employer pays in state unemployment insurance (SUI) tax. Rates and wage limits for these taxes vary by state, so it’s crucial to find out the right numbers.

#3. Add Employee Benefits Costs

After the taxes, you should calculate the cost of all the benefits that you provide to your employees. This includes benefits like health insurance premiums, retirement contributions, life insurance, as well as the cost of paid time off, since that is also a part of the compensation package.

According to recent data from the Bureau of Labor Statistics Employer Costs for Employee Compensation, the average cost of benefits for private industry workers is 29.6% of the total compensation. This can give you a rough estimate, but your exact numbers can be higher or lower.

#4. Factor In Overtime, Bonuses, and Variable Pay

One of the best ways to factor in overtime, bonuses, and variable pay is to look at historical data. Review patterns related to seasonal operations or performance incentives to determine what you spent in prior months or years.

Then, you can make data-driven estimates based on the expected scenarios. When doing labor cost budgeting, it’s recommended to create a range and account for both conservative and optimistic situations.

#5. Include Payroll Processing or Software Fees

Many small businesses use specialized software for payroll processing to speed up the process and ensure accuracy. This software typically comes with a monthly subscription, which should be included in the payroll budget calculations, along with any additional administrative costs.

On the other hand, some businesses outsource payroll processing entirely, which significantly reduces administrative burden but costs more. Fees for these payroll services often combine a base fee with a per-employee fee.

#6. Combine All Costs to Create Total Payroll Budget

Once you’ve calculated all the previous values, you want to add them together to get the final sum, which represents your total payroll budget. Depending on your previous calculations, the final figure may also represent a range to account for different scenarios.

It’s a good practice to add a small contingency fund (e.g., 3–5%) to the total payroll budget to cover any unexpected costs.

Payroll Budget Example

To show you how to calculate a payroll budget in practice, we’ll use a payroll budget example. Let’s assume that our sample business has the following:

• 3 full-time, salaried employees, each earning $48,000 per year.
• 1 part-time, hourly worker, earning $20 per hour while working 20 hours per week.
• Payroll taxes include Social Security, Medicare, and FUTA
• Benefits amount to $450 per month per full-time employee.
• Payroll software costs are $150 per month.

Now, let’s see a step-by-step calculation based on our sample business.

Step 1: Gross Wages

• Full-time: 3 * $48,000 = $144,000
• Part-time: $20 * 20 * 52 = $20,800
• Total annual wages: $164,800
• Total monthly wages: $164,800 / 12 = $13,733

Step 2: Payroll Taxes

• Social Security: $164,800 * 0.062 = $10,218
• Medicare: $164,800 * 0.0145 = $2,390
• FUTA: $7,000 * 0.06 * 4 = $1,680
• Total annual payroll taxes: $10,218 + $2,390 + $1,680 = $14,288
• Monthly payroll taxes: $14,288 / 12 = $1,191

Step 3: Employee Benefits

• Monthly employee benefits: $450 * 3 = $1,350
• Total annual benefits: $1,350 * 12 = $16,200

Step 4: Overtime, Bonuses, and Variable Pay

• Overtime estimates for an hourly employee: $1,500 per year
• Bonuses estimated in total: $5,000
• Total annual variable pay: $1,500 + $5,000 = $6,500
• Monthly variable pay: $6,500 / 12 = $542

Step 5: Payroll Software Costs

• Monthly software fee: $150
• Total annual software fee: $150 * 12 = $1,800

Step 6: Total Payroll Budget

• Annual payroll budget: $164,800 + $14,288 + $16,200 + $6,500 + $1,800 = $203,588
• Monthly payroll budget: $13,733 + $1,191 + $1,350 + $542 + $150 = $16,966

5 Tips for Controlling Payroll Costs

Now that you know how to calculate a payroll budget, here are five tips for controlling the costs without having to resort to downsizing:

1. Review and optimize benefits. Every year, you should review the current package of benefits to see if the premiums have spiked and if there are better options.
   
   
2. Implement overtime policies. Set clear policies for overtime, where employees have to ask managers for approval to work beyond their standard hours.
   
   
3. Classify employees correctly. Incorrect classification can result in more overtime pay than needed. Plus, employee misclassification can lead to significant penalties.
   
   
4. Outsource HR tasks. Depending on the size and the needs of your business, outsourcing certain HR and administrative tasks to PEOs and similar organizations can be more cost-efficient than hiring dedicated staff to manage them in-house.
   
   
5. Hire strategically. In some cases, it can be more beneficial to hire independent contractors or temporary workers than full-time employees. This is especially true for seasonal or project-based work.

How Often Should You Update Your Payroll Budget?

How often you should update your payroll budget depends on the complexity of your business and the external factors, like economic changes.

There are three common timeframes, and they are:

• Monthly updates. These are typically for businesses that have fluctuating hours, encounter increased seasonal demand, or experience frequent staffing changes.

• Quarterly updates. These updates are for stable companies that have predictable revenue and labor costs.

• Annual updates. Annual updates are good for long-term planning and forecasting, but they shouldn’t be used alone. You should supplement them with monthly or quarterly payroll budget updates.

You can also update your payroll budget outside an established schedule if your business has experienced significant expansion or restructuring, or if there have been considerable shifts in the market.

6 Common Payroll Budget Mistakes to Avoid

Here are some of the most common mistakes that can lead to unexpected expenses:

• Forgetting employer taxes. One of the biggest mistakes you can make is forgetting to account for the employer’s share of payroll taxes. Payroll tax rates aren’t negligible, and they add a significant amount to the total budget.

• Ignoring employee turnover. Turnover increases employer payroll expenses through the cost of recruitment, training, and hiring. The cost of hiring an employee can be high, which is why it’s important to account for potential turnover and try to minimize it.

• Underestimating overtime. Failing to account for overtime can lead to unexpected expenses. These costs can ramp up quickly, especially in states where the rates are even higher than 1.5.

• Not updating the budget after raises/hiring. After you hire a new employee or give the existing one a raise, you should immediately update your budget. Otherwise, you can run into issues in the next payroll cycle.

• Not accounting for benefits increases. The cost of various benefits can increase each year. That’s why you should closely monitor the rates from your provider and make sure to account for the changes when calculating your payroll budget.

• Using outdated tax rates. Tax laws and rates are subject to change. The IRS, state, and local tax institutions periodically adjust the rates, so you should keep track of them to make sure that your calculations are accurate.

Manage Your Payroll With Paystub.org

Paystub.org can help you calculate, document, and track your payroll expenses, helping you budget and forecast more accurately. We developed several software tools that allow you to generate precise and compliant payroll and tax documentation with ease.

If you’re running a small business, you should consider using one of the following generators:

• Pay stub generator features a built-in calculator for rates and taxes, allowing you to quickly determine gross pay, net pay, and all deductions.
• Form W-2 generator makes year-end tax form preparation easy and helps you get a broader look at your annual payroll.
• Form 1099 generator allows you to document payments made to independent contractors.

We also have an invoice generator, which makes billing clients easy and helps you track your revenue.

Final Thoughts

Learning how to calculate a payroll budget, prepare for different scenarios, and include contingency funds is one of the best things you can do for the financial stability of your business. It helps you reduce stress and allows you to make long-term plans for your operations.

By having a well-structured payroll budget, you’ll prevent surprises and make better decisions regarding hiring, promoting, and expanding. Remember to regularly review the numbers and make adjustments when needed to keep your payroll accurate, predictable, and in line with your goals.

How to Calculate a Payroll Budget FAQ

#1. What’s the difference between gross payroll and payroll budget?

The difference between gross payroll and payroll budget is that a budget includes payroll but also other costs, like taxes, benefits, and payments to independent contractors.

#2. How do seasonal workers affect payroll budgeting?

Seasonal workers affect payroll budgeting by creating fluctuations. They increase your payroll costs, but only in certain parts of the year, and thus require forecasting and planning based on historical data.

#3. Do contractors count toward the payroll budget?

Yes, contractors count toward the payroll budget, even though they are not traditional employees. When budgeting for employee compensation, you should account for these expenses to get a better picture of your workforce expenses.