Payroll Compliance: The 10 Most Costly Mistakes Employers Make

Payroll Errors Are Expensive

Payroll mistakes are among the most common and most costly compliance failures for employers. They result in back-wage liability, liquidated damages (often doubling the amount owed), penalties, and legal fees. Class and collective action lawsuits over payroll violations routinely produce settlements in the hundreds of thousands to millions of dollars. Most of these errors are preventable.

The Ten Most Costly Mistakes

1. Misclassifying Employees as Independent Contractors

This remains the most consequential payroll mistake an employer can make. When a worker classified as a contractor is found to be an employee, the employer owes back taxes, unemployment insurance, workers' compensation premiums, benefits, overtime, and penalties. The IRS, DOL, and state agencies all pursue misclassification aggressively.

Prevention: Apply the applicable classification tests (federal and state) to every worker relationship. When in doubt, classify as an employee.

2. Misclassifying Non-Exempt Employees as Exempt

Classifying an employee as exempt from overtime when they do not meet both the salary and duties tests results in liability for all unpaid overtime, plus liquidated damages. This is particularly common for positions with "manager" in the title but limited actual managerial duties.

Prevention: Audit every exempt classification against the specific duties test for the applicable exemption. Do not rely on job titles or salary alone.

3. Failing to Pay for All Hours Worked

Off-the-clock work, including pre-shift preparation, post-shift cleanup, working through meal breaks, and responding to emails and messages after hours, must be compensated. Employers who know or should know that employees are working off the clock cannot avoid liability by having a policy against it if they fail to enforce the policy.

Prevention: Implement reliable timekeeping, train managers to prevent off-the-clock work, and address violations promptly.

4. Incorrect Overtime Calculation

The regular rate of pay for overtime purposes must include most forms of compensation, not just the base hourly rate. Shift differentials, non-discretionary bonuses, commissions, and certain other payments must be factored into the regular rate. Many employers calculate overtime based on base pay alone, resulting in underpayment.

Prevention: Work with your payroll provider to ensure the regular rate calculation includes all required compensation elements.

5. Applying the Wrong Minimum Wage

When federal, state, and local minimum wages differ, the highest rate applies. Employers with employees in multiple jurisdictions sometimes apply a single rate across all locations. Some also fail to update rates when mid-year increases take effect.

Prevention: Maintain a current list of all applicable minimum wage rates and update payroll promptly when rates change.

6. Improper Deductions

Deductions that reduce pay below minimum wage, deductions without proper authorization, and deductions prohibited by state law (such as deducting for cash register shortages or damaged equipment) are common violations.

Prevention: Review every payroll deduction against both federal and applicable state law. Obtain proper written authorization for voluntary deductions.

7. Late or Incorrect Final Paychecks

State laws impose specific deadlines and requirements for final pay, including whether unused vacation must be paid out. Violations can trigger waiting-time penalties that accrue daily.

Prevention: Know the final pay deadline in every state where you have employees and build the process to meet it consistently.

8. Failing to Track Hours for All Non-Exempt Employees

The FLSA requires employers to maintain accurate records of hours worked for all non-exempt employees. Failure to keep records shifts the burden to the employer in wage disputes, meaning the employee's estimates of hours worked will often be accepted.

Prevention: Require all non-exempt employees to record their time, including remote workers. Review and approve timesheets before processing payroll.

9. Mishandling Tipped Employee Pay

Tip credit violations, including failing to provide the required notice, including managers in tip pools, or paying below the tipped minimum wage when tips do not make up the difference, create significant liability.

Prevention: Ensure your tipped employee practices comply with both federal and state law, which may differ substantially.

10. Ignoring State-Specific Requirements

State payroll requirements beyond minimum wage include pay frequency rules, pay stub content requirements, expense reimbursement mandates, and supplemental wage tax rates. Each state has its own set of requirements.

Prevention: Audit your payroll practices against the specific requirements of every state where you have employees.

The Cost of Getting It Right vs. Getting It Wrong

A payroll compliance audit costs a fraction of a single wage and hour lawsuit. Invest in getting your payroll practices right: audit regularly, work with qualified payroll professionals, and address issues as soon as they are identified. The cost of prevention is always less than the cost of remediation.