Once you hire an employee, you’re responsible for accurately calculating their paycheck. Whether you employ hourly or salaried workers, you must understand the difference between gross and net pay. Understanding how certain deductions and your tax obligations factor into both gross and net pay can help you run a smooth payroll process.
In this blog, we’ll walk you through the key differences between gross and net pay, how to calculate each correctly, and how gross and net pay is impacted by certain employee benefits, like health reimbursement arrangements (HRA) and stipends.
What is gross pay?
Gross pay, or gross wages, is the total amount of money a worker earns during a set pay period before their employer withholds taxes, deductions for voluntary benefits, and other payroll deductions. You should record an employee’s gross pay on their pay stub each payroll period.
You should count all your employees’ income sources in their gross wages, including reimbursements, commissions, and bonuses. You should also include overtime pay earned by hourly workers and any eligible exempt employees.
It’s important to note that an employee’s gross pay must meet the federal minimum wage or your state’s minimum wage, whichever is higher.
Individuals reference gross pay in many situations. Employers give the gross pay amount when discussing compensation as part of a new hire’s employment contract. The government also uses this figure to determine federal and state income tax brackets and student loan repayment plans.
How do you calculate gross pay?
To calculate gross pay for your salaried employees for a given pay period, you’ll need to divide their annual salary by the number of times you pay them throughout the year. For example, employees paid once a month will have 12 pay periods, and those paid biweekly will have 26 pay periods.
Suppose you have a salaried employee who makes $65,000 a year. If you pay them once a week (equaling 52 pay periods a year), their weekly gross income is $1,250.
You can also calculate annual gross income from what an employee receives during a set pay period. If you pay a salaried worker $5,000 once a month, you can multiply $5,000 by 12 pay periods to get their annual income of $60,000.
If you have hourly employees, you can calculate their gross pay by multiplying how much they make an hour by the number of hours they worked during a given pay period.
For example, if you have an hourly employee who works 40 hours a week at $15 per hour, their gross pay during a biweekly pay period will be $1,200. Remember to include any overtime hours they received in the calculation if necessary.
What is net pay?
Net pay, or take-home pay, is the amount of money an employee receives after their employer makes any necessary payroll deductions from their gross pay. This may include mandatory deductions, like taxes, or voluntary deductions, like those for certain health benefits. Employees' net pay is generally listed in bold on their pay stubs to stand out from their gross pay.
Some common deductions that can affect net pay are:
- Federal income tax withholdings
- State income tax withholdings
- Social Security, Medicare taxes, and payroll taxes, like the Federal Insurance Contribution Act (FICA) and the Federal Unemployment Tax Act (FUTA)
- Court-ordered wage garnishments, like credit card loans, student loan debt, unpaid child support, alimony, outstanding medical bills, and unpaid taxes
- Health insurance premiums
- Life insurance premiums
- Some voluntary deductions, like contributions made to HRAs, health savings accounts (HSAs), and flexible savings accounts (FSAs)
- Retirement plan contributions, like 401(k)s or IRAs
- W-4 Form
- Charitable donations
As a business owner, you’re responsible for adequately calculating and deducting all necessary expenses from your employees’ paychecks before giving them their net payment.
How do you calculate net pay?
Once you figure out an employee’s gross wages by using the calculations in the previous section, figuring out their net pay is simple. The formula to calculate is this: Gross pay – voluntary and mandatory deductions = net pay.
For example, if you have an employee that makes $2,600 in gross wages biweekly but deductions each pay period equals $800, their net pay each paycheck will be $1,800.
Every employee’s net pay will be different. Not all your employees will receive the same annual salary, they may not have the same voluntary deductions, or they may have wage garnishments. Therefore, it’s important to do accurate calculations for each individual employee so they receive the right amount of take-home wages.
Are HRAs and stipends considered gross pay or net pay?
The IRS considers HRAs pre-tax benefits, also known as tax-advantaged benefits. With most pre-tax benefits, employers deduct the benefit from an employee’s paycheck before withholding federal taxes, reducing their taxable income liability.
Only employers can contribute to an HRA, and their contributions are made on a pre-tax basis. This means they’re exempt from an employee’s gross pay. They’re also free of payroll taxes, like FUTA and FICA, for employers. Additionally, HRA reimbursements are income-tax-free for employees, provided they have a health insurance policy that meets minimum essential coverage (MEC).
On the other hand, most employee stipends are taxable income because the IRS treats them as extra wages added to an employee’s paycheck. This means you should include them in your employees’ gross pay as an additional form of income. You also must include taxable stipends on your employees' W-2 Forms and withhold the appropriate state and federal taxes.
Some stipends, like commuter benefits and tuition reduction benefits, can be tax-free if you meet specific IRS qualifications. If you want to offer a tax-free stipend, check IRS Publication 15-B1 to see which ones are eligible or work with a tax professional or benefits specialist for assistance.
If this is your first time running payroll at your company, knowing the ins and outs of gross pay and net pay is vital. An employee’s pay stub should always indicate their gross wages, any deductions, and their final net pay amount. But you don’t have to do these calculations by hand.
Using automated payroll software can help you streamline your payroll process. With these programs, you can run accurate paychecks, pay your employees quickly and easily, track your deductions, benefits, and taxes, and keep you compliant with state and federal regulations.