The process of managing employee payroll is often time-consuming—unless, that is, another company is hired to take care of it instead. Payroll outsourcing can lead to big cost savings and provide access to payroll management experts, but doing so also comes with unique challenges and risks. Our 2022 guide takes you through the ins and outs of how payroll outsourcing works and how your company can best evaluate a possible outsourcing strategy.
What Is Payroll Outsourcing?
What Is Payroll?
Payroll involves much more than simply mailing checks. It encompasses a variety of tasks, not all of which are necessarily carried out by the same entity. The process begins with the integration of employees into a payroll system and extends through end-of-year tax responsibilities.
Payroll “functions” include gathering employee information, setting up automatic payments and direct deposits, tracking hours or timesheets, calculating wages owed, distributing pay stubs and even garnishing wages as directed by court order. It also includes managing information relevant to the tax process such as health insurance and workers’ compensation claims.
The term “payroll” can describe both a company’s list of employees to be paid and also the total amount an employer owes in wages and salaries. In the modern business context, however, payroll most often refers to the process of paying employees or to the entities responsible for carrying this out.
What Is Outsourcing?
For most of the 20th century, companies strove to own and exercise control over all business functions and assets. Economic theories of the day advocated growth in all reasonable directions to exploit economies of scale. This mindset of vertical integration extended into companies’ internal processes as well. It wasn’t until the late 1980s that many companies, hindered by bloated internal structures, began to see broad strategic value in “hiring away” work once completed in-house. Once the possible cost savings of the practice became clearer, there was no turning back.
This act of hiring away business functions, or “outsourcing,” is now recognized as a widely applicable business strategy, even if its ethical implications and socioeconomic, political and cultural consequences are often overlooked. Its financial value as a near-term, cost-cutting measure has been boosted dramatically by globalization, which opened access to international labor far less immediately expensive than America’s domestic workforce.
Outsourcing Payroll
In the early days of strategic outsourcing, companies were most comfortable hiring away low-skill tasks distant from sensitive business areas. Nowadays, many companies do the opposite and outsource critical functions such as customer service and money-management tasks. This has grown to include many activities normally performed by administrators or human resources departments—including payroll duties.
Allowing a third party to direct company funds and manage highly sensitive information may once have been unthinkable. Much of the payroll process, however, involves routine tasks and follows established guidelines, making it possible to delegate responsibilities to trusted partners without relinquishing decision-making authority.
What Is Payroll Co-Sourcing?
“Payroll co-sourcing” describes a hybrid model in which some elements of the payroll process are hired away while others are completed in-house. One advantage of splitting up the responsibilities is that companies can get “hands-on” in specific areas they’d rather not entrust to a third party, all while still enjoying some of the cost advantages of outsourcing. Somewhat to the contrary, other companies co-source payroll duties if they believe an external service will be more adept at specific tasks, keeping the process in-house except for when they’d rather turn to an expert.
Outsourced Payroll Functions
It’s possible (though not ubiquitously desirable) to hand over virtually all payroll functions to an external service. Outsourced responsibilities can include:
- Payroll account setup
- Payment method setup
- Tracking time worked
- Calculating wages owed
- Delivering pay
- Instituting security measures for safeguarding company and employee information
- Ensuring compliance with government regulations
- Withholding payroll taxes, income taxes and garnished wages
- Managing employee deductions
- Remitting payroll taxes
- Completing end-of-year tax work
How Payroll Outsourcing Works
Initial Steps
Preparing to hire away payroll functions represents the majority of a company’s actual work in the outsourcing process. The first step is for the company to decide on a preferred degree of outsourcing. In other words, whether the company wishes to fully outsource or co-source, and if the latter, how does it wish to divide responsibilities? A company may decide, for example, that they’d like a third-party service to handle only the tax issues associated with payroll.
Arranging Payroll Outsourcing
In 2022, a wide selection of “payroll outsourcing providers” are to be found both domestically and internationally. While different companies will have different criteria for evaluating a good match, they all must ensure a provider maintains adequate protections for employee data and complies with relevant regulations.
Once a payroll outsourcing provider has been selected, both parties must agree on “terms of engagement.” This is when the provider’s specific duties are officially established and also when compensation for services rendered is addressed. Finally, the client shares all relevant information the provider needs to complete the payroll functions it will assume.
Making Payroll Happen
Once information has been exchanged and procedures established, the payroll outsourcing provider begins its actual duties. This almost always involves distributing pay on a clearly defined schedule (every two weeks is popular). As with performing payroll functions in-house, applicable taxes must be withheld by the provider before payments are made.
Typically, providers report to the client on a regular, predetermined basis, confirming services rendered and detailing performance. For the client, this is an opportunity to ensure everything is going according to plan. The final major component of the process is for outsourced end-of-year tax duties. This includes both submitting documentation to tax authorities—which the provider has maintained throughout activities—and remitting the tax dollars themselves.
Payroll Outsourcing Benefits
Cost Savings
In many cases, companies outsource payroll because they’ve determined it to be more cost-effective than managing payroll in-house. This has historically been one of the main incentives for any kind of outsourcing, and payroll functions are no exception. If these functions are passed along to a payroll outsourcing provider in a country with generally lower salaries and wages, much of the difference in employee compensation is recouped by the client company and savings can be significant.
This can be true even when payroll is outsourced domestically. A New York- or San Francisco-based company that keeps payroll in-house, for example, must pay “big city salaries” to attract the right employees for managing payroll, just like the rest of its internal workforce. If many hours of work can instead be assumed by third-party employees somewhere with a lower cost of living, the outsourced functions tend to become cheaper to perform.
Letting Professionals Do the Work
Another benefit to outsourcing is that payroll functions can be assumed by providers specializing in effective payroll management. For most companies, performing payroll functions in-house amounts to nothing more than an important housekeeping duty; the company itself is expert in something entirely different. A payroll outsourcing provider or “payroll service bureau,” on the other hand, may perform payroll functions and nothing else. If it does offer other services as well, these are likely to be in similar areas.
Not only does this imply greater overall experience with matters of payroll, it also means that the third-party provider should have effective management systems in place for the full range of payroll functions. They likely use employees with task-specific training and have all the necessary software on hand.
Naturally, the quality of payroll outsourcing will vary, but it’s clear many companies still see these third-party payroll managers as more effective than internal capabilities. Mistakes involving taxes or adherence to regulations can be time-consuming and costly to resolve, so there’s a strong incentive to get everything right the first time. “Leaving it to the pros” can be especially beneficial for large companies with complex and burdensome payroll responsibilities.
Increased Focus on Core Functions
A company’s core business functions—whatever it does to generate revenue—are understandably its main priority. Devoting resources to more peripheral functions such as payroll is unavoidable, but relying on time and effort from in-house staff inevitably chips away from opportunities for revenue or growth and can further detract from company efficiency when unexpected issues arise.
The only types of businesses that identify payroll management as a core function are, well, the payroll outsourcing providers themselves. Outsourcing payroll stands to greatly reduce a major administrative distraction for most companies, allowing them to “cut the fat” from their employee rosters and keep their organizations focused on other tasks.
Payroll Outsourcing Disadvantages
Less Oversight
Outsourcing payroll means giving up direct supervision of at least some of its many processes. While a client company remains in charge of setting expectations and is compelled to monitor a provider’s success, there’s no real substitute for the level of oversight achieved through managing payroll functions internally.
Finding a trustworthy third-party provider goes a long way, but a company can’t just pass off any payroll mistakes that arise as the fault of its provider and move on. At the end of the day, the company is still responsible for properly compensating its employees, and problems created or left unresolved by the provider will continue to cost time and money until they’re addressed. The client company also remains liable for tax remittance whether or not it has outsourced this particular payroll function, meaning it’s on the hook for any errors even if it’s not immediately responsible.
Decreased Data Security
Perhaps even more concerning is the increased risk of a breach into sensitive data that outsourcing inevitably brings. While many cloud-based programs for payroll data management use encrypted servers and firewalls for security, they are juicy targets for malicious activity.
Data security risks such as these never completely go away, but transferring sensitive information (Social Security numbers, bank account information and the like) outside the walls of the company and potentially across the globe does increase exposure. When a company keeps everything internal, these types of risks tend to go down.
Best Practices for Outsourcing Payroll
Focus on Provider Reputation and Experience
When choosing a payroll outsourcing provider, it’s important to remember what’s at stake. A good provider will make things easy for the client, but client companies shouldn’t be lured into a false sense of security. Even the best payroll managers are prone to mistakes or data breaches. Take the time to make sure a provider is both trustworthy and experienced to minimize these inherent risks of outsourcing.
Remain Aware of Regulations and Tax Burdens
As mentioned before, these are further areas where a misstep by a payroll outsourcing provider can become a problem for both the provider and the client company. If a company is outsourcing internationally, it shouldn’t assume that it can ignore employment regulations in the provider’s country, as these can be very different from those in the United States. A company should also never assume that all applicable taxes from the payroll process have been successfully remitted by a provider—always double-check that the figures are correct, as the consequences for an error can be costly and will fall entirely on the client company.
Take Your Time
Companies experienced in arranging outsourcing contracts with third-party entities can rely on past experience for guidance. For companies newer to outsourcing, however, it’s worth taking plenty of time to select the right provider and to make sure all other aspects of an arrangement check out.
Outsourcing company functions such as manufacturing processes or customer service might seem like a bigger deal than simply finding a new payroll department somewhere else. Don’t forget payroll fuels a company’s “engine,” underpinning its greatest asset: its workforce. Add to that the sensitivity of the data involved, and it’s easy to see why these aren’t decisions to rush into.
Bottom Line
Payroll outsourcing certainly has advantages, but no single resource has the ability to point a company toward guaranteed success with payroll management. Company leaders should not take a decision about outsourcing payroll lightly, but should understand its convenience and financial savings. A solid understanding of payroll outsourcing’s pros and cons, along with accurate information on existing payroll management costs, can offer helpful guidance.