Payroll Outsourcing: Pros, Cons, & Risks (vs In-House Payroll)

Remote work and international trade open up international labor and consumer markets to even small businesses and startups. To grow quickly in this environment, many companies turn to business process outsourcing services, such as payroll outsourcing. A business no longer needs to slowly grow out of a single location and develop all services in-house; even a startup can now search for clients all over the world and professionally develop complex business processes through outsourcing.

One of the business processes most applicable to an outsourcing model is payroll processing. Payroll processing is mainly an administrative task that does not differ greatly between companies and for companies of different sizes. It is, however, necessary, and relates to a number of other crucial processes such as regulatory compliance, accounting, records keeping, tax reporting, and benefits administration.

Outsourcing the management of these business functions can be especially attractive to startups and small businesses. An owner who is trying to enter the market, perfect a product or service, keep customers happy, and still stay within budget, rarely has the time to learn all of the regulations and processes involved in correct and efficient payroll processing. For businesses hiring international staff, remote workers, or opening offices in other states, it can be even more complex and difficult to maintain regulatory compliance in the various jurisdictions where employees work.

For companies that are not hiring remote workers or opening up offices in multiple jurisdictions, payroll outsourcing may provide an advantage as well; it brings in a third-party partner who can ensure compliance in payments and deductions, and frees up time and capital that business owners can channel towards growth and improved products and services. 

What is payroll outsourcing? 

Payroll outsourcing, in the most simple sense, is hiring a third party to process employee payroll distribution and record keeping. Payroll outsourcing is done by companies of all sizes, however, it is most commonly a solution for growing small and medium enterprises (SMEs). Payroll processing does not replace the work of an accounting or HR department, but it does free up employees to pursue work that directly affects the core business, which can help reduce expenses for SMEs.

Payroll outsourcing may be done by a company specializing in that task, generally known as a payroll outsourcing provider or a payroll service bureau. It is also commonly done by accountancy firms and Professional Employer Organizations (PEOs). An accountancy firm with local offices may provide the greatest level of service for a company based in one jurisdiction. For others, a payroll outsourcing provider may be more attractive because they are often able to service employees in many states and countries, and may offer additional options such as full HR outsourcing. For those considering working with a PEO, one that offers payroll outsourcing services only as an option may be a good way to start the relationship before fully committing to all PEO services.  

The Internal Revenue Service (IRS) provides an excellent breakdown of the different types of payroll service provider in the United States. 

What is included in payroll outsourcing?

Outsourced payroll services will also generally include the processing of deductions for employee contributions to benefits packages, as well as employee taxes.

Since the payroll processor will be withholding for benefits payments and (often) making those payments, they will work with benefits providers and often integrate their software systems.

A payroll outsourcing provider must be knowledgeable in the state and national laws regarding payroll, and they should be able to provide proof that employee payroll was processed in accordance with those regulations.

Finally, the outsourced payroll processor must integrate with the time-keeping system used by the client. This may take the form of data punch cards, fingerprint scans, software systems, data provided by HR, or a combination.

The payroll servicer will then provide the client with a report of hours worked and paid, tax deductions made, and benefits payments made.

How does payroll outsourcing work?

An outsourced payroll services provider calculates the total hours worked (including overtime, sick days, etc) for each employee. They then make deductions for tax payments and any employee benefits contributions.

Then, checks are issued or direct deposits are made to both employees and benefits providers.

The payroll processor presents a bi-weekly or monthly report to the client with full details on total payroll disbursement, total tax withheld, and benefits payments made.

Most payroll outsourcing services work with many different clients and should have professionals trained in accounting, benefits administration, and tax reporting. Some providers may specialize in a specific industry or geographic area (New York State, or facilities services, for example). Others though may be sufficiently knowledgeable and experienced to provide services to all US states and multiple industries. Other payroll outsourcing services specialize in international payroll processing in multiple jurisdictions. Payroll processing may also be bundled with a number of other HR or accounting services.

What are the benefits of outsourcing payroll?

1. You save time

In small and quickly growing companies, employees often wear many hats, performing functions across different categories. Payroll processing is essential and must be done on time. What’s more  it can take up many work hours when all related tasks are included. Small companies may only have one or two employees handling payroll processing, all HR tasks, as well as client order fulfillment. During busy times, payroll processing can take valuable time that could otherwise be spent on tasks that keep customers happy and grow the company.

2. You save money

Payroll outsourcing can do the work of a full-time salaried employee, or in larger companies, a whole department. Payroll outsourcers stay in business because they are able to offer these services at a high level of professionalism and at a lower cost than in-house processing would be. In startups, the resources may simply not be there to hire an in-house professional. For a company hiring international remote workers, payroll outsourcing can reduce the need for legal counsel or consultants on international labor regulations.

3. You end up with fewer payroll processing errors

Payroll processing errors can result in employee dissatisfaction if payments are late, loss to the company if payments are incorrect and not caught, and even fines if it results in a breach of tax or legal regulations.

Payroll outsourcing providers specialize in doing one set of tasks well. The success of their business relies on processing and reporting payroll correctly and professionally. Generally, this should result in fewer errors than an in-house system.

4. Payroll compliance is assured

First-time business owners experience a steep learning curve in all areas, and learning the ins and outs of payroll processing regulations will not generally be on their list of pressing problems to solve. New companies fulfilling large orders may need to hire new staff quickly; learning how to comply with local regulations in correctly processing salaries, withholding taxes, and paying benefits may be lost in the shuffle. For larger companies, the difficult moment could come when they are expanding into a new state or country and the home office team has not learned the difference in regulatory environments. In all of these cases, errors could go on for extended periods of time, creating trouble down the road when they are discovered.

There are other potential compliance issues that may not be readily apparent to business owners at first: For instance, vacation and leave time must be paid in some jurisdictions but not in others. In some countries, year-end bonuses are mandatory and tied to salary level. Tax laws and anti-discrimination regulations can vary in each state. A good payroll outsourcing provider can ensure that compliance is met before they are discovered by employee complaints or government audits.

What are the disadvantages or risks of outsourcing payroll?

1. Personal data risk

All data held electronically is exposed to some amount of risk. Technological developments can provide data thieves with more tools, driving the need for increased security from company owners. When information is held off-site, as in the case of payroll outsourcing, there is increased exposure to the risk of a data breach. If a payroll outsourcing provider is hacked, the client may not even be aware that their employee data has been stolen.

2. Client company still legally responsible

While payroll outsourcing can help ensure that compliance with local regulations is met, the responsibility for compliance still falls on the employer, not the payroll processor. In some jurisdictions outsourcing payroll may not be all that needs to be done in order to ensure that all local regulations are being met. In many countries, for instance, employers are required to have a legally registered company in that country in order to employ nationals. There may be labor laws that do not directly affect payroll and are thus unknown to the payroll processor.

If payroll processing is outsourced to a PEO, and that PEO is also acting as the co-employer, however, this risk can be mitigated. Since PEOs act as employer of record, liability and responsibility for following local regulations sits with them rather than with the client. For businesses who want iron-clad assurance that the third party agency has sole compliance liability for payroll they can engage a PEO that has been certified by the IRS. 

3. Loss of control

Outsourcing any business process will result in some loss of control. When outsourcing payroll, all data will be held by the third party, not the employer. For management teams who frequently need to access employee data after hours or on weekends, this could be an issue. Some services may make all data available at all times through a software service, this can reduce the disadvantage, providing staff and management are able to successfully navigate the software. 

How can payroll outsourcing risks be managed?

1. Choose the right provider

Choosing the right partner for payroll outsourcing is vital: In one Ernst & Young survey, 32 percent of respondents reported that it was difficult to work with payroll service providers. 

Before you choose a payroll outsourcing provider, make sure you know exactly what you’re looking for. If your staff is all based locally, and you only need outsourcing for this one process, you may want to look at local or regional accounting firms. If you anticipate wholly outsourcing more HR and administrative tasks in the future, look for larger Business Process Outsourcing (BPO) providers that also offer the services you will need further down the road.

If you have a small administrative department and are looking to make payroll and other HR tasks simpler for them, you may want a provider that has a powerful, easy to use and integrate software platform. A Human Resources Information System (HRIS) may be a good option if your staff are already somewhat familiar with payroll and deductions.

If you are or will be operating in multiple regions either nationally or internationally, only look into payroll outsourcing services that operate in those jurisdictions. The job requires expertise on local regulations and needs a provider who can ensure compliance.

Some PEOs offer payroll outsourcing as a standalone service. If you are hiring internationally and your employees need to be hired by a local company by law, a PEO operating in the area will be able to help with employer of record services as well as payroll processing. If you are thinking of partnering with a PEO for access to PEO insurance packages, handling of liability, or HR outsourcing, signing up for payroll outsourcing through the PEO may be a good firs step and save you time and money when adding additional services.

Once you’ve narrowed down your needs, look for providers in your area, preferably also serving your industry. Look at online reviews, and ask your peers for recommendations. A good provider should be on top of compliance issues in every region and industry you will be hiring for, have strong security protocols in place, and be readily available for customer service or online access to your accounts. As with any service, compare pricing before signing up.

2. Ensure a robust agreement with provider

Once you’ve found a payroll outsourcing provider, take a look at the contract. Pricing should be explained clearly, most likely calculated with a base service charge and additional charges per employee payroll processed, plus any additional services. Check for possible penalties for late payments or breaking the contract. How long will the contract be valid, and how long will prices be locked in at the agreed-upon rate? Ensure that your data will be kept private and that there is an acceptable legal channel to pursue of this or any other clauses in the contract. If there is an error on the part of the outsourcer that may or may not lead to a fine against the employer, are they held financially or legally responsible in any way? Compare the customer service and data access availability in the contract to the access previously discussed to ensure you have the support and availability promised.