Third Party Payroll Providers: Friends or Foe?

Summer 2019 Article

Many employers outsource their payroll services to a third-party payroll provider. Using a third-party provider has many benefits, including assuring deadlines and deposit requirements are met and streamlining business operations.

Legal Implications

Despite these benefits, however; employers that outsource payroll services are ultimately responsible for tax and legal requirements and are therefore not shielded from legal liability for failure to meet state and federal requirements.  Additionally, third-party payroll providers are not considered an “employer” within the meaning of the Labor Code or Wage Order and therefore may not be liable for any legal issues related to payroll mistakes.

Common Error – the Overtime Calculation Case Study

One common error that companies make is failing to review wage statements that are distributed to employees by third-party payroll providers. An employer’s failure to review wage statements for potential legal errors can create substantial legal liability for the employer.

One common mistake that is made on wage statements is the calculation of overtime.  While most employers are aware that overtime must be calculated at the employee’s “regular rate” of pay, many employers are not aware of the what the “regular rate” actually entails.

The Federal Labor Standards Act (“FLSA”) provides that the “regular rate” is calculated to include the employee’s straight hourly rate multiplied by the numbers of hours worked plus non-discretionary bonuses[1] and commissions.[2] This total is then divided by the number of hours the employee worked, to get the employee’s regular rate. 

For example, if the straight hourly rate of employee A is $12.00 per/hour, and employee A worked 50 hours in one week and made $100 in commission, the regular rate is calculated as follows:

$12.00 x 50 = 600 + $100 (commission) = $700/50 = $14.00 (regular rate)

As demonstrated above, employee A’s hourly rate is $12.00 per/hour, but her “regular rate” is $14.00 because the regular rate includes her commission earned for that week.  Frequently, employers fail to include the commissions and non-discretionary bonuses in the regular rate, which in turn, creates an inaccurate calculation for the employee’s overtime rate.

An employee’s overtime is then calculated by multiplying the straight hourly rate by all overtime hours worked, plus one-half (1/2) of the employee’s regular rate of pay times all overtime hours worked.

Using the above example involving 10 hours of overtime for a 50-hour week, the overtime compensation would be calculated as follows:

$12.00 (straight hourly rate) x 10 (overtime hours worked) = $120

$14.00 (regular rate) x .5 x 10 = $70

$120 + $70 = $190 (Employee A’s total overtime compensation)

If a third-party payroll provider fails to include an employee’s commission and/or non-discretionary bonus in its regular rate of pay, as illustrated in the above example, employee A would have been paid $10 less than what is required by law. While this number may seem insignificant, simply one error on a wage statement (even a de minimis one) that is replicated for every employee, can result in hundreds to thousands of inaccurate wage statements. Each inaccurate wage statement comes with various legal penalties, which vary state to state, plus the potential of reasonable costs and attorneys’ fees and other damages.

The lesson to be learnt here is that while employers often, and many times rightfully assume that their third-party payroll provider is complying with all legal requirements, third-party payroll providers regularly fail to oversee certain legal and tax issues, similar to the issue set out in the example above.

Therefore, it is vital that companies review its wage statement practices, including wage statements created by third-party payroll providers, to limit employer liability.


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[1] 5 CFR §551.514

[2] 5 CFR §551.511