Gross pay vs. net pay: What's the difference?

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 explain the key differences between gross and net pay, how to calculate each correctly, and how certain employee benefits, like health reimbursement arrangements (HRA) and stipends, impact gross and net pay.

Takeaways from this blog post:

• Gross pay is the total amount a worker earns before their employer takes out any taxes, benefits, or other deductions.
• Net pay is the amount of money an employee receives after deductions from their gross pay, including taxes and voluntary contributions for benefits.
• Employee benefits often affect employees’ gross and net pay, but some benefits have no impact. For instance, HRAs are tax-free benefits, meaning allowances don’t count toward gross pay and are exempt from payroll taxes.

What is gross pay?

Gross pay, or gross employee 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’ types of income in their gross wages, including taxable reimbursements, investment income, capital gains, commissions, and bonuses. You should also include overtime rate pay that hourly workers and any eligible exempt employees earn.

It’s important to note that an employee’s gross pay must meet the federal minimum wage or your state or local 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 must 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 their hourly earnings 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, such as taxes, or voluntary deductions, like those for certain health or retirement benefits. Employees' net pay is generally listed in bold on their pay stubs to stand out from their gross pay. Employees can use their net pay to get a more accurate picture of their financial health.

Some common additional 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 payments, like credit card loans, student loan payments, unpaid child support, alimony, outstanding medical bills, and tax payments
• Health insurance payments for premiums
• Life insurance payments for premiums
• Some voluntary deductions, like contributions made to pre-tax benefits like health savings accounts (HSAs) and flexible savings accounts (FSAs)
• Retirement 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 using the calculations in the previous section, figuring out their net pay is simple. The formula to calculate net pay is this:

For example, if an employee 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 employees will receive the same annual salary. They may not have the same voluntary deductions or wage garnishments. Therefore, it’s essential to calculate each employee's correct amount of take-home wages accurately so they can get a clearer picture of their financial performance.

“Taxes significantly impact the difference between gross and net pay,” said Dana Ronald, CEO of Tax Crisis Institute. “Understanding the various employee tax withholdings is essential because they can vary based on salary, benefits, and allowances. It's also essential for employees to be aware that adjustments in W-4 forms can influence the amount withheld for taxes, thereby affecting their net pay.”

How do employee benefits impact gross pay or net pay?

Various types of employee benefits will affect gross and net pay differently. Let’s take a look at a few examples below.

Health benefits

Certain health benefits impact an employee’s gross and net pay in different ways.

For instance, an employee participating in an employer-sponsored group health plan will have their contribution toward their policy deducted from their paycheck, impacting their take-home pay. However, this isn’t the case if the employee is participating in an HRA.

The IRS considers HRAs tax-free 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 annual income liability. However, since an HRA follows a reimbursement model, employers don’t include allowances in employees’ gross pay to begin with. Because they’re omitted from gross pay, reimbursements will also be left out of an employee’s net pay amount.

Only employers can contribute to an HRA, and they make their contributions on a pre-tax basis. This means contributions are also 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.

Employers only need to report HRA allowances if they accidentally reimburse an employee who doesn’t have minimum essential coverage (MEC). In this case, the allowance for the month is taxable. Otherwise, only the qualified small employer HRA (QSEHRA) has W-2 reporting requirements. Instead of reporting a QSEHRA allowance as gross income, employers report it in Box 12 with code FF.

Stipends

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-B to see which ones are eligible or work with a tax professional or benefits specialist for assistance¹.

Retirement benefits

Employee contributions made to retirement plans such as 401(k)s will, in most cases, be taken out of their gross pay and reduce their tax liability. If an employer matches employee contributions toward a retirement plan on a pre-tax basis, that employer match won’t impact gross or net pay.

Conclusion

Knowing the ins and outs of gross and net pay is vital if this is your first time running payroll at your company. 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.

This article is for informational purposes only and shouldn’t be relied on for tax or legal advice. Keep detailed records and contact a financial advisor to determine your tax liability.

This post was originally published on July 27, 20123. It was last updated on July 19, 2024.

1. https://www.irs.gov/forms-pubs/about-publication-15-b