What Is Gross Pay? Legal Definition and Practical Application

If you’re not from an accounting background or if you never used any accounting software, gross pay, net pay, and taxes can easily sweat you. But, after all, it’s your money on the paper that is jumping all around! This article will give you a complete understanding of what is gross pay, net pay, and how they’re calculated for salaried and hourly-based employees.

What is Gross Pay?

Gross pay is the amount an employee receives before any deductions and taxes.

In other words, gross pay is the total amount of money an employer agrees to pay an employee as their CTC (cost to the company) or annual salary. To calculate it, just multiply the number of hours worked by the pay rate.

For example, Dave joined a company as a full-time software developer, and his company agreed to pay him $240,000 a year. It means Dave’s annual gross pay is $240,000.

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What is Net Pay?

Net pay is the amount an employee receives after all deductions and taxes are taken out.

In other words, net pay is the amount that an employee finally receives in-hand. It’s a take-home salary.

For example, Dave’s gross pay is $240,000 a year, but what he finally gets in his bank account will be lower than this.

How to Calculate Gross Pay?

1. Gross Pay = Annual Salary Amount / Number of Pay Periods.
2. Gross Pay = Hours Worked in a Pay Period * Hourly Rate (+ Overtime Hours * Hourly Overtime Rate)

Let’s walk through the process step-by-step.

For a salaried employee you’ll need two components:

1. Annual salary: which the employer agreed upon to pay the employee at the time of hiring. $240,000, for example, in the case of Dave above.
2. Pay periods structure: to determine the frequency of the pay cycle. 

The number of pay periods is basically the number of times the employee gets paid in a year. For example:

• Weekly (52 pay periods),
• Bi-weekly (26 pay periods),
• Semi-monthly (24 pay periods) or
• Monthly (12 pay periods)

Once you figure out these two components, i.e., annual salary and pay periods, you need to put them in a simple equation:

Gross Pay = Annual Salary / Pay Periods

For example, Dave’s annual salary is $240,000, and he is getting paid monthly. So, Dave’s gross pay will be: $240,000 / 12 = $20,000. It means Dave gets $20,000 as a gross pay every month when payroll runs.

For an hourly employee you’ll need to consider three components:

1. Hourly rate of the employee (discussed and decided it at the time of hiring).
2. Employee’s working hours per pay period.
3. Any other income stream like overtime pay, commission, and tips.

Again, put these figures in a simple equation once you find them.

Gross Pay = (Hourly Rate x Total Hours) + Other Income

For example, Kelly is a waitress, and she earns $25 per hour. She is paid weekly and worked 20 hours for the past week. Plus, she earned $200 as tips. So, Kelly’s gross pay for that specific period will be: $25 X 20) + $200 = $700.

How to Calculate Net Pay

Calculating net pay is a bit complicated as compared to calculating gross pay. Since we consider all kinds of mandatory and optional taxes, we need to handle multiple components here. Here’s the process:

1️⃣ Calculate gross pay

First, we need to figure out the gross pay of the employee because all the deductions will be done from this amount. We have already done it above and found Dave’s gross pay to be $20,000 per pay period.

2️⃣ Determine the voluntary pre-tax deductions

The next step is to calculate and subtract all the voluntary (a.k.a pre-tax) deductions from the gross amount. These taxes are not mandatory, but it helps lower the employee’s taxable income. It includes retirement contributions, health benefits, life insurance premiums, etc.

For example, Dave contributes $200 per paycheck to his health insurance and $500 to his retirement. Now, we need to subtract this amount from Dave’s gross pay.

$2,000 – $200 – $500 = $1,300 (Dave’s taxable income)

3️⃣ Calculate and subtract mandatory payroll taxes

After pre-tax deductions, it’s time to subtract mandatory taxes. They are mainly two types in the U.S.:

1. FICA payroll tax: it’s 15.3 percent of the employee’s taxable income.  The rule is half of this tax (7.65 percent) is paid by the employee and another half by the employer. This amount directly goes to the employee’s Social Security and Medicare. Out of this employee’s 7.65 percent, 6.2 percent goes to Social Security, and 1.45 percent goes to Medicare tax.
2. Federal income taxes: it varies depending upon employee’s pay, Form W-4 information, and filing status. To figure out how much an employee owes in federal income taxes, check federal income tax withholding tables in IRS publication 15.

Retaking Dave’s example, assuming he hasn’t taken any unpaid leave, we need to deduct FICA and Federal tax from his taxable gross pay.

Dave’s Taxable Gross Pay – Medicare Taxes (1.45%) – Social Security Taxes (6.2%) – Federal Income Tax (10% of $1,300) = Dave’s Net Pay

For this pay period and with previously calculated figures in mind, we’ll easily find out that Dave’s net pay for the given pay period is going to be:

1300 – (0.0145×1,300) – (0.062×1,300) – (0.1×1,300) = $1,070.55

In other words, though Dave’s gross earning every month is $2,000, he finally gets $1,070.55 per month after all the deductions. (You may also need to pay state and local taxes depending upon where you live)

4️⃣ Account other mandatory deductions

In some cases, an employee may have other mandatory payroll deductions called wage garnishments. It includes child support payments, delinquent student loans, unpaid taxes, and credit card debt. If that’s the case, the employer can withhold a specific amount from each paycheck.

Gross Pay vs Net Pay Wrap Up

So as you can see, while the calculations may seem intimidating, the concepts of gross pay and net pay are actually very simple:

• Gross pay is payment before deductions;
• Net pay is payment after deductions;
• Net pay = Gross pay – deductions.

We at Everhour hope that this article was helpful in understanding the basics of calculating gross pay and net pay for salaried and hourly employees.

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