Payroll fraud occurs when a worker cheats the system to get a higher paycheck. Small businesses are more likely to be at risk than larger ones because they place a higher level of trust in their employees and often have fewer safeguards in place. This can result in tax payments not being made or employees being paid inaccurately—ultimately impacting your bottom line and resulting in potential fines and litigation.
Because it can take many forms—from internal cases, like buddy punching, or external ones, like hacks and malware—it’s best to understand what payroll fraud is in order to avoid it. Ultimately, the most secure processes involve regular audits, multiple internal controls, and payroll automations.
One of the easiest ways to ensure a strong and reliable payroll process is by using a payroll software that allows you to manage your employees, payments, and taxes all in one place. For help deciding which is best for you, check out our guide to the top payroll software for small businesses.
Detecting Payroll Fraud: Red Flags
While some forms of payroll fraud are easier to detect, some can be very difficult to identify and can go on for a long time without ever being recognized. There is no single thing that can be done to detect payroll fraud time after time, but there are a few red flags that business owners can be sure to watch out for. These include:
- Changes in payroll records that you don’t recognize
- Employees who list identical information (bank account numbers, SSNs, etc.)
- Errors or gaps in payroll records
- Unexpected emails concerning payrolls you didn’t submit or payroll emails from unrecognizable email addresses
These are just a few of the warning signs to watch out for—remember, payroll fraud can take many forms and can go unnoticed for a long time. According to the Association of Certified Fraud Examiners (ACFE), the median duration between the start of a payroll fraud scheme and its detection is 18 months, which is more than enough time for there to be significant financial damage to a company. The good news is that this detection time is actually down by six months from a similar ACFE report from 2020. Businesses are understanding this problem more and taking proactive steps to discourage fraud and detect it faster. That’s why you should perform a payroll audit of your company’s records regularly.
Why Understanding Payroll Fraud Is Important for Small Businesses
Payroll fraud can be systematic, causing you to lose huge amounts of money without noticing. In fact, businesses lose about 5% of their annual revenue to payroll fraud annually. Besides that, this can lead to a loss of trust within the workforce, as it can cast doubt on long-time employees. More than half of employee perpetrators have worked for their employer for at least six years, leading to a level of trust the employee may take advantage of. If small businesses don’t have the right payroll securities in place, there can be a huge toll caused by this theft.
Common Types of Payroll Fraud & How to Prevent Them
In addition to understanding what payroll fraud is, it’s important to know what the most common forms of payroll fraud are so you can be on the lookout.
1. Buddy Punching
What it is: Also called “buddy clocking,” this is when a worker gets someone else to clock in and out for them, whether clocking them in early, clocking them out late, or clocking them in/out when they aren’t even there.
How to prevent it: The easiest way to prevent buddy clocking is with time tracking software that includes authentication, such as a password, a fingerprint, an ID badge, or facial recognition. Check out our reviews of the best time tracking software to find one with these features.
2. Pay Rate Alterations
What it is: Just like it sounds, it is when someone alters the pay rate of an employee in the payroll system itself. This usually requires someone who works with the payroll system, although it could be on behalf of another employee or someone hacking into the system. Smart fraudsters will alter the rate just before payday and change it back after or do it intermittently to reduce the chance of being caught.
How to prevent it: Start by ensuring that your payroll software is password-protected and that you limit access to the features each employee needs. Next, match pay rate authorization documents to the payroll register, especially when doing payroll reconciliations.
3. Padding Work Hours
What it is: This is one of the most common types of payroll fraud cases and involves padding timesheet entries, usually in small increments. This is typically done by hourly-paid workers wanting to earn an extra buck—or for habitually late employees who don’t log their latency correctly.
How to prevent it: First, have a clear policy about clocking in and out so that employees understand the rules. The easiest next step is to sync your payroll software with your time tracking software to feed the data automatically. Some software can be set up with predefined rules that will not let employees clock in outside a specific time window. Finally, enforcing manual approval of overtime and arranging payroll audits can catch some of these problems.
4. Outstanding Advances/Not Repaying Overpayments
What it is: In these cases, an employee asks for an advance or accidentally gets overpaid and does not pay it back. Sometimes, the accounting department may classify this as “expenses,” and it goes unnoticed.
How to prevent it: Some of this may be caused by confusion of the employee—a common search engine question is, “Do I have to pay back an overpayment of wages?” Be sure the employee understands that an advance or overpayment must be repaid. Spell it out in the company handbook as well.
To prevent purposeful fraud, ensure your accounting practices are tight and have oversight, such as through periodic payroll audits. Many payroll software and PEOs will allow advances and automatically deduct them from the next paycheck.
5. Ghost Employees
What it is: A “ghost employee” is when a name is included on the payroll list but doesn’t exist in the company. This occurs when someone with access to the payroll software either creates a fake employee in the records or doesn’t delete a terminated employee and then alters the records so that the direct deposit or check goes to them.
How to prevent it: Periodic audits against employee lists can spot this—check not only for phantom names but also fake Social Security numbers and duplicate addresses. Also, look for non-contractor paychecks that have no deductions attached (usually, the perpetrator wants to get the maximum amount). Finally, be sure your offboarding procedures include purging the employee from the payroll system.
6. Paycheck Diversion
What it is: This type of payroll fraud happens when an employee takes and cashes the check of another employee.
How to prevent it: If you can, pay employees by direct deposit or pay card. When paying via paycheck, keep strict control over them by requiring employees to be positively identified before getting their check (with ID if needed) and then lock up any unclaimed checks.
7. Expense Reimbursement Fraud
What it is: This is when a worker gets paid back for expenses that weren’t incurred, were personal expenses, or cost less than the employee reported—and they pocketed the difference.
How to prevent it: First, have clear spending policies that spell out what expenses are claimable and what the limits are. Next, have security checks including micro checks, to look at receipts and ensure they amount to the pre-approved charges, and macro checks for periodic reviews of reimbursements for any individual or departments that are oddly above average.
If you have payroll software, ask about tools that can automate this tedious process. Some will allow you to upload documentation of the expense so that you have a backup handy when you decide to do a thorough review.
8. Fake Commissions
What it is: In this case, a worker inflates their sales report or has someone on the payroll team overpay their commission.
How to prevent it: Make sure to create a clear process for paying sales commissions. In addition to clear policies and double-checking percentages and pay vs sales, look for suspicious activity, such as an increase in commissions when sales are dropping. Also, periodically check top performers or those with a sudden rise in commissions.
9. Unauthorized Overtime
What it is: This occurs when an employee claims to have worked extra hours beyond their scheduled time without the necessary approval.
How to prevent it: To combat this type of payroll fraud, businesses should implement strict overtime policies requiring prior approval. Using automated time clock software can help monitor actual work hours and flag any discrepancies—check our recommended time clock software for some options. Regular audits of payroll records will ensure compliance and deter potential fraud. It’s also a good idea to provide training for both managers and employees on the importance of adhering to overtime policies.
10. Fraudulent Benefit Claims Scheme
What it is: This payroll fraud involves manipulating or inventing claims on health insurance, pension or retirement plans, or other employee benefits.
How to prevent it: Establish a robust verification process for all claims that your company processes. Regularly review and audit benefit distributions to help identify irregular patterns.
11. Phishing Attacks
What it is: Not every payroll fraud comes from within your company. Cybercriminals use phishing emails to deceive employees into giving sensitive payroll information. These emails masquerade as legitimate requests from company executives or payroll providers.
How to prevent it: Implement robust email security measures and conduct regular employee training on how to recognize and report phishing attempts. The State Department has even issued a recent notice to employers about phishing attempt increases.
Reporting Payroll Fraud
Businesses can respond to fraud by reporting it as a criminal action, suing the perpetrator, or doing nothing. Many organizations will not prosecute a fraudster because of fear of bad publicity or cost, and some just decide that internal discipline (such as firing or docking future paychecks) is sufficient.
Take Careful Notes
If you suspect fraud (or have discovered it and want to report it), start by keeping or gathering your evidence, as successful prosecution depends on accurate notes. Record dates and times, activities, and locations as applicable, and note the amount of money involved. If you can download the reports from the payroll software, store them in a separate file. Take screenshots with timestamps in case the evidence is tampered with later.
Report to the Authorities
When it comes to reporting payroll fraud to the authorities, there are two options:
- Reporting in-house: If you are not the owner or overall boss of the company, reporting in-house may be tricky. You may not be sure who is involved or concerned about retribution. So, choose a manager you trust (in the accounting or HR department or the fraudster’s chain of management), and do not be afraid to skip levels of management if you have doubts. Many businesses offer anonymous tip lines; in fact, most tips come from anonymous sources. Just be sure to have your evidence available.
- Reporting to outside authorities: If you are the business owner or are an employee concerned that reporting within your company may put you in danger or threat of being fired, your best bet is to contact the FBI, which specializes in this kind of fraud. The second choice is the state attorney general. Some states have hotlines dedicated to payroll fraud reporting.
How to Prevent Payroll Fraud—Best Practices
To effectively shield your business from payroll fraud, a proactive and comprehensive strategy is essential. Whether facing threats from within your organization or external actors, it’s vital that you take a multi-faceted approach. No single strategy is capable of preventing all payroll fraud.
- Strengthen internal controls. Your internal payroll controls act as a gatekeeper to sensitive information. Segregation of duties is key, ensuring no single employee has control over all aspects of payroll. This means separating responsibilities among different team members for initiating, authorizing, and reviewing payroll transactions.
- Automate your payroll processes. As much as your budget allows, payroll automations not only streamlines your operations but also adds a layer of security. These systems come equipped with features designed to detect anomalies, like unusual payment amounts or alterations in pay rates. They also maintain a detailed audit trail, making it easier to trace any irregularities back to their source.
- Conduct regular audits and reconciliations. Conducting regular audits is critical to identify and prevent payroll fraud. These audits can be announced or surprised, encompassing a thorough review of payroll records, employee files, and timekeeping systems. Reconciling payroll accounts regularly will also help to spot unauthorized transactions promptly.
- Educate and train employees. Awareness of potential payroll fraud is a powerful tool. Train your payroll employees on the types of payroll fraud they might encounter and enlist their help in spotting suspicious activities. Establish a clear whistleblower policy that encourages any employee to report concerns without fear of retaliation.
- Secure your IT infrastructure. Employ firewalls and anti-malware tools, and keep your software up to date to fend off cyber attacks. Educate your employees about phishing scams and the importance of being cautious with email attachments and links, which can be common entry points for hackers.
Bottom Line
The longer payroll fraud happens, the more costly it is for the business—and most often, businesses do not get back their losses. By understanding the types of payroll fraud and applying procedures to prevent them, you can reduce your chances of becoming a victim. Some steps are as simple as clear pay and clock-in guidelines, and others may already be available to you. Also, investing in a payroll service that has anti-fraud tools will be beneficial—check our guide to the best payroll services for some options.
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