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Blog Banner of Payroll Fraud A Complete Guide

Payroll Fraud: A Complete Guide

Running a business requires effort on all fronts. You must ensure that production is always at optimum level and that workers are satisfied with the company culture. Another critical aspect of managing a company is safeguarding against defrauding activities like payroll fraud.

Stealing within an organization can take place in many ways, such as stealing raw materials and machinery, infrastructure vandalism, and time theft. However, payroll fraud is the toughest to detect because it’s often concealed.

In its simplest form, payroll fraud involves an employee or the employer manipulating the payroll system within the organization to take the money they are not entitled to. For small and medium businesses, payroll fraud can be a significant obstacle.

Such companies must be protected against payroll fraud schemes because payroll frauds are two times more likely to happen at small and medium-sized companies than at larger organizations. It can take multiple routes, from misclassifying employees to using ghost employees.

We created this complete guide on payroll fraud to help you understand how it affects the business and what payroll fraud prevention methods you can implement.

Payroll fraud occurs when an individual illicitly changes the company’s payroll system to manipulate the calculation of employee compensation to their own benefit. It’s a crime that employers or employees can commit.

Staff commits payroll fraud by indulging in malpractices like time theft when they clock in the hours that they do not work. Some employees secretly increase their compensation rate by manipulating the payroll system, which can amount to payroll fraud.

Employers can commit this fraud by withholding the wages of the workers. This way, they benefit from what they owe to the staff. Simply put, payroll fraud is a mechanism that one of the parties utilizes to enrich themselves by deceitfully stealing from the other.

Six different types of payroll fraud

As we mentioned before, payroll fraud can take several forms. As an HR manager, you must know the most common types of payroll fraud. Here are some common payroll frauds that can be avoided by being vigilant.

1. Misclassification

Workers provide different classifications depending on the number of hours they work, their job role, their relationship with the company, and other details. For instance, workers are often classified as full-time, part-time, or contract workers.

When employees misclassify their status in the payroll system, they steal the benefits they are not entitled to. Sometimes, employers misclassify workers willingly to save costs like unemployment taxes, staff benefits, and payroll taxes.

Any intentional misclassification is termed payroll fraud and makes the employer or the employee liable for legal consequences.

2. Timesheet fraud

In companies, timesheet fraud is the most common type of payroll fraud. When workers manipulate the working time that they record in the timesheet to get paid for more hours than they worked, workers can commit timesheet fraud by padding the work hours by clocking in extra hours in the timesheet.

Also, they may access the payroll system to falsify their wages and increase their hourly pay rates.

3. Ghost payroll

When companies pay nonexistent staff unwittingly, it is termed ghost payroll. This payroll fraud is typically committed by someone in human resources who has easy access to the organization’s payroll system. The perpetrators of this type of payroll fraud create fake staff in the payroll system or do not remove the staff any longer employed with the company.

In doing so, they falsify the employment records to keep collecting money from the organization in the form of the ghost employee’s paycheck.

4. Third-party payroll scams

Some payroll frauds can also be committed externally. Often, employers think payroll frauds can be committed only internally, but scams like W-2 and payroll diversion schemes have third-party perpetrators.

A W-2 scam is a sophisticated type of cyberattack where a cybercriminal tricks employees or HR managers into handling sensitive employee information. The perpetrators use this information, including employee ID, income records, and other sensitive data, to file fraudulent tax returns.

In a payroll diversion scam, perpetrators manipulate the staff into changing their direct deposit information. While workers think that the paychecks are cashed into their bank accounts, the money is transferred to cyber criminals. This type of payroll fraud is often committed by sending staff fraudulent emails or hacking into a company’s payroll system.

5. Workers’ compensation fraud

One of the frequently faced payroll fraud schemes in the construction and mining industry, worker’s compensation fraud, is when a worker fakes an injury or falsely claims that an injury occurred at work to collect workers’ compensation. This type of payroll fraud can badly impact self-insured companies. 

Alternatively, this can have a worse impact on the insurance companies that may resume the rise of workers’ insurance premiums.

6. Commission schemes

Some employees may receive bonuses or commissions attached to their sales targets. Also, some companies offer incentives to contractual workers for hitting milestones such certain percentage of project completion. The aim of providing such incentives is to encourage staff to work harder and excel at their jobs.

But, some staff may figure out loopholes in the commission schemes to avail the commissions or bonuses they didn’t earn honestly. This is a commission scheme fraud which is punishable as payroll fraud.

Another type of commission fraud is committed by contractors who agree to provide a certain number of workers on site but avail fewer workers saving on the labor cost while charging companies for the agreed number of workers.

While these are some of the most common payroll frauds, there can be other types of employer payroll frauds depending on your organization’s business model and payroll system. The only way to be secured against such fraud is to know how to detect them.

How to detect payroll fraud

Payroll fraud schemes are notoriously difficult to cover. As there are several compliance laws that a company must follow, it becomes easier to identify such frauds if your organization continues to implement compliance policies stringently. 

However, there is always scope for human error. Also, as technology improves, cybercriminals are carrying out extremely sophisticated payroll frauds that can be difficult to identify. The financial implications can be devastating if it continues for a long time.

According to the Association of Certified Fraud Examiners, a typical payroll fraud scheme lasts 24 months. There is no simple solution to detect payroll fraud schemes. There is no definite indicator of payroll fraud, but some red flags that can help you with payroll fraud prevention. 

  • Errors or gaps in payroll records are the first signs of payroll scams. You must be diligent with payroll records auditing. 
  • Any unexplained changes in the payroll records also indicate an attempt to commit fraud. 
  • Staff listing identical addresses or bank account details in their records might be attempting to commit payroll fraud. 
  • Unexpected emails were sent to staff regarding payroll without the knowledge of managers.
  • There are unaccounted transactions in the company account which has no valid source. This can be committed by cybercriminals having access to the payroll system.

These are some of the warning signs that must be acted upon immediately. Remember, there are several types of payroll fraud, and it is essential to regularly review your company’s payroll and accounting records for discrepancies.

Modern payroll software has built-in features to detect any anomalous activity related to payroll records. Furthermore, payroll automation is the best way to identify any irregularities sooner and save monetary loss to the business.

Can you take legal action against employees for payroll fraud?

There can be several payroll fraud schemes, but the severity level is also varied. Whether it is a felony or not depends on the law of the state where payroll fraud is committed. However, the more money a fraudster steams from the company, the harsher the legal consequences.

An employer can file a lawsuit against any employee who commits payroll fraud. Employers can sue to recover the stolen money and seek punishment as per the law against fraud. As payroll fraud falls under the purview of labor laws, you will have to consult your local lawyer to fully understand the legal actions you can take against such fraud.

Employers and employees have legal rights to sue for back pay if their employer has illegally withheld their wages. But it would be best to act quickly when you find out that your employer is committing payroll fraud. According to law, the stature of limitations is two years for unintentional wage violations and three years for intentional wage violations to report any payroll fraud committed by the employer against the workers.

How to prevent payroll fraud?

Prevention is better than cure. This is why you must take the steps necessary for payroll fraud prevention. While lawsuits and recovery of stolen money are secondary steps, first, you must ensure all measures are taken to mitigate fraud.

1. Use tools to avoid timesheet fraud

You must ditch paper or excel timesheets and switch to automated staff time and attendance management software like Truein.

Truein is a state-of-the-art staff attendance management software that’s cloud-based. It uses face recognition and AI to recognize staff and record work hours. Its temper-proof engineering ensures no manipulation of the attendance or overtime records. 

Furthermore, Truein integrates with most payroll software that ensures no timesheet fraud is committed at any level. It also eliminates buddy punching and offers advanced features such as leave management, attendance policy, contract worker management, and real-time staff tracking.

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2. Understand staff classification

As a manager, you must understand staff classification. Misclassifying staff not only has financial implications but is also against the law. For instance, IRS’ Employer’s Supplemental Tax Guide for worker classification guidelines severely penalizes workers for misclassification.

3. reate clear workers’ compensation policies

Create clear policies around reporting workplace injuries. Your workers must know who to report workplace injuries to, when, and how. Install security cameras at work sites so that any potential workplace injuries are recorded as evidence. It is how you can prevent workers’ compensation fraud.


Payroll fraud is a felony punishable by law, but its financial implications on the overall business can be devastating. It can happen to small and large companies, which is why there must be measures for payroll fraud prevention and early detection. As the consequences can be more than loss of money and can result in privacy invasion, you must implement the solutions we have shared in this guide.

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