Lesson 37 - Beginner accounting course

37. Understanding Gross Pay vs. Net Pay

When employees receive their paychecks, the amount deposited in their bank accounts is usually less than their total earnings. This difference is due to payroll deductions and employer obligations. Understanding the distinction between gross pay and net pay is essential for both employers and employees, as it affects financial planning, tax compliance, and business accounting.

What is Gross Pay?

Gross pay is the total amount of earnings an employee receives before any deductions. It includes:

• Base salary or hourly wages

• Overtime pay

• Bonuses and commissions

• Paid time off (vacation, sick leave, holidays)

• Other compensation, such as tips or allowances

For example, if an employee earns $20 per hour and works 40 hours per week, their gross pay for the week is:

If they also receive a $50 performance bonus, their total gross pay becomes $850.

What is Net Pay?

Net pay (also known as take-home pay) is the amount an employee receives after all deductions and withholdings. It is the final amount deposited into their bank account or given as a paycheck. The deductions typically include:

• Federal and state income taxes

• Social Security (6.2%) and Medicare (1.45%) taxes (FICA taxes in the U.S.)

• Retirement plan contributions (e.g., 401(k) in the U.S., pension deductions in other countries)

• Health insurance premiums

• Union dues or other voluntary deductions

Example: Gross Pay vs. Net Pay Calculation

Assume an employee has a gross monthly salary of $5,000. The following deductions apply:

• Federal income tax: $500

• State income tax: $200

• Social Security tax (6.2%): $310

• Medicare tax (1.45%): $72.50

• Health insurance premium: $150

• 401(k) retirement contribution: $250

Employer's Payroll Tax Contributions

Employers are also responsible for payroll taxes, which do not affect an employee’s net pay but increase business expenses. These include:

• Matching Social Security and Medicare taxes

• Unemployment insurance

• Workers’ compensation insurance (where applicable)

Using the same example, the employer pays:

• Social Security (6.2% of $5,000) = $310

• Medicare (1.45% of $5,000) = $72.50

• Unemployment insurance (assumed at 1%) = $50

Impact on Financial Statements 

Key Takeaways

• Gross pay is the total earnings before deductions.

• Net pay is what employees actually receive after taxes and deductions.

• Employers pay additional payroll taxes, which increase business costs.

• Proper payroll accounting is crucial for financial planning and compliance with tax regulations.