Payroll Accounting in India: Complete Guide for Employers

Introduction: The Costly Mistake

Suresh ran a growing IT services company in Bangalore with 45 employees. He outsourced payroll to a local accountant who “knew the basics.” Everything seemed fine—until a PF inspection revealed three years of wrong calculations.

“We had been calculating PF on basic salary only, ignoring special allowance which should have been included,” Suresh recalls. “The penalty and arrears came to ₹8.7 lakhs—more than our quarterly profit.”

That expensive lesson taught Suresh what every employer must learn: payroll accounting isn’t just about paying salaries—it’s about compliance, precision, and protecting both employer and employee interests.

This guide will help you understand payroll accounting comprehensively.

Understanding Salary Structure in India

Components of Indian Salary

1. Basic Salary

• Foundation of salary structure
• Usually 35-50% of CTC
• Base for PF, gratuity, and other calculations
• Fully taxable

2. Dearness Allowance (DA)

• Compensates for inflation
• Common in government and PSU sectors
• Included in PF calculation
• Fully taxable

3. House Rent Allowance (HRA)

• For meeting rental expenses
• Tax exemption available under Section 10(13A)
• Usually 40-50% of basic (50% for metro cities)

4. Special Allowance

• Balancing figure in salary
• May or may not be part of PF calculation (depends on structure)
• Fully taxable

5. Conveyance Allowance

• For commuting expenses
• Fully taxable after 2018 budget changes

6. Medical Allowance

• Fixed medical expense reimbursement
• Fully taxable (unless actual bills submitted)

7. Leave Travel Allowance (LTA)

• For travel within India
• Exempt for actual travel expenses
• Claimable twice in a block of 4 years

8. Other Components

• Performance bonus
• Retention bonus
• Variable pay
• Stock options (ESOPs)

Sample Salary Structure

For an employee with CTC ₹8,40,000 per annum:

Statutory Deductions and Contributions

Provident Fund (PF)

The Employees’ Provident Fund is governed by EPF & MP Act, 1952.

Applicability:

• Establishments with 20+ employees (10 for some notified industries)
• Mandatory for employees earning up to ₹15,000/month basic
• Optional for higher earners (can opt-in at joining)

Contribution Rates:

Calculation Example:

Employee Basic + DA = ₹25,000/month

Important Notes:

• Monthly contribution due by 15th of following month
• Late payment attracts interest and damages
• ECR (Electronic Challan cum Return) filing mandatory

Employee State Insurance (ESI)

Governed by ESI Act, 1948, providing medical and cash benefits.

Applicability:

• Establishments in notified areas with 10+ employees
• Employees earning up to ₹21,000/month

Contribution Rates:

Calculation Example:

Gross Salary = ₹18,000/month

• Employee ESI: 0.75% × 18,000 = ₹135
• Employer ESI: 3.25% × 18,000 = ₹585
• Total: ₹720

Benefits Covered:

• Medical benefits (self and family)
• Sickness benefit
• Maternity benefit
• Disablement benefit
• Dependent benefit
• Unemployment allowance

Professional Tax

State-level tax on employment income. Rates vary by state.

Sample Rates (Karnataka):

Sample Rates (Maharashtra):

Note: Maximum annual professional tax is ₹2,500.

TDS on Salary (Section 192)

Employer must deduct tax at source on salary payments.

Steps for TDS Calculation:

Step 1: Compute annual gross salary Step 2: Allow exemptions (HRA, LTA, etc.) Step 3: Allow deductions under Chapter VI-A Step 4: Calculate tax on net taxable income Step 5: Divide by 12 for monthly TDS

Example Calculation (FY 2024-25, New Regime):

Payroll Processing Steps

Step 1: Attendance and Leave Management

Capture:

• Working days
• Leave taken (earned, casual, sick, LOP)
• Overtime hours
• Work from home days

Calculate:

• Loss of Pay (LOP) deductions
• Overtime payments
• Attendance incentives

Step 2: Variable Components

Process:

• Performance incentives
• Sales commissions
• Shift allowances
• Special payments

Step 3: Gross Salary Calculation

Formula: Gross Salary = Fixed Components + Variable Components - LOP Deductions

Step 4: Statutory Deductions

Calculate and deduct:

• Employee PF contribution
• Employee ESI contribution
• Professional Tax
• TDS on salary

Step 5: Other Deductions

Process:

• Loan EMI recoveries
• Advance salary adjustments
• Notice period recovery
• Any other authorized deductions

Step 6: Net Salary Calculation

Formula: Net Salary = Gross Salary - All Deductions

Step 7: Payment Processing

Execute:

• Bank transfer (NEFT/RTGS/IMPS)
• Salary slip generation
• Payment advice to bank

Step 8: Statutory Payments

Deposit:

• PF challan (by 15th)
• ESI challan (by 15th)
• Professional Tax (monthly/quarterly per state)
• TDS (by 7th of following month)

Journal Entries for Payroll

Monthly Salary Booking

Entry 1: Salary Expense Recognition

Salary and Wages A/c                Dr.    6,50,000
HRA A/c                             Dr.    1,95,000
Conveyance A/c                      Dr.      32,000
Special Allowance A/c               Dr.    1,23,000
    To Salary Payable A/c                           10,00,000
(Being salary for the month provided)

Entry 2: Statutory Deductions

Salary Payable A/c                  Dr.    1,54,200
    To PF Payable (Employee) A/c                      78,000
    To ESI Payable (Employee) A/c                      7,500
    To Professional Tax Payable A/c                    4,000
    To TDS Payable (Salary) A/c                       64,700
(Being statutory deductions from salary)

Entry 3: Employer Contributions

PF Contribution Expense A/c         Dr.      78,000
ESI Contribution Expense A/c        Dr.      32,500
    To PF Payable (Employer) A/c                      78,000
    To ESI Payable (Employer) A/c                     32,500
(Being employer's statutory contributions)

Entry 4: Salary Payment

Salary Payable A/c                  Dr.    8,45,800
    To Bank A/c                                      8,45,800
(Being net salary paid to employees)

Entry 5: Statutory Payments

PF Payable (Employee) A/c           Dr.      78,000
PF Payable (Employer) A/c           Dr.      78,000
PF Admin Charges A/c                Dr.       3,250
EDLI A/c                            Dr.       3,250
    To Bank A/c                                      1,62,500
(Being PF challan payment)

Payroll Compliance Calendar

Monthly Compliances

Quarterly Compliances

Annual Compliances

Common Payroll Challenges and Solutions

Challenge 1: PF Wage Calculation

Issue: Confusion about which allowances to include in PF wages

Solution:

• Basic + DA: Always included
• Special Allowance: Include if it’s part of regular pay
• Conveyance/HRA: Generally excluded
• Best Practice: Consult EPF guidelines; when in doubt, include

Challenge 2: HRA Exemption Calculation

Issue: Computing correct HRA exemption for tax purposes

Solution: Exemption is LEAST of:

1. Actual HRA received
2. Rent paid minus 10% of salary
3. 50% of salary (metro) or 40% (non-metro)

Example:

• HRA received: ₹15,000/month
• Rent paid: ₹12,000/month
• Basic salary: ₹30,000/month
• Location: Delhi (metro)

Exemption = Least of:

1. ₹15,000
2. ₹12,000 - (10% × 30,000) = ₹9,000
3. 50% × 30,000 = ₹15,000

Exempt HRA: ₹9,000/month

Challenge 3: Employee Exit Processing

Issue: Calculating full and final settlement

F&F Settlement Checklist:

• Pending salary
• Leave encashment
• Gratuity (if applicable)
• Bonus (pro-rata)
• Reimbursement pending
• Deductions: Loan recovery, notice period, etc.

Challenge 4: Arrears Processing

Issue: Handling retrospective salary revisions

Solution:

1. Calculate incremental amount for each month
2. Add TDS on arrears to current month
3. Consider relief under Section 89 for large arrears
4. Update PF contributions if basic changed

Payroll Software Options for Indian Businesses

For Small Businesses (1-50 employees)

Zoho Payroll

• Cloud-based
• ₹50/employee/month
• Auto compliance updates
• ESI/PF integration

RazorpayX Payroll

• Modern interface
• Direct account credits
• Compliance automated
• Suitable for startups

For Medium Businesses (50-500 employees)

Keka HR

• Complete HRMS with payroll
• Performance management
• Employee self-service
• Starting ₹6,999/month

greytHR

• Established Indian vendor
• Strong compliance features
• Leave and attendance integration
• Scalable pricing

For Large Enterprises

SAP SuccessFactors

• Global capabilities
• Complex organization support
• Advanced analytics

Workday

• Cloud native
• Real-time insights
• Change management support

Best Practices for Payroll Management

Documentation

1. Maintain appointment letters with clear salary breakup
2. Keep investment declaration forms updated
3. Document all deductions with employee authorization
4. Archive payroll records for 8 years minimum

Process Controls

1. Maker-checker mechanism for payroll release
2. Monthly reconciliation of payroll with GL
3. Audit trail for all changes
4. Segregation of duties between HR and Finance

Employee Communication

1. Clear salary slips with all components
2. Investment proof submission reminders
3. Tax planning guidance at start of year
4. Form 16 distribution by due date

Compliance Monitoring

1. Calendar reminders for all due dates
2. Regular compliance audit by external expert
3. Keep up with rule changes through professional updates
4. Maintain statutory registers as required

Key Takeaways

1. Salary structure matters – Proper design saves taxes legally
2. PF/ESI compliance is critical – Penalties are severe
3. TDS accuracy protects employees – Wrong deductions cause problems
4. Automate where possible – Reduces errors and saves time
5. Document everything – For audits and disputes
6. Stay updated on rules – Labor laws change frequently
7. Employee satisfaction – Timely and accurate pay builds trust

Disclaimer

This article is for educational purposes only and does not constitute professional advice. Payroll regulations change frequently. Consult a qualified professional for implementing payroll systems in your organization. Verify current rates and rules with official sources like EPFO and ESIC.

Checklist for Payroll Setup

• Define salary structure aligned with company policy
• Register for PF, ESI, Professional Tax
• Set up payroll software/Excel system
• Create compliance calendar
• Establish approval workflows
• Design salary slip format
• Plan Form 16 generation process
• Train team on statutory updates

Getting payroll right isn’t just about compliance—it’s about treating your employees fairly and building trust that makes them want to give their best.