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Types of Payroll Fraud and methods to prevent it

Payroll fraud is the number one source of employee theft   and accounting fraud that affects 27 percent of all businesses. It happens twice as often in small organizations with less than 100 employees compared to large organizations. According to the Association of Certified Fraud Examiners, the average duration of payroll fraud is approximately two and half years. The average loss from each payroll fraud lasting over a period of 30 months is estimated to be $63,000  . The additional monetary loss to the organization is in the form of penalties from the regulatory authorities for failing to adhere to payroll compliance requirements.  

Payroll fraud can strike businesses of all types across the globe. A school district finance director misused his position to enrich himself with an extra $150,000 over a period of ninety-six months in Delaware. In South Africa, Prasa (Passenger Rail Agency of South Africa) has, since 2020, paid salaries to more than 3,000 ghost or fictitious employees. Payroll fraud losses can be substantial depending on the extent and duration of the fraud. In one case, the president of a global payroll processing company defrauded the organization to the tune of $26 million.

What are the types of payroll fraud?

Payroll fraud is essentially altering employee records, time cards, pay scale, or job categories to facilitate illegal payments to existing or non-existent employees resulting in financial losses to the organization.

Some common types of payroll fraud are:

Ghost employee fraud

It refers to the non-existent or fictitious employees being added to the payroll records. Payments for these employees are illegally diverted to other employee accounts or siphoned off through other means. It is typically more prevalent in large organizations with more employees and weak internal controls.

Timesheet fraud

Employees falsify their timesheets to include extra hours which they have not worked. This results in extra payments to employees, which they are not entitled to, causing financial loss to the organization. In some instances, employees get other co-workers to clock in and out for them when they are not working.

Workers misclassification

Employee benefits depend on workers being classified as employees or independent contractors. It happens by mistake when employers misclassify employees unintentionally.

However, in many cases, the fraud is self-inflicted by employers by intentionally classifying employees as independent contractors to avoid paying payroll taxes, unemployment allowances, or workers’ compensation insurance.

Payscale alterations

In this payroll fraud, either employees' grades are altered, or their hourly rates are changed to qualify them for a higher payment than they are entitled to. This fraud happens due to the collaboration of employees with the human resources (HR) and payroll departments.

Wage theft

It is an employer perpetuated payroll fraud in which workers are effectively paid below the legally entitled minimum wages as per compliance requirements. The other forms of wage theft include overtime violations, off-the-clock violations, illegal deductions, and others. Measuring wage fraud is challenging since it takes many forms, and compliance violations are not always reported or recognized. It affects 17 percent of low-wage workers across all demographic categories.

How to prevent payroll fraud?

The instances of payroll fraud can be reduced significantly through effective supervision and appropriate payroll solutions.   The solution will ensure only authenticated employees are paid and identify any anomalies in payroll processing.

Roles segregation

You should demarcate HR and payroll roles so that the HR personnel who enroll new employees in the system shouldn’t be associated with payroll processing or reconciliation of payroll reports.   

A payroll solution integration with HCM suites ensures seamless flow of data for an error free payroll processing. It also helps maintain data integrity and prevent any unauthorized alterations to employee records.

Effective checks and balances

You should have oversight in the form of a senior executive’s approval requirement for overtime payments and commission checks.

You should implement a system for quarterly and annual reconciliation of payroll books. Additionally, you should audit your payroll records by a third party to detect ghost employees and other instances of payroll fraud.

Outsource payroll processing

You can source the services of a reputable payroll service provider to help you mitigate the risk of payroll fraud. You can benefit from their technology solutions that leverage Artificial Intelligence (AI) and Machine Learning (ML) for timely detection of fraud and help prevent financial loss to your organization.

Restricted access to payroll data

You should limit the access to payroll information to only selected employees who perform essential functions in payroll processing. The role-based access will enable you to maintain the sanctity of payroll information along with ensuring data privacy and security.  

Payroll solutions augmented with Artificial Intelligence and Machine learning capabilities enable you to detect anomalies. The security features prevent any unauthorized access to the employees’ data.

Culture of integrity

All the mitigating measures for payroll fraud prevention will not have much of an impact if you don’t create a culture of integrity within the organization. The top management needs to set an example of expected behavior, and it also should be reinforced on a periodic basis through internal employee communication.

Conclusion

Payroll fraud can financially weaken your organization, especially in industries where human resources are at a high cost. It is important for your organization to create a culture of integrity and values to mitigate instances of employee theft through payroll manipulation.   

One of the best ways to prevent payroll fraud is by implementing payroll solutions such as Ramco. The payroll solution will also help you reduce errors and improve productivity and compliance.