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Payroll fraud is a significant concern for organizations of all sizes, especially small businesses. Falsified time sheets, inflated expenses, or the creation of ghost employees can drain resources, undermine trust, and jeopardize the financial health of your company.

This article covers the common tactics employees can use to perpetrate payroll fraud and outlines strategies that you can employ to detect and prevent this type of fraudulent activity, safeguarding your business.

What is Payroll Fraud?

Payroll fraud is when an employee falsifies information in order to receive more financial compensation than they have earned through work. It can look like an employee doctoring a time sheet, diverting funds, or creating fake employees. We’ll cover the common types of payroll fraud and, most importantly, how to protect your business.

Small businesses are more likely to be victims of payroll fraud as many do not have robust anti-fraud policies in place. A 2020 report from the Association of Certified Fraud Examiners found that the average payroll fraud scheme is in place for 2 years before it is detected.

Payroll fraud occurs in over 14 percent of businesses with fewer than 100 employees, as reported by a senior payroll expert. Luckily, payroll fraud is easy to catch if you’re aware of the methods and is preventable if you have anti-fraud policies in place. 

5 Common Types of Payroll Fraud

(And How to Prevent Them)

1. Clock-in Fraud 

Clock-in fraud is when an employee has a friend clock them in before they get to work or out after they leave.

In extreme cases, the employee has someone else clock them in and out on days in which they don’t even show up for work. This leads to the employee getting paid for hours they didn’t work. 

How to Prevent Clock-in Fraud

The most effective way to prevent clock in fraud is to have some sort of verification system when employees clock in. When an employee clocks in, require their keycard, or if possible their fingerprint. 

Having a security camera watching can help reduce clock-in fraud as can a biometric time clock. It can also help to have a supervisor working near where a time clock is, so they are able to witness who is using it. 

2. Ghost Employee Fraud 

This type of fraud occurs when an employee creates a fictitious employee on the payroll, and then diverts the fake employees salary into one of their accounts. Businesses with large or changing payrolls are especially vulnerable. 

For example, consider a small retail store with a staff of 30 employees. Due to the store’s limited resources, the owner relies on a single employee to manage all payroll responsibilities. This employee sees an opportunity to exploit the lack of oversight and creates a ghost employee, funneling the fake employee’s salary into their personal account. The scheme could go undetected for months if unchecked.

How to Prevent Ghost Employee Fraud

The best way to prevent ghost employee fraud is to regularly audit your payroll. Check your payroll system for employees you don’t recognize, and be extra vigilant when employees have paychecks delivered to the same bank account.

Implement a thorough verification process for new hires and maintain clear records of employee information. Assigning payroll responsibilities to multiple team members and conducting internal and external audits can also help detect discrepancies and reduce the risk of fraud.

3. Paycheck Diversion 

If an employee takes and cashes a paycheck meant for someone else, they are committing diversion fraud. This is especially likely to occur when an employee has quit, as they might forget to pick up their final paycheck. 

How to Prevent Paycheck Diversion

In order to prevent paycheck diversion, have a system in place for how employees pick up their paychecks. Make them present some form of identification, and be wary of how you deliver an employee’s last paycheck.

4. Pay Rate Alteration

If an employee can access the payroll software, they can change their salary or hourly rate to get paid more than they’ve earned. While this type of fraud is more difficult to commit, it can be very hard to catch. 

How to Prevent Pay Rate Alteration

The most effective way to prevent pay rate alteration fraud is to minimize the number of people who have access to the admin settings of your payroll service. Ensure that the login is protected with a strong password, and every quarter run an audit to make sure the pay rates are correct. 

5. Commission / Performance Bonus Fraud

If your employees get paid on commission, or have certain pay bonus incentives, you are at risk of this type of payroll fraud. It is when an employee creates graduated materials to inflate the number of sales or bonuses they are eligible to receive payment for. 

How to Prevent Bonus Fraud

Routinely checking sales data against commission statements is the simplest and most effective way to catch commission fraud.

You can also randomly audit someone’s commission or bonus payments, and make sure to check out any sharp increases in bonus or commission payouts. 

How to Protect your Business 

In addition to what’s outlined above, every business should take a few important steps to protect themselves not just from payroll fraud, but from all types of fraud. 

Steps to prevent payroll fraud 

  1. Make it clear you’re looking for fraud
  2. Create checks and balances
  3. Randomly audit pay history
  4. Use secure payroll software

1. Make it clear you’re on the lookout for fraud

Making it explicit that you’re on the lookout for payroll fraud is the most efficient way of lowering your risk. 

Mention it in new hire training, put that you have payroll fraud prevention measures in the employee handbook, and bring it up in all-hands meetings. Simply making people aware that you’re aware of fraud as a potential issue dramatically decreases the risk of it. 

2. Create checks and balances

Ensure your payroll fraud prevention initiative is not entrusted to one person. Separate the duties that are required for your business’s administration. 

Entrusting too much to one person both increases their ability to abuse their power and increases the cost of their mistakes. A system of checks and balances on the employees who conduct your payroll dramatically minimizes fraud risk.

3. Randomly audit pay history

Every month, randomly audit a few of your employee’s paychecks. After that, briefly overview the month’s payroll report. 

This only needs to take a couple of minutes, but makes a meaningful difference in increasing your security and ensuring there are no substantive issues. 

4. Use secure payroll software

Invest in a reliable and secure payroll system with built-in controls and fraud detection features. Ensure that the system is regularly updated with the latest security patches and updates.

Outsource Payroll

Another style of approach to reducing fraud risk is to outsource your payroll. Payroll outsourcing companies have  experience detecting and mitigating fraud risks, and are able to effectively implement all of the best practices regarding payroll. Outsourcing your payroll also comes with a wide array of other benefits.

Benefits of outsourcing 

  • Reduces fraud risk
  • Takes payroll off your plate
  • Minimizes the chance for payroll errors
  • Affordable for small and midsize businesses
  • Allows your business to operate more efficiently

There are many reputable payroll outsourcing companies, each with different policies, offerings, and pricing structures.

The company which will be the best fit for your business will depend on how frequently you pay your employees  and what if any other services you want the company to provide. Consider their payment structure, and if they can satisfy your payroll needs. 

What if You Discover Fraud? 

If you discover fraud, you have options for discipling the perpetrator and reconciling what was stolen. The easiest and first option to pursue is to confront the employee. If they are willing to pay back the stolen funds, you can avoid the headache of pursuing more time and resource intensive options. 

If they are not willing to pay back the money, you also have the option you have is to report the fraud to law enforcement. After all, fraud is stealing, and stealing is a crime. 

Depending on the type and scale of the fraud, the investigation may be carried out by the local police, the state attorney general, or the FBI.

Legal Action

If the employee can’t or won’t pay back the money and the sum stolen is less than $10,000, you may want to pursue action in small claims court. In small claims court no lawyers are present, making it a cheaper and easier way of resolving disputes. 

Regardless of which type of legal proceeding you need, it’s important to collect evidence of the fraud. Record the times at which the fraud was committed, and how much was stolen. Be prepared to present clearly how the fraud was done. 

Final Thoughts on Payroll Fraud

Payroll fraud is a problem whose presence in the cultural consciousness is not proportionate to its scope. It’s widespread, and can have dramatic consequences. Its difficulty to catch means it can plague your businesses for a long period of time, without you even knowing it.

Luckily, the steps to protect your business from payroll fraud are easy to follow. Establish checks and balances, perform random audits, and communicate clearly to your employees you’re serious about fraud. 

Doing payroll well can be difficult, and intensive. It may make sense to outsource your payroll. Employing a payroll service is an affordable and efficient solution.

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