Payroll Fraud Prevention: Strategies, Red Flags, and Best Practices

Payroll Fraud
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Payroll fraud is a significant challenge that can have serious financial and reputational consequences for organizations. According to the Association of Certified Fraud Examiners (ACFE), payroll fraud accounts for 8.7% of all occupational fraud cases and can last on average for 30 months before detection. To safeguard your business, it’s crucial to understand the types of payroll fraud, recognize red flags, and implement strong internal controls. This article explores common types of payroll fraud, warning signs, and actionable strategies for prevention and detection.

Common Types of Payroll Fraud

  1. Falsified Timesheets and Attendance Fraud:
    • Employees overstate the hours worked or manipulate overtime to receive higher payments.
    • “Buddy punching” occurs when one employee clocks in/out for another.
  2. Ghost Employees:
    • Creating fictitious employees in the payroll system or keeping former employees on the payroll.
    • Fraudster directs wages to their own account or an accomplice.
  3. Commission Fraud:
    • Inflating sales figures or creating fictitious sales to receive higher commissions.
  4. Payroll Adjustment Fraud:
    • Unauthorized changes to payroll data, including pay rates, bonuses, and benefits.
  5. Expense Reimbursement Fraud:
    • Employees submit false or inflated reimbursement claims for travel, meals, or other business expenses.
  6. Misclassification of Employees:
    • Misclassifying employees as contractors or adjusting job titles to avoid taxes or benefits.
  7. Advance Payment Fraud:
    • Employees request advances without authorization or repay them inaccurately.

Warning Signs and Red Flags for Potential Fraud

  1. Unusual Payroll Variations:
    • Significant unexplained fluctuations in payroll expenses.
  2. Payroll Adjustments Without Documentation:
    • Frequent or large adjustments in payroll data without proper documentation.
  3. Discrepancies in Payroll and Tax Reports:
    • Differences between internal payroll records and tax filings or government reports.
  4. Duplicate Bank Accounts:
    • Multiple employees sharing the same bank account or addresses.
  5. Irregular Overtime Payments:
    • Excessive or inconsistent overtime claimed by specific employees.
  6. Ghost Employee Red Flags:
    • Employees without identification, Social Security numbers, or tax file numbers.
    • Employees with the same address, bank account, or emergency contact.
  7. Manipulated Timesheets:
    • Timesheets altered after supervisor approval.

Internal Controls and Procedures to Prevent Fraud

  1. Segregation of Duties:
    • Separate payroll processing, approval, and distribution functions among different personnel.
    • Ensure no single individual has control over the entire payroll process.
  2. Access Controls:
    • Implement role-based access controls to payroll and HR systems.
    • Limit access to sensitive payroll data to authorized personnel only.
  3. Timesheet Approval and Verification:
    • Require supervisors to approve timesheets.
    • Regularly verify timesheets against work schedules and attendance records.
  4. Review and Approval of Payroll Changes:
    • Require dual approval for all payroll changes, such as new hires, raises, or terminations.
    • Document all payroll adjustments and maintain approval records.
  5. Regular Payroll Reconciliation:
    • Reconcile payroll records with bank statements, tax filings, and internal accounting records.
    • Investigate discrepancies promptly.
  6. Employee Verification and Onboarding:
    • Verify identification, Social Security numbers, and references for new employees.
    • Conduct background checks on new payroll and HR staff.
  7. Expense Reimbursement Controls:
    • Implement clear policies for expense reimbursements.
    • Require original receipts and managerial approval for all claims.
  8. Payroll System Audit Trails:
    • Enable audit trails in payroll systems to track changes and access.
    • Review audit trails regularly for suspicious activity.
  9. Periodic Payroll Audits:
    • Conduct regular internal or external payroll audits to identify anomalies.

Conducting Payroll Audits to Identify Potential Fraud

  1. Define the Audit Scope and Objectives:
    • Identify the time period, payroll functions, and specific risks to be audited.
    • Set objectives like detecting ghost employees, verifying expense claims, or reviewing tax compliance.
  2. Collect and Analyze Payroll Data:
    • Gather payroll records, timesheets, bank statements, and tax reports.
    • Compare payroll records with tax filings and accounting ledgers.
  3. Identify Anomalies and Red Flags:
    • Look for duplicate addresses, bank accounts, or inconsistent job titles.
    • Compare overtime payments and bonuses across different departments.
  4. Examine Payroll Adjustments:
    • Review payroll changes for accuracy, proper documentation, and approvals.
    • Pay special attention to salary increases, bonuses, and employee classifications.
  5. Evaluate Internal Controls:
    • Assess the effectiveness of segregation of duties, access controls, and approval processes.
    • Identify control weaknesses that could lead to payroll fraud.
  6. Prepare the Audit Report and Action Plan:
    • Summarize audit findings, highlighting discrepancies and areas of risk.
    • Develop an action plan to address findings and improve payroll controls.

Responding to Suspected Cases of Fraud in Payroll

  1. Investigate Promptly:
    • Form an investigation team that includes HR, payroll, legal, and internal audit representatives.
    • Interview relevant personnel and review suspicious payroll records.
  2. Preserve Evidence:
    • Secure payroll records, audit trails, and emails.
    • Avoid alerting suspected individuals until evidence is collected.
  3. Implement Corrective Measures:
    • Stop further fraudulent activity and correct inaccurate payroll data.
    • Strengthen internal controls to prevent recurrence.
  4. Take Disciplinary Action:
    • Follow company policies and labor laws when taking disciplinary action.
    • Terminate employees involved in fraud and pursue legal action if necessary.
  5. Report to Authorities:
    • Report payroll fraud to regulatory authorities, such as tax agencies or the police, if required.
    • Consider involving external auditors or fraud investigators.
  6. Communicate with Stakeholders:
    • Inform affected stakeholders (e.g., employees, investors) about the fraud incident and response measures.


Preventing payroll fraud requires a proactive approach that includes strong internal controls, regular payroll audits, and timely investigation of red flags. By understanding common types of payroll fraud and implementing best practices, organizations can safeguard their finances, maintain compliance, and build a culture of transparency and accountability.


How to identify payroll fraud?

Look for red flags like ghost employees, unauthorized payroll changes, duplicate bank accounts, and excessive overtime payments.
Conduct regular payroll audits and compare payroll records with bank statements and tax filings.

How could payroll fraud be committed?

Payroll fraud can be committed through falsified timesheets, creating ghost employees, misclassifying workers, inflating commissions, or unauthorized payroll adjustments.

How do you control employee fraud?

Implement segregation of duties, approval processes, and access controls.
Conduct regular payroll audits and investigate red flags promptly.
Foster an ethical workplace culture through employee training and clear policies.

What is the definition of payroll fraud?

Payroll fraud is the intentional manipulation of payroll records or systems to receive unauthorized compensation, benefits, or expense reimbursements.

How to prevent and detect payroll fraud?

Prevent payroll fraud through strong internal controls, segregation of duties, and secure access controls.
Detect fraud by conducting regular payroll audits, reconciling payroll with accounting ledgers, and reviewing audit trails.

Which of the following are three categories of payroll fraud?

Falsified Timesheets: Overstating work hours or buddy punching.
Ghost Employees: Creating fictitious employees or keeping former employees on the payroll.
Payroll Adjustments: Unauthorized changes to salaries, benefits, or bonuses.