Payroll Fraud: How to Detect, Prevent, and Report It

A few extra minutes here, a forgotten clock-out there—until you realize those "small mistakes" have cost your business thousands. Payroll fraud doesn't announce itself with alarm bells. It quietly drains your resources while you're focused on serving customers and growing your team.

Here's what makes it especially painful for small businesses: the Association of Certified Fraud Examiners found that organizations with fewer than 100 employees suffer an average loss of $141,000 per fraud case. When you're operating on tight margins, that's not just a setback—it can be devastating.

But here's the thing: once you know what to look for, payroll fraud becomes much easier to spot and prevent. Whether you're wondering if those questionable timesheets count as fraud, need to know the legal consequences, or want to protect your business before problems start, this guide covers everything you need.

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TL;DR Payroll fraud penalties, red flags, and prevention

Payroll fraud is serious business, and small business owners need to know the risks:

Common payroll schemes to watch for:

• Timesheet fraud: Falsifying hours worked—the most common type.
• Buddy punching: One employee clocking in for another.
• Ghost employees: Fake workers created to redirect paychecks.
• Payroll tax evasion: Pocketing withheld taxes instead of paying the IRS.

Warning signs: Watch for overtime that doesn't match your busy periods, employees who always clock in at the exact same time, missing paperwork for certain workers, and payroll expenses climbing even though you haven't hired anyone new.

How to stop it: Use time tracking that requires a selfie and confirms location, make sure two people approve any pay changes, and run regular audits. If you spot fraud, report it to the IRS using Form 3949-A.

What is payroll fraud?

Payroll fraud happens when someone manipulates a company's payroll system to steal money. This includes:

• Falsifying timesheets
• Creating fake employees
• Manipulating pay rates
• Pocketing tax withholdings

While some cases involve complex schemes, most start with simple timesheet manipulation that compounds over months.

Small businesses are particularly vulnerable because they typically operate with fewer internal controls and a trust-based culture. Modern technology has made detection easier—automated systems flag suspicious patterns that would take hours to spot manually, catching warning signs before small discrepancies become major losses.

The real impact starts small but adds up fast. An employee padding their timesheet by 15 minutes daily steals over 90 hours annually—that's more than two full work weeks of wages for time never worked.

Payroll fraud vs. time card errors

Not every payroll discrepancy is fraud. The key difference comes down to intent.

Honest mistakes happen all the time: 

• Forgetting to clock out for lunch
• Math errors in manual calculations
• Accidentally clocking in at the wrong time
• Misunderstanding break policies

These are time card errors—unintentional mistakes that can get easily corrected when noticed. If something happens once and gets corrected, it's likely an error. If it's a repeated pattern despite correction attempts, it's possibly fraud.

Types of payroll fraud in small businesses

Small businesses face several common fraud schemes. Here's what to watch for:

Timesheet fraud

Timesheet fraud involves falsifying start and end times, break durations, or remote work hours. It's one of the most common types of payroll fraud. What makes it particularly insidious is how it begins with minor adjustments that compound over time.

Hot tip: Photo verification and GPS-enabled clock-ins prevent time theft manipulation with real-time alerts for suspicious patterns.

Buddy punching

Buddy punching happens when one employee clocks in or out for another who isn't present. According to the American Payroll Association, 75% of U.S. businesses lose money to buddy punching, costing between $1,400 and $6,000 per worker annually. 

Beyond the money, buddy punching creates serious liability issues—if an employee who hasn't actually arrived is injured on their way in but they're already "clocked in," you face potential workers' compensation complications.

Hot tip: Selfie verification at clock-in matches employee profiles automatically, and GPS confirms work location—making buddy punching virtually impossible.

Ghost employee fraud

Ghost employee fraud involves creating fictional employees or keeping terminated employees on payroll, then redirecting their paychecks to the fraudster. This scheme typically requires access to payroll systems and results in significantly higher median losses than other fraud types.

Hot tip: Complete employee documentation and photo verification during onboarding make creating ghost employees difficult.

Payroll processing manipulation

Employees with payroll software access sometimes adjust their own pay rates, add unauthorized bonuses, or manipulate their recorded hours. This fraud is particularly difficult to detect because the fraudster understands the system and knows how to hide their tracks.

Hot tip: Dual approval requirements and detailed audit trails of all payroll adjustments prevent solo manipulation.

Commission and pay rate fraud

Commission fraud and wage manipulation involve inflating sales data to increase commissions or making unauthorized changes to base pay rates and bonuses. This often happens during hectic periods when supervisors are distracted.

Hot tip: Integrated POS and time tracking verify sales activities against work hours, flagging suspicious patterns automatically.

Payroll tax fraud

Payroll tax fraud occurs when someone with payroll responsibilities withholds taxes from employee paychecks but pockets the money instead of remitting it to the IRS. This scheme is particularly dangerous because it exposes business owners to severe penalties, interest charges, and potential criminal prosecution—even when they didn't commit the fraud themselves.

Hot tip: When your payroll system calculates, withholds, and files taxes automatically, there's no manual handling where funds can disappear.

How to detect the signs of payroll fraud

Payroll fraud rarely happens overnight. Most schemes leave warning signs that savvy business owners can spot before losses mount. Learning to recognize these red flags helps you catch fraud early and protect your bottom line.

Time tracking red flags

Time tracking red flags reveal patterns in how employees clock in and out that don't match normal work behavior. These suspicious patterns often indicate timesheet fraud or buddy punching schemes where employees manipulate their recorded hours.

Watch for these warning signs:

• Overtime hours spiking without corresponding business activity
• Multiple employees with identical clock-in and clock-out times consistently
• Perfect 40-hour weeks with zero variation over extended periods
• Employees who never take vacation

Compare timesheet data against actual business needs, security footage, and manager observations. Modern employee time clock systems with GPS verification and photo clock-ins automatically flag these inconsistencies before they impact payroll.

Employee behavior red flags

Employee behavior red flags often surface before financial discrepancies appear in your records. Fraudsters typically display defensive or controlling behaviors around payroll processes, especially when their schemes face scrutiny or potential exposure.

Key behavioral warning signs include:

• Payroll staff resisting time off or refusing to delegate duties
• Defensive reactions to routine timesheet questions
• Resistance to new time tracking systems
• Team members living beyond their apparent means

Pay attention to employees who refuse to take vacations or insist on handling all payroll tasks alone—this control often hides ongoing fraud. Creating a culture where questions about pay and hours are normal helps identify defensive behaviors that warrant closer investigation.

Financial red flags

Financial red flags appear in your payroll reports and budget analyses when the numbers don't align with your business reality. These discrepancies signal potential fraud schemes like ghost employees, unauthorized bonuses, or manipulated pay rates.

Monitor for these financial anomalies:

• Payroll expenses increasing without corresponding headcount growth
• Commission payments inconsistent with sales reports
• Payroll totals exceeding budgeted amounts by significant margins
• Unusual adjustments outside normal processing times

Regular budget reconciliation and month-over-month comparisons catch these patterns early. Cross-reference payroll data with sales reports, POS systems, and actual staffing levels to verify that wages align with business performance.

Documentation red flags

Documentation red flags indicate gaps or irregularities in your employee paperwork and payroll records. Missing or suspicious documents often accompany ghost employee schemes and payroll processing manipulation.

Critical documentation issues to watch for:

• Missing approval signatures on pay rate changes
• Incomplete employee records or missing I-9 forms
• Multiple employee records with identical addresses or bank account information
• Paychecks that consistently go unclaimed

Conduct regular audits of employee files and payroll documentation to ensure everything is complete and accurate. Systems that require proper documentation before processing payments prevent many of these issues from occurring in the first place.

Tax fraud red flags

Tax fraud red flags emerge when payroll tax obligations don't match what's actually being remitted to tax authorities. Payroll tax fraud schemes involve diverting withheld taxes for personal use instead of paying the IRS, creating serious legal exposure for business owners.

Warning signs of payroll tax diversion:

• IRS or state tax authority notices about missing or late payments
• Discrepancies between employee pay stubs and actual tax deposits
• Payroll staff restricting access to tax filing records or login credentials
• Unexplained delays between payroll processing and tax remittance
• Employee complaints about Social Security or tax withholding discrepancies

Monitor tax payment schedules closely and verify that withheld amounts actually reach tax authorities on time. Automated payroll systems that file taxes directly with the IRS eliminate the opportunity for manual diversion while providing clear audit trails of all tax transactions.

How to prevent payroll fraud

Preventing payroll fraud doesn't require complex systems or expensive consultants. The most effective strategies combine smart technology with basic management practices that make fraud harder to pull off and easier to catch.

Implement automated time tracking

Paper timesheets and honor systems made sense when you had five employees who all worked in the same room. But as your team grows or spreads across locations, manual tracking creates too many opportunities for manipulation.

Modern time tracking systems combine biometric verification, GPS tracking, and automated monitoring to create comprehensive fraud prevention. These tools create undeniable digital records of when and where employees work, flagging suspicious patterns before they impact your bottom line.

The real power comes from automation. When your system automatically alerts you that someone clocked in 30 minutes early three days this week, or that two employees have identical time entries, you can address issues immediately instead of discovering them weeks later during payroll processing.

Require photo verification and GPS tracking

Buddy punching thrives in environments where nobody can prove who actually clocked in. A simple PIN code can be shared. A physical time card can be punched by anyone. But a selfie taken at clock-in? That's hard to fake.

How photo verification prevents fraud:

• Matches the person clocking in with their employee profile automatically
• No manager needs to stand at the time clock checking faces
• The system verifies identity instantly at every clock-in

How GPS tracking adds protection:

• Confirms employees are at your work location when they clock in
• Eliminates parking lot clock-ins before actually starting work
• Creates location records for remote and field teams

These features don't just prevent fraud—they create accountability without micromanagement. Your team knows their attendance is verified, and you get peace of mind without having to constantly monitor who's working.

Set up dual approval systems

Here's a reality check: any payroll management system where one person has complete control is vulnerable to fraud. It doesn't matter how much you trust them. The temptation combined with the opportunity is too much for some people to resist.

Divide payroll responsibilities:

• Person 1: Processes payroll and enters hours
• Person 2: Approves and verifies the entries
• Person 3: Reconciles results with bank statements

This segregation of duties makes solo manipulation nearly impossible. When the person who enters hours can't approve them, and the person who approves them doesn't reconcile the bank account, each person acts as a check on the others.

For very small businesses: The owner should approve what staff processes. Yes, it takes a few extra minutes each pay period. But those minutes are worth it when they prevent someone from quietly adding hours, creating ghost employees, or manipulating pay rates.

Conduct regular audits

Fraudsters count on you being too busy to check their work carefully. They rely on the assumption that if something has been "working fine" for months, nobody will question it. Regular audits shatter that assumption.

Monthly reconciliation checklist:

• Compare timesheets with bank statements
• Match payroll totals against budget projections
• Verify employee counts in your system match actual team members
• Confirm tax deposits match withheld amounts

Use both audit types:

• Planned quarterly audits: Maintain regular oversight with predictable checkpoints
• Surprise audits: Deter fraud because employees never know when records might be reviewed

The combination sends a clear message: we're paying attention, and discrepancies get caught before $500 becomes $5,000.

Maintain detailed documentation

Think documentation is just bureaucratic busywork? The IRS doesn't. Detailed payroll records aren't just good practice—they're legally required. But beyond compliance, documentation creates an audit trail that makes manipulation difficult and detection easier.

Document everything:

• All payroll transactions and wage payments
• Pay rate changes with written approval
• Overtime approvals and manager authorization
• Timesheet adjustments with explanatory notes

Why documentation protects you:

• Deters fraud by creating accountability
• Helps you spot patterns when something feels off
• Provides evidence for termination or prosecution
• Supports insurance claims if fraud occurs

Modern payroll systems maintain these records automatically, making documentation easy instead of tedious.

How to report payroll fraud

Discovering payroll fraud puts you in a tough spot. You want to do the right thing, but you also need to protect yourself and make sure your report actually leads to action. Here's how to report payroll fraud effectively.

Document everything before you report

Before you pick up the phone or fill out any forms, gather your evidence. The more documentation you have, the more seriously your report will be taken.

What to collect:

• Timesheets showing falsified hours or suspicious patterns
• Bank records proving redirected payments or unauthorized transactions
• Emails, text messages, or recordings discussing the fraud scheme
• Security footage that contradicts clock-in times
• Payroll reports showing ghost employees or unusual adjustments
• Any other records that support your suspicions

Create a detailed timeline of when each incident occurred and how you discovered it. Make copies of everything and store them securely—ideally somewhere the fraudster can't access. If evidence exists only in digital form, save it to a personal device or cloud storage before it can be deleted or altered.

Report to the IRS for tax-related fraud

If the fraud involves payroll taxes—like an employer pocketing withheld taxes instead of paying the IRS—report it using IRS Form 3949-A.

What Form 3949-A asks for:

• The suspect's name and address
• Social Security number or Employer Identification Number (if you know it)
• A clear description of the fraud and what laws were violated
• The tax years involved and estimated dollar amounts
• How you know about the fraud and what evidence you have

You can file this form completely anonymously if you're worried about retaliation. Just leave the contact information section blank. However, providing your information helps if the IRS needs to follow up with questions that could strengthen the case.

How to submit it: You can submit Form 3949-A online through the IRS website, or download the PDF, fill it out, and mail it to the address listed in the instructions.

About whistleblower rewards: The IRS Whistleblower Program offers financial incentives for reporting significant tax fraud. If the fraud involves at least $2 million in taxes, penalties, and interest, you may qualify for a mandatory award of 15-30% of what the IRS ultimately collects. That's a separate process using Form 211, but it's worth knowing about if you're reporting substantial fraud.

For general questions about IRS reporting procedures, call 1-800-829-1040.

Contact other authorities for non-tax fraud

Not all payroll fraud involves taxes. Sometimes you're dealing with wage theft, timesheet manipulation, or embezzlement that needs attention from different agencies.

State labor departments: If the fraud involves wage violations, misclassification of employees, or failure to pay properly, contact your state's department of labor or wage and hour division. They handle complaints about unpaid wages, overtime violations, and illegal payroll practices.

Local law enforcement: For straightforward theft or embezzlement—like someone stealing from the company or creating ghost employees—file a police report with your local law enforcement agency. They can investigate criminal activity and potentially press charges.

State attorney general: For larger, more complex fraud cases affecting multiple employees or involving significant amounts of money, your state attorney general's office may take up the case. They have resources for prosecuting white-collar crime.

Protect your business from payroll fraud

Look, you didn't start your business to become a payroll fraud detective. You've got customers to serve and a team to lead. That's where Homebase comes in.

We've built features that can be helpful for catching payroll fraud right into our time tracking and payroll system:

• Photo capture at clock-in creates a visual record you can review to stop buddy punching
• GPS-enabled clock-ins confirm your team is actually at work
• Alerts for late arrivals, approaching overtime, and missed punches help you spot issues

No more Sunday night panic over questionable timesheets. No more wondering if those hours are legit. Just straightforward time tracking and payroll that protects your business while you focus on growing it.

Try Homebase for free today.

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Payroll fraud FAQs

What is the most common type of payroll fraud?

The most common type of payroll fraud is timesheet fraud. It’s the most common because it's easy to commit and often starts small, making it difficult to detect until losses accumulate. Employees falsify their start and end times, manipulate break durations, or pad their hours by small amounts that add up significantly over time.

Can you go to jail for payroll fraud?

Yes, you can go to jail for payroll fraud. Payroll fraud is typically prosecuted as a felony when amounts exceed state thresholds, which usually range from $500 to $1,000. Sentences range from probation for minor first-time offenses to 20 years or more for large schemes. First-time offenders committing felony payroll fraud often face one to five years in prison.

Is falsifying a timesheet illegal?

Yes, falsifying timesheets is illegal and can be prosecuted as fraud, theft, or embezzlement. Even adding 15 minutes daily to your timesheet can accumulate to felony-level amounts within a year. At $15 per hour, that's over $900 annually—crossing the felony threshold in most states.

How much does payroll fraud cost small businesses?

Payroll fraud costs small businesses approximately $141,000 per case according to the Association of Certified Fraud Examiners. Small businesses experience higher losses relative to their size compared to large corporations because they typically have fewer fraud prevention controls and detection takes longer.

Who typically commits payroll fraud?

Employees at all levels commit payroll fraud. Timesheet fraud is usually committed by hourly employees, while more sophisticated schemes like ghost employees and payroll processing manipulation are typically committed by managers or payroll staff who have system access.

What's the difference between time theft and payroll fraud?

The difference between time theft and payroll fraud is that time theft is a specific subset of payroll fraud, referring to getting paid for time not actually worked—taking excessively long breaks, buddy punching, or falsifying clock-in times. 

Payroll fraud is broader and includes ghost employees, commission fraud, payroll tax evasion, and wage manipulation schemes beyond just time-related issues.