Inside Job:

How Payroll Fraud Thrives

in Small Businesses

Picture this: It’s a Friday afternoon. Payroll has just run, your employees are happy, and you’re looking forward to a weekend that doesn’t involve spreadsheets, emails, or mysterious phone calls from the bank. Then, somewhere between your second cup of coffee and a blissfully quiet inbox, a thought creeps in.

Wait… who is “Chris P. Bacon” on my payroll report?

If you laughed, good - humor is healthy. If you also opened your payroll records just now, even better. Because while “Chris P. Bacon” might be a joke, payroll fraud is not.

Here’s the uncomfortable truth: small businesses are prime targets for internal financial fraud, and payroll is one of the easiest places for it to hide. Small businesses (fewer than 100 employees) are also disproportionately impacted, facing higher fraud losses as a percentage of revenue compared to larger organizations. The Association of Certified Fraud Examiners reports that payroll fraud occurs in nearly 1 out of every 4 small businesses - and it can quietly drain tens, even hundreds of thousands of dollars before you notice.

Why? Because payroll is the perfect disguise for theft. Regular, predictable transactions don’t raise eyebrows. A few extra hours here, a “new hire” who isn’t real, or a sneaky pay rate change… these can slip through unnoticed, especially when the person committing the fraud is the same person processing the payroll.

The good news? Spotting payroll fraud isn’t about becoming a paranoid micromanager who watches every keystroke your staff makes. It’s about knowing the warning signs and building systems that make fraud difficult, risky, and easy to detect.

In this guide, we’ll walk through:

• The most common payroll fraud schemes (and how they work in real life)
• Red flags you can’t afford to ignore
• Prevention strategies that actually work
• What to do if you suspect fraud is happening in your business

By the end, you’ll know exactly how to spot trouble before it snowballs - and how a little professional oversight (hello, CAS professional) can keep your payroll honest, your employees accountable, and your profits where they belong: in your business.

Now, let’s talk about why payroll fraud is so sneaky… and why it loves companies with staff like yours.

Why Payroll Fraud is a Silent Profit Killer

Payroll fraud doesn’t crash into your business like a burglar smashing a window - it’s more like a slow leak in the roof you don’t notice until the ceiling caves in. The real danger isn’t always the amount stolen in one hit - it’s the fact that it can keep happening over and over, quietly bleeding your business until one day you’re wondering why cash flow feels tighter than it should.

The Numbers Are Not on Your Side

According to the Association of Certified Fraud Examiners (ACFE), payroll fraud lasts a median of 18 - 30 months before it’s detected. That’s two and a half years of padded hours, phantom paychecks, or “accidental” pay raises before someone catches on. And here’s the kicker: small businesses lose a median of $150,000 per fraud case.

Why so long before it’s caught?

• Payroll looks normal. When the same amounts go out every pay cycle, your eyes gloss over anomalies.
• Trust bias. Owners often trust payroll staff completely - sometimes they’re family members or long-term employees.
• Complexity. Payroll involves taxes, deductions, benefits… things that can be tricky to decipher without detailed oversight.

Why Payroll is a Prime Target

Fraudsters love payroll because:

1. It’s repetitive. Patterns hide in repetition.
2. It’s essential. People get paid no matter what - meaning fraudulent transactions piggyback on a process you can’t skip.
3. It’s “inside” work. You need access to payroll systems to commit payroll fraud, so it’s usually an insider with knowledge of your procedures.

In many small and mid-sized businesses, one person wears all the hats - HR, payroll, bookkeeping. That’s convenient… until you realize it’s also the perfect setup for fraud. No one is checking the checker.

The Emotional Toll You Don’t See

Losing money hurts, but the deeper wound comes from the betrayal. When you discover an employee you trusted has been stealing from you, it’s not just a financial problem - it’s a morale and culture problem. The rest of your staff wonders who’s next. Trust between teams erodes. You become more suspicious. And in some cases, the damage to relationships can be permanent.

If that all feels a little too bleak, here’s the silver lining: payroll fraud leaves clues. And once you know what those clues look like, you can spot them long before two and a half years go by.

The Most Common Payroll Fraud Schemes

Payroll fraud isn’t one-size-fits-all. There are multiple ways it can be pulled off - and fraudsters often pick the method that’s easiest to hide in your business’s specific setup. Let’s break down the most common schemes, how they work, and what they might look like in real life.

Ghost Employees

How it works:
A “ghost employee” is someone who exists on your payroll but not in your workplace. They might be a completely fictitious person, a former employee who was never removed from the system, or even a relative of the payroll processor.

Mini-scenario:
At Acme Manufacturing, payroll clerk Steve adds a new “employee” named Jamie Turner. Jamie’s paycheck gets direct-deposited into Steve’s personal account. Jamie never clocks in, never produces work, and never shows up for the company holiday party. Yet Jamie keeps “earning” $1,200 every two weeks for months before anyone notices.

Why it works:
If no one outside of payroll regularly verifies the employee roster, ghost employees can float along in the background for a long time.

Falsified Hours or Overtime

How it works:
Hourly employees inflate their hours or submit unauthorized overtime. Sometimes it’s subtle - a few minutes extra every day. Other times, it’s blatant, like clocking in for an entire shift they never worked.

Mini-scenario:
Maria works in the warehouse and has a friend in payroll. She clocks in for 8 hours, leaves after 6, and her friend “fixes” the timesheet so it still shows a full day. Over time, those two-hour gaps add up to thousands in unearned pay.

Why it works:
If supervisors don’t compare hours worked to actual schedules - or if the person inflating hours is also the person approving them - the fraud blends in with legitimate overtime.

Unauthorized Pay Rate Changes

How it works:
An employee temporarily bumps their hourly rate or salary in the payroll system, runs payroll, and then changes it back afterward to avoid detection.

Mini-scenario:
In a small marketing firm, payroll is handled in-house by one trusted office manager. She quietly changes her hourly rate from $22 to $35 for one payroll run. After payday, she switches it back. Unless the owner is reviewing payroll reports in detail, the “bonus” goes unnoticed.

Why it works:
Many business owners only glance at total payroll costs, not individual pay rates, making small bumps hard to spot.

Commission or Bonus Padding

How it works:
Employees who earn commissions or bonuses based on performance may inflate sales numbers, backdate deals, or falsify performance metrics to trigger higher payouts.

Mini-scenario:
A sales rep claims to have closed three large accounts at the end of the quarter, earning a $2,500 bonus. In reality, the contracts never signed. By the time the truth surfaces, the bonus is long gone.

Why it works:
Commission and bonus calculations can be complex, and business owners often rely on reports generated by the same employees benefiting from them.

Expense Reimbursement as Payroll Padding

How it works:
An employee submits fake or inflated expense reports, which are then processed through payroll as “reimbursements” - making the payment look legitimate in accounting records.

Mini-scenario:
The office manager submits a reimbursement for “client lunch meetings” that never happened. Since reimbursements don’t trigger tax withholding, they can blend into payroll without raising a red flag.

Why it works:
Expense reimbursements are often approved with minimal scrutiny, especially if the amounts seem small or routine.

The scary part? None of these schemes require Hollywood-level hacking skills - just access, opportunity, and a lack of oversight. But each one leaves signs in your payroll records if you know what to look for.

Red Flags That Should Make You Pause

Payroll fraud might be sneaky, but it rarely operates without leaving footprints. If you know where to look, you can spot signs before they snowball into massive losses.

These clues don’t guarantee fraud is happening - but they do guarantee you should take a closer look. Think of them as the flicker of smoke that says, maybe check the kitchen before the whole house is on fire.

1. Paychecks to People You Don’t Recognize

• What it looks like: A name on the payroll register that no one in the office has ever met, or that doesn’t match your HR records.
• Real-world tip-off: You overhear a manager say, “Who’s Taylor on the payroll report? We don’t have a Taylor.”

2. Multiple Paychecks to the Same Bank Account

• What it looks like: Two or more employees having direct deposit set to the same routing and account number.
• Real-world tip-off: Your payroll summary shows “Account ending in 4392” listed twice - for two “different” employees.

3. Overtime Patterns That Don’t Make Sense

• What it looks like: The same employee always has overtime, even during slow weeks, or overtime logged outside normal business hours.
• Real-world tip-off: Your café’s slowest day is Tuesday, yet one employee logged six hours of overtime… every Tuesday this month.

4. Payroll Expense Growing Faster Than Your Team

• What it looks like: Total payroll rising by 10–20% with no new hires, raises, or added hours.
• Real-world tip-off: Your revenue is flat, your team size is steady, yet payroll is eating a bigger slice of the budget each month.

5. “One Person Only” Payroll Access

• What it looks like: Only one employee can log in, run, or review payroll - and they push back on anyone else doing it.
• Real-world tip-off: Your bookkeeper “can’t” take vacation because “no one else knows the system.”

6. Unusual Employee Behavior Around Payday

• What it looks like: Overly defensive responses to payroll questions, sudden reluctance to provide documentation, or excessive interest in payroll timing.
• Real-world tip-off: An employee reacts with visible panic when you say you’ll be reviewing payroll this week.

7. Changes in Pay Rates Without Approval Records

• What it looks like: Pay rate changes in the system that you didn’t authorize or that have no HR paperwork attached.
• Real-world tip-off: An audit reveals someone was paid at a higher hourly rate for one pay period, then switched back down.

8. Former Employees Still Getting Paid

• What it looks like: Terminated employees’ names still appear in the payroll run - sometimes months after leaving.
• Real-world tip-off: You spot a paycheck to someone who moved out of state last quarter.

9. Expense Reimbursements Processed Through Payroll

• What it looks like: “Reimbursements” regularly showing up as non-taxable payroll items without receipts or supporting documentation.
• Real-world tip-off: An employee gets $200-$300 “reimbursements” every month for vague items like “miscellaneous supplies.”

10. Payroll Reports That Don’t Match Other Records

• What it looks like: Discrepancies between payroll, timecards, and job schedules.
• Real-world tip-off: A warehouse employee logs 50 hours in payroll but only 38 hours on the shift schedule.

11. Frequent “Corrections” or Off-Cycle Payments

• What it looks like: Multiple one-off payments outside the regular payroll cycle, often labeled as “adjustments.”
• Real-world tip-off: You see four separate “manual checks” issued last month, all to the same employee.

12. Bank Reconciliation Headaches

• What it looks like: Payroll withdrawals that don’t match your payroll provider’s report totals.
• Real-world tip-off: Your bank account shows $24,350 in payroll withdrawals, but the payroll summary says $23,100.

Pro tip: Any one of these could be a simple mistake - but repeated patterns mean it’s time to dig in. Even if you don’t find fraud, you’ll probably uncover process weaknesses that could be exploited later.

Mini Case Study: The Case of the Ever-Growing Payroll

When Jenna took over as CEO of her family’s small manufacturing business, she expected a learning curve. What she didn’t expect was that her biggest challenge wouldn’t be sales, supply chain, or customer service - it would be payroll.

At first, the signs were easy to miss. The payroll expense report showed a steady climb over six months, but Jenna chalked it up to “inflation” and “a few overtime-heavy projects.”

Then came the first eyebrow-raiser: during a casual conversation, her production manager asked, “Hey, who’s Eric? I don’t think I’ve met him.” Jenna didn’t think much of it - until she checked the employee list and realized Eric had been on payroll for four months… yet no one could say what shift he worked.

A deeper look revealed more oddities:

• Eric’s paycheck was deposited into the same bank account as another employee - a warehouse associate named Dave.
• One office employee’s hourly rate had jumped by $7 for a single pay period, then quietly dropped back down.
• Three “manual adjustments” had been made last month, all for round numbers, all without documentation.

Jenna brought in an outside accounting consultant to review the records. Within two days, they uncovered the truth: Dave had convinced his friend in payroll to set up a ghost employee (Eric), funneling extra paychecks into Dave’s account. The friend also padded her own pay rate on occasion, and the “manual adjustments” were split between them as off-cycle bonuses.

By the time it was discovered, the scheme had run for nine months, costing the business just over $48,000. Worse than the money, though, was the fallout - the betrayal left Jenna reluctant to trust anyone with financial access, and morale in the payroll department cratered.

Key takeaways from Jenna’s case:

• The red flags weren’t isolated - they built on each other.
• Even small anomalies can indicate bigger problems.
• Independent payroll reviews would have caught the scheme in its first month.

How to Prevent Payroll Fraud Before It Starts

Stopping payroll fraud isn’t about turning your business into a spy movie. It’s about setting up processes that make fraud difficult to pull off, easy to detect, and not worth the risk.

Here’s your prevention playbook:

Step 1: Separate Duties Like Your Profits Depend on It (Because They Do)

• What to do: Make sure no single person controls the entire payroll process.
• One person enters data.
• Another approves it.
• A third (or you) reviews the final payroll report before it’s submitted.
• Why it works: Fraud often happens when one person has full control from start to finish — and no one else is looking.
• Pro tip: Even in small teams, you can bring in your bookkeeper or accountant as the second set of eyes.

Step 2: Review Payroll Reports Every. Single. Time.

• What to do: Compare the payroll register to your current employee roster, pay rates, and approved hours before hitting “Submit.”
• Why it works: This one step would stop ghost employees, unauthorized raises, and many fake overtime claims before they’re paid.
• Pro tip: Don’t just glance at totals - scan line by line for names, rates, and hours that look off.

Step 3: Set Payroll System Permissions Wisely

• What to do: Limit payroll software access based on job role, and keep an updated list of who can make changes.
• Why it works: The fewer people who can add employees or change rates, the fewer opportunities for fraud.
• Pro tip: Use audit trails in your payroll software to see who made what changes and when.

Step 4: Require Documentation for Any Change

• What to do: Make it policy that all pay rate changes, bonuses, or off-cycle payments require signed approval and backup documentation.
• Why it works: Fraudsters hate paper trails. Legit changes will have no problem passing this test.
• Pro tip: Store approvals in a centralized, secure location - not on someone’s desk or personal laptop.

Step 5: Reconcile Payroll to Bank Statements

• What to do: Match payroll withdrawals against your payroll register every cycle. Investigate any mismatches immediately.
• Why it works: This catches unauthorized payments, overpayments, and timing differences before they pile up.
• Pro tip: Reconciliation is a perfect task to outsource to a CAS provider who’s independent from the people running payroll.

Step 6: Use Surprise Audits

• What to do: Schedule periodic, unannounced payroll reviews.
• Why it works: When employees know their work could be checked at any time, fraud risk drops dramatically.
• Pro tip: These don’t have to be hostile - frame them as “process reviews” to improve accuracy.

Step 7: Cross-Train and Require Time Off

• What to do: Make sure more than one person can run payroll, and require payroll staff to take vacation days.
• Why it works: Many schemes are discovered when the perpetrator isn’t there to cover their own tracks.
• Pro tip: Cross-training also keeps payroll running smoothly if someone quits or is out unexpectedly.

Step 8: Educate Your Team on Fraud Awareness

• What to do: Hold periodic training on what payroll fraud looks like and why it’s taken seriously.
• Why it works: Employees are more likely to speak up if they spot something suspicious - and less likely to try something themselves.
• Pro tip: Keep it light but clear. You’re not accusing anyone - you’re building a culture of transparency.

Step 9: Bring in Independent Oversight

• What to do: Involve your CAS/accounting provider in regular payroll reviews and reconciliations.
• Why it works: Outside eyes catch things insiders miss (or ignore). Plus, it’s harder to collude when there’s a neutral third party in the mix.
• Pro tip: Even quarterly independent reviews can prevent long-term fraud.

Preventing payroll fraud isn’t about mistrusting your team - it’s about protecting your business, your employees, and your peace of mind. The right controls create a fair system where honest people thrive, and dishonest ones get caught fast.

What to Do If You Suspect Payroll Fraud

Your crisis playbook for acting fast, smart, and legally.

Finding a red flag in payroll is stressful - but the way you respond can mean the difference between stopping the problem quickly or letting it spiral into something much worse.

Here’s your step-by-step action plan:

Step 1: Stay Calm and Avoid Tipping Off Suspects

• Why: If the person committing fraud catches wind of your suspicion, they may cover their tracks, destroy evidence, or even retaliate.
• How: Keep your review discreet. Don’t make sudden changes to their access yet - that’s coming later.

Step 2: Quietly Gather Evidence

• What to collect:
• Payroll registers for the last 6-12 months
• Employee rosters and HR files
• Timesheets or scheduling records
• Bank statements tied to payroll withdrawals
• Payroll change logs from your software
• Why: You’ll need a clear, documented timeline to prove the fraud and quantify the damage.

Step 3: Secure Payroll Access

• Why: Prevent further tampering while you investigate.
• How: Change passwords, revoke system access for anyone under suspicion, and make sure only authorized personnel can access payroll and bank accounts.
• Pro tip: If you use a payroll provider, alert them and temporarily freeze any non-standard changes.

Step 4: Bring in Backup

• Who to involve:
• Your CAS/accounting/bookkeeping provider
• HR (internal or outsourced)
• Legal counsel if needed
• Why: Fraud investigations need to be thorough, unbiased, and compliant with labor laws - especially if the case might lead to termination or prosecution.

Step 5: Conduct a Confidential Review

• What to do: Cross-check payroll records against employee rosters, approved pay rates, and hours worked. Look for discrepancies, patterns, and missing documentation.
• Why: The review will confirm whether anomalies are mistakes or deliberate fraud.

Step 6: Decide on Immediate Action

• Options include:
• Placing the suspect on administrative leave
• Terminating employment (with legal guidance)
• Reporting to law enforcement
• Why: The action you take will depend on the severity of the fraud and your ability to prove intent.

Step 7: Communicate Carefully

• Why: Gossip spreads fast, and accusations can damage morale or reputation if handled poorly.
• How: Keep the circle small, share only facts, and emphasize your commitment to transparency and fair processes.

Step 8: Fix the Weak Spots

• What to do: Review your internal controls to ensure the same scheme can’t happen again.
• Why: Even if you stop the current fraud, failing to close the gaps invites repeat offenses.

Pro tip: Document everything. Whether you pursue legal action or not, having a paper trail protects you from wrongful termination claims and shows due diligence.

Remember “Chris P. Bacon” from our intro? In the best version of your business, may that be the only kind of ghost employee you ever encounter — a harmless inside joke, not a real drain on your bottom line.

Payroll fraud loves to hide in the ordinary. It slips into familiar patterns, blends in with legitimate transactions, and counts on the fact that you’re too busy running your business to notice. But here’s the good news: now you know what it looks like, how to spot it, and how to shut it down before it costs you money, trust, and maybe a few nights’ sleep.

When you:

• Separate payroll duties
• Review reports carefully
• Keep a close eye on anomalies
• Involve an independent reviewer like a CAS provider

…you’re not just preventing fraud — you’re protecting your culture, your profits, and your peace of mind.

The moral of the story? Payroll fraud prevention isn’t about being suspicious of everyone. It’s about making honesty the easiest option in your business. You’re building a system where the truth is clear, the numbers are clean, and the only surprises in payroll are pleasant ones (like finally remembering to give out that well-deserved bonus).

If you’d like a head start, grab our Payroll Fraud Red Flag Checklist — a simple, powerful tool you can use to run quick monthly “fraud health checks” without needing to dig through every report yourself.

Here’s to keeping your payroll as boring as possible… because boring payroll means your money is right where it should be.

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as financial advice. Consult with a qualified professional for personalized guidance tailored to your specific needs and situation. Feel free to reach out to The Numbers Agency for a free consultation to see how we can help!