10 Types of Payroll Fraud and How to Prevent Them

It’s one of the most common ways employees can steal from a business. Payroll fraud is when an employee accesses the payroll system to take money they haven’t earned. When someone commits payroll fraud, it doesn’t just mean a loss of money; it compromises private information and databases. That’s why a business’s best bet is to focus on payroll fraud prevention. To do that, we’ll start by defining payroll fraud, its types, and include a few real-life examples. We’ll also touch on prevention tips to keep your organization safe.

What is payroll fraud?

“Payroll fraud or payroll manipulation is when someone alters a payroll system to manipulate their or others’ compensation. Both employees and employers can commit payroll fraud by falsifying timesheets, issuing unauthorized bonuses, or paying fictitious or terminated employees.”

Payroll manipulation can lead to the following repercussions for businesses:

• Financial loss
• Reputational damage
• Legal consequences
• Money laundering

Repercussions can vary in severity, which is why knowing the various types of fraud will help organizations protect their business.

What are the types of payroll fraud schemes?

In this economic climate, criminals use various schemes to commit payroll fraud. Knowing the 10 most common frauds is the first step to a strong prevention strategy. Here’s what to look out for:

1. Ghost employees

Ghost payroll is when an someone adds an employee to the payroll when the company does not employ that employee. There are several situations where ghost employee fraud can occur:

• Someone creates fake employee records to receive undeserved pay
• An employee falsifies hours and salaries to receive a higher paycheck
• Temporary workers remain on payroll to receive a paycheck
• And more

Real-life payroll fraud example: In 2023 a grand jury in Chicago indicted a nursing home employee with seven counts of wire fraud for defrauding a nursing home, falsifying records, and generating payments to ghost employees (people who never worked at the home). As told by court documents, Alisha Richardson logged false hours for the “ghost” employees, depositing and cashing the paychecks herself. Ultimately, the nursing home paid over $100,000 to workers who never worked for the nursing home.

2. Falsified hours and overtime

Falsifying hours or timesheet fraud is when an employee manipulates their work hours, receiving pay for time they didn’t work. Employees can falsify hours by:

• Inflating hours, reporting that they clocked in before or clocked out after they did
• Falsifying entries and reporting incorrect time data
• Taking longer or more breaks than authorized
• Buddy punching, putting in an incorrect arrival or leave time for another employee
• Logging regular time as overtime

Real-life example: In this payroll fraud case, Joseph Winstead, a Washington, D.C. postal worker, conned USPS out nearly $40,000 in unearned wages by claiming he was on jury duty during a federal trial. Winstead falsified court paperwork to receive reimbursement (he was excused before deliberations). Ultimately, three years later, Winstead pled guilty to fraud.

3. Commission Fraud

Commission fraud occurs when commission-based employees abuse the framework and falsify sales. This type of fraud can work in several ways:

• Inventing sales: A retail employee records a fake purchase to initiate a commission. B2B sales members can create a fraudulent sales contract.
• Overstating sales: A worker either manipulates internal sales reports or invoices or exaggerates sales on the company’s POS.
• Inflating commission: An employee alters a company’s commission records showing a higher pay rate.

Real-life example: This employer payroll fraud began in 2015. While employed at US Compounding Inc (USC), a sales representative formed an agreement with a veterinarian. In the agreement, the sales rep would use the veterinarian’s license to create fake prescription orders to justify shipping prescription drugs to consumers. The veterinarian was promised a 10% commission on all sales generated through his license even though those prescriptions were fraudulent. The fraudsters generated $1 million in sales per year until eventually pleading guilty to fraud.

4. Buddy Punching

During buddy punching, an employee asks a coworker to clock them in or out for their work shift. Buddy punching can occur in two ways:

• Punching cards: An employee runs late and asks another employee to punch their timesheet, hoping their manager won’t notice their arrival.
• Signing in electronic timesheets: An employee shares their clock-in information with another employee who (username and password) clocks them in or out of a system.

5. Pay rate alterations

Pay rate alterations explain when an employee alters their pay, receiving a higher hourly rate than they should. Typically, pay rate fraud occurs when a manager approves fraudulent timesheets with higher pay rates. This costs the company more money and takes resources away from what could be profitable ventures.
Real-life example: One Boston police captain was found guilty of an overtime scheme when he inflated his team’s overtime hours so he and his team “earned” double what they should have made. This scheme cost the police force a significant amount of money.

6. Worker Misclassification

Worker misclassification describes an instance where a company incorrectly classifies an employee as an independent contractor. This type of fraud may occur if someone in the business wants to save money. Employees receive mandated and non-mandated benefits, rights and protections, and a salary subject to salary deductions. Independent contractors, on the other hand, must pay their own taxes, social security contributions, and benefits.

Essentially, employers may engage in worker misclassification to avoid contributing towards an employee’s payroll tax.

Real-life example: General contractor Whiting-Turner subcontracted work to Welch Mechanical Contractors who then hired workers from labor brokers. Welch sought to decrease costs and avoid paying minimum wage and benefits by misclassifying the workers as independent contractors. Whiting-Turner could then deny workers minimum wage, overtime pay, and sick leave even though they technically qualified as employees. In 2024, Attorney General Brian L. Schwalb sued Whiting-Turner for misclassification.

7. False claims for reimbursement

A reimbursement fraud scheme is when an employee submits falsified reimbursement receipts or submits the same receipt more than once. Expense reimbursement frauds typically fall into four categories: mischaracterized expenses, overstated expenses, fictitious expenses, and multiple reimbursements.

• Mischaracterized expenses: An employee submits a personal purchase such as airline tickets, a hotel, technology devices, and so on as a business expense.
• Overstated expenses: The expense is recorded costing more than the cost of the item or service, such as an employee expensing $40 for a $15 meal.
• Fictitious expenses: An employee files an expense for a purchase that was never made. This can be a meal, a gift, or other items.
• Multiple reimbursements: An employee submits the same expense several times or files a reimbursement request for the same service multiple times.

Real-life example: Former internet technology director, Juan Hicks stole more than $1 million from his employer by creating fake invoices and expense reports for purchases he never made and falsifying credit card statements to make purchases seem like business expenses. In 2023, Hicks pleaded guilty to wire fraud.

8. Advances and loan fraud

Refusing to pay back payroll advances is another type of payroll fraud. Typically when employers give employees an advance on their next pay, the company will deduct the amount from the employee’s next paycheck. Unfortunately, if the finance team doesn’t note the loan, employees escape repayment and earn undeserved money from the company.

9. Duplicate payment fraud

Duplicate payment fraud occurs when an individual attempts to get someone to pay for something they have already paid for. This can occur through:

• Duplicate invoices: vendors may purposely issue identical invoices with slight changes (eg changing the date) to bypass the accounts payable solution.
• Billing schemes: Employees can create several invoices and “pay” the recipient for products they never delivered.
• Check fraud: Vendors create fake receipts for expense reports or use the business account to write checks for personal use.

Real-life example: Though perhaps unintentionally, Zelle charged random Chase Bank account owners multiple times for a single payment. The widespread Zelle glitch created duplicates of charges and doubled fees.

10. Payroll diversion scheme

Payment diversion schemes also called business email compromise or BEC) describe scenarios where cybercriminals trick an employee with access to the organization’s international payroll system – into changing direct deposit information and rerouting an employee’s salary or wages to another account.

Payroll diversion schemers usually utilize phishing emails and send them out to payroll team members. Skilled fraudsters can make the emails appear like legitimate internal communications and ask the employee to update an individual’s direct deposit information. This allows the cybercriminal to control the fraudulent account.

Real-life payroll fraud example: In 2023, cybercriminals targeted USPS employees searching for their payroll system with a identical website that tricked hundreds of employees into providing their usernames and passwords. The cybercriminals then used employees’ information to access the system and reroute employees’ paychecks. All in all, The American Postal Workers Union said loses totaled around $1 million.

How to prevent payroll fraud

While you may not be able to end payroll fraud indefinitely, you can catch the unlawful behavior if you have a robust fraud prevention strategy. Here’s what you’ll need to:

• Create a system of checks and balances: Segrate the duties so that one person prepares the payroll and someone else reviews it.
• Limit access to payroll data and controls: Only authorized individuals should have access to payroll information.
• Switch to electronic timesheets: A clock-in solution that requires two-step authentication or biometrics can prevent buddy punching.
• Outsource payroll: Outsourcing payroll means a reputable provider will oversee duties instead of employees tenopted to exploit the system.
• Carefully audit payments: Monitoring your payments on a regular basis can help prevent and catch fraud.
• Conduct background checks: Verify that employees handling sensitive information have a clean record.
• Implement employee training: Help employees understand the risks of to phishing emails and how to spot them.
• Have a passwords policy: Require employees to change passwords every 2-3 months and use a unique password for each login.
• Use a payroll software: A payroll platform with data analytics can spot anomalies in pay records in seconds.
• Follow up: Speak to employees who turn in receipts that don’t look authentic.

With all of the above tactics, there are two that can put you a step ahead of fraudsters. Those are conducting regular audits on internal controls and using technology that specializes in preventing payroll fraud. Regular audits give criminals shorter windows to steal from companies. It also allows companies to spot suspicious activity nearly right away before losing significant resources.

What happens though if human resources are sparse? Payroll technology can help fill in any gaps. Using AI and machine learning, payroll solutions that focus on fraud detection can immediately flag behaviour that looks off and scan though hundreds of records in seconds to identify patterns.

Say goodbye to payroll fraud cases

Vigilance and thorough preventive measures can effectively prevent payroll fraud. But businesses can take one step further in isolating their company from such threats by using payroll platforms that come with AI safety measures to prevent fraud, maximize finance efficiency, and utilize payroll experts in identifying payroll fraud trends.

Guard your company against payroll fraud with Papaya Global. Try a demo.