How to Set Up Payroll in India for the First Time: Step-by-Step Guide 2026

Why Getting Payroll Right on Day One Matters More Than You Think

The first payroll run in a new company — or the first payroll run after switching HRMS — sets the template for everything that follows. Get the salary structure right, and every subsequent month's payroll runs in under two hours. Get it wrong, and you spend the next six months correcting TDS calculations, managing employee complaints about wrong deductions, and explaining to your accountant why the PF ECR does not reconcile with the payroll register.

This guide is for HR managers and founders setting up payroll for the first time in India. It covers what to decide before you run your first payroll, how to build a salary structure that is both compliant and tax-efficient, and what to verify before you transfer salaries.

Before You Run Payroll: The Decisions That Cannot Be Deferred

Decision 1: Define Your CTC Structure

CTC (Cost to Company) is not the same as gross salary, which is not the same as take-home pay. Before running payroll, define how each employee's CTC is split into components.

A simple, compliant salary structure for Indian companies in 2026:

• Basic salary: 40–50% of CTC. This is the foundation for PF, HRA, and gratuity calculations. Higher basic means higher PF deduction and higher take-home HRA exemption, but also higher employer PF cost. Lower basic reduces PF cost but reduces gratuity liability calculation.
• HRA (House Rent Allowance): 40% of Basic (non-metro cities) or 50% of Basic (metro cities — Delhi, Mumbai, Kolkata, Chennai). Employees who pay rent can claim exemption on HRA, reducing their taxable income.
• Special Allowance: The balancing figure — whatever is left of CTC after all other components. Fully taxable.
• LTA (Leave Travel Allowance): Optional. Exempt twice in a four-year block for actual travel costs within India. Including LTA in CTC reduces taxable income for employees who claim it.
• Employer PF contribution: 12% of Basic + DA (up to ₹25,000 under the new ceiling). This is a cost above salary — not deducted from employee's gross salary, but paid by the employer.

Decision 2: Choose the Tax Regime Default

From FY 2023-24, the new tax regime is the default. Employees who want to remain on the old regime must actively opt in and declare their preference to the employer. Decide your company's process for collecting tax regime declarations before the first payroll run.

Employees on the new regime: no 80C deductions, no HRA exemption, lower slab rates. Employees on the old regime: all deductions available (80C up to ₹1.5 lakh, HRA exemption, standard deduction of ₹50,000, etc.), higher slab rates.

Decision 3: Set the PF Contribution Basis

Under the new PF wage ceiling (₹25,000 from September 2026), PF is calculated on Basic salary up to ₹25,000. For employees with Basic above ₹25,000, PF is calculated on ₹25,000 (statutory minimum). Employees can choose to contribute on their full Basic above ₹25,000 as Voluntary PF — document this election before the first payroll run.

Decision 4: Determine ESIC Eligibility

List all employees earning up to ₹21,000 gross per month — these employees are covered under ESIC. For a startup with all employees above ₹21,000, there may be no ESIC obligation initially. For companies with lower-paid employees (support staff, junior associates), register with ESIC before the first payroll run.

Decision 5: Determine Professional Tax Applicability

Identify which states your employees work in. Check whether each state levies professional tax. For employees in PT states, configure the correct slab in your payroll system before running payroll.

Building a Compliant Salary Structure: Worked Example

Let's build a salary structure for an employee with CTC of ₹10,00,000 per annum (₹83,333/month) in Bangalore, Maharashtra.

Monthly CTC breakdown:

• Basic: 40% of CTC = ₹33,333/month
• HRA: 50% of Basic (metro) = ₹16,667/month
• Special Allowance: ₹83,333 - ₹33,333 - ₹16,667 - ₹3,500 (employer PF) - ₹833 (employer ESIC if applicable) = ₹28,000 (approximate)
• LTA: ₹10,000/month (optional)

Monthly deductions:

• Employee PF: 12% of ₹25,000 (new ceiling) = ₹3,000 (since Basic ₹33,333 > ₹25,000 ceiling)
• Employee ESIC: Not applicable (gross > ₹21,000)
• Professional tax: Karnataka — based on annual salary ₹10 lakh → ₹2,500/year → ₹208/month (approximately)
• TDS: Calculated on projected annual taxable income after applicable deductions and chosen tax regime

Net take-home (approximate): ₹83,333 (gross) - ₹3,000 (PF) - ₹208 (PT) - TDS

The First Payroll Run: Step-by-Step

Step 1: Enter All Employee Data

For each employee, enter: legal name, date of joining, department, designation, PAN, UAN (if existing), bank account number and IFSC, salary structure and monthly CTC, work state (for PT), and tax regime choice.

Step 2: Set Up Leave Policy

Configure the leave policy before the first payroll run if your company deducts LOP for unplanned absences. Define: annual earned leave entitlement, accrual method (monthly or annual credit), carry-forward rules, and the LOP formula (monthly salary ÷ working days × absent days, or monthly salary ÷ calendar days × absent days — your HRMS should use one consistently).

Step 3: Collect Investment Declarations for Employees on Old Regime

Employees who have opted for the old tax regime should submit Form 12BB declaring their 80C investments (PPF, ELSS, insurance premiums, home loan principal), HRA details (rent amount, landlord PAN if rent > ₹1 lakh/year), and any other deductions they plan to claim. These declarations are used to calculate TDS for the year — they are not proof of actual investment (that comes at year end).

Step 4: Run and Verify Payroll

After entering all data, run payroll and verify the output before paying any salaries:

• Check one employee in each salary band manually against the formula
• Verify PF deduction is 12% of Basic (capped at ₹25,000 ceiling for employees above the ceiling)
• Verify ESIC deduction is 0.75% of gross wages for eligible employees
• Verify PT is correct for each state
• Verify TDS is projecting correctly based on declared investments

Step 5: Generate Payslips and Review

Generate payslips for all employees and review three or four manually. The payslip must clearly show: all earnings components, all deduction components, gross salary, total deductions, and net pay. Send payslips to employees before salary transfer, not after.

Step 6: Generate PF ECR, ESIC Challan, PT Challans

After payroll is verified, generate:

• PF ECR file for upload to the EPFO employer portal
• ESIC ECR file for upload to the ESIC portal
• State-wise PT challans for each PT state where you have employees

Step 7: Transfer Salaries and Pay Statutory Dues

Transfer salaries to employee accounts. Then pay the statutory dues — PF by the 15th of the following month, ESIC by the 15th of the following month, PT by the state-specific due date.

Common First Payroll Mistakes

Wrong PF Base

Using gross salary instead of Basic + DA as the PF base. PF is calculated on wages — Basic salary is the primary component. Including HRA or Special Allowance in the PF base inflates PF deductions and creates a reconciliation problem.

TDS Not Configured Before First Payroll

If TDS is not configured in month 1, you will need to recover all of month 1's TDS from months 2 and 3 — meaning employees see unusually high TDS deductions in later months. Configure TDS before the first payroll run.

Probation Period Salary Treated Differently

Many companies have a lower salary during probation. If the employment contract specifies a probation salary that is different from the confirmed salary, configure the transition correctly in the HRMS. PF must be deducted even during probation.

Not Registering PF and ESIC Before First Payroll

PF and ESIC registration must be completed before the first payroll run, not after. Running payroll without PF registration means the ECR file cannot be generated, and the challan cannot be paid. PF contributions from day 1 are the employer's obligation regardless of when registration is completed.

Frequently Asked Questions

Can a startup defer PF deduction for the first few months?

No. PF deduction is mandatory from the first salary for all covered employees. Deferring PF deduction creates a liability that includes interest (12% per annum) on the deferred amount. Register for PF before or in the same month as your first payroll run.

Is LTA mandatory to include in salary?

No. LTA is an optional component that you can include or exclude based on company policy. Including it provides a tax-exempt benefit for employees who travel — they can claim actual travel costs (up to the LTA component) as exempt twice in a four-year cycle. Excluding it simplifies payroll slightly but removes a tax-saving vehicle from the employee's CTC.

Should Basic be 40% or 50% of CTC?

Under the new wage code definition of wages (when implemented), Basic + DA must be at least 50% of CTC. The Payment of Wages Code has been notified but its implementation date has not been set as of 2026. Structuring Basic at 50% of CTC now avoids the risk of needing to restructure salary components when the new wage code takes effect — but it increases PF cost for employees with Basic below ₹25,000. For employees with Basic above ₹25,000, there is no additional PF cost from raising Basic to 50% of CTC (PF is capped at ₹25,000 anyway).

What is the correct formula for LOP deduction?

The standard formula is: Monthly salary ÷ Number of working days in the month × Number of LOP days. "Working days" means the number of days the establishment was open, not calendar days. For a month with 26 working days and an employee absent for 2, LOP = Monthly salary ÷ 26 × 2. Ensure your HRMS uses working days, not calendar days, to avoid overstating LOP deductions.

---

Setting up payroll for the first time? PeopleVio guides you through salary structure setup, PF and ESIC configuration, and TDS initialisation in five to seven working days — and includes a first payroll validation run with your onboarding manager. Book a demo.