PEO or no? A deep dive into payroll models
- Claire Baker
- Jan 31, 2024
- 7 min read
Updated: Apr 30, 2024
Summary
A Professional Employer Organization (PEO) hires your employees and leases them back to you at a mark-up. PEOs are rarely as cost-effective as they seem.
Modern payroll service providers (PSPs) give you many of the same benefits of a PEO with much more flexibility at a lower cost.
The trade-offs of not hiring your team directly can indirectly harm your business.
Modern payroll service providers like Gusto and Rippling make it easier than ever to save time and stay compliant with a lean PeopleOps/HR team (or none at all!).
PEOs are a good fit for employers...
with a low head count & low turnover who are seeking better rates on insurance
whose worker's comp premiums are too high
who have a lot of lower-wage positions with high turnover
Try our free self-assessment for a recommendation on which model is right for you:
While a small team's People Operations may be less complex, managing payroll and related tasks demands a disproportionate amount of work early on.
HR can be intimidating, so it's tempting to outsource your payroll (and everything that comes with it) to a PEO. But PEOs often come with trade-offs that business owners regret later.
Before you engage a PEO, think through the problem that you are trying to solve and how your People strategy may evolve over time. Payroll is one of your biggest operating costs, and therefore one of your business's biggest investments. Using a PEO hands control of that investment to a vendor that doesn't have a vested interest in the success of your business or your team.
What's the Difference?
People with broad experience in HR and People Operations are hard to find, but both PEOs and modern payroll systems make it easier to run your HR and PeopleOps in-house without a subject matter expert on staff.
PEO
PEOs are known for their all-inclusive HR services. For small businesses, that might mean paying for services you don't really need. There are a lot of hidden fees and mark-ups that add up over time.
Since the PEO is legally responsible for your employees, they use rigid processes to make sure that their client-companies (you) follow the law. It often takes just as much work from your team to follow the PEO's rules as it would take you to handle those same processes in-house.
Payroll Software, a more flexible alternative
Payroll software providers (what we'll call PSPs) are more like the à la carte option. You get to pick what you need and control how it's delivered. Pricing is transparent, and you have more control to opt out of additional fees.
Some PSPs make it easier to self-manage your People processes than others. I recommend Gusto or Rippling for most small business owners and startup founders.
Working with a PSP doesn't mean that you need to figure out all of your business's payroll taxes, compliance, and benefits on your own. Many accountants and HR consultants (like me!) offer payroll management services customized to your business for a fraction of the cost of a PEO.
(Sunk) Costs
🙀 Did you know that payroll providers that offer both PEO and PSP products use nearly identical customer workflows for both? If you're going through the same steps, what are you really paying the PEO for?
In the old days, payroll administrators needed a lot of specialized knowledge to calculate taxes and deductions. Qualified HR professionals could demand high salaries, making in-house HR prohibitively expensive for smaller teams.
These days, most payroll providers deliver a low-maintenance experience that is as seamless as a PEO without the extra costs or loss of control. Most will file your quarterly payroll taxes, new hire reports, etc. as part of their core service. Easy-to-use workflows prevent errors, automatic alerts let you know if you make a mistake, and customer service teams are standing by to help if you get stuck.
PEOs may be tempting early on when the savings on insurance premiums and operational overhead offset the subscription fee. However, they become less attractive as the hidden costs increase with the size and complexity of your organization.
PEOs have many hidden costs and mark-ups (most PEOs cost 3%-15% of payroll when accounting for markups and hidden fees). As your total payroll grows and you add additional services, so does the cost of your PEO. Fees and hidden costs also increase with the complexity of your organization.
By the time a company outgrows its PEO, they are often trapped. Migrating off of a PEO is a pain in the neck and the balance sheet. In addition to the cancellation fees, you'll also need to build out all of your People systems, government accounts, and insurance plans from scratch. No wonder PEO users are reluctant to consider a different model!
Maintaining a PSP still involves some work-intensive processes, but it's not as much extra work as you may think. Most everyday processes take the same amount of work to relay through the PEO as to handle it yourself.
💡Did you know some PEOs add a mark-up to your tax rate? Many taxes have a maximum contribution or aren't applied to the first n dollars per year. Some PEOs charge the same "tax" rate on every dollar and pocket what the government doesn't collect.
Example
The estimates below are based on real invoices for PEO and PSP clients.
AcmeCo has 50 employees, 25 of whom are paid hourly. They are considering options that would cover the basic payroll software, track I-9 verifications, and offer a higher level of support, just in case.
In the example below, AcmeCo would pay $70,370 more per year (85%) for a PEO to deliver essentially the same services as a PSP.
Category | PEO annual per-employee cost | PEO total annual cost for 50 employees | PSP annual per-employee cost | PSP total annual cost for 50 employees |
Basic Payroll | $889/ employee | $44,450 | $144 | $7,200 |
E-verify | n/a | $1000 | Free | $0 |
Hourly time tracking | $864/ employee | $21,600 (assumes half of staff is hourly) | $0 | $0 |
Full service payroll/Priority support | $88/ employee | $4,400 | $72 | $3,600 |
Total | $1,841 | $71,450 | $216 | $10,800 |
Insurance Plans
Many small and early-stage businesses are attracted to the PEO model because of the insurance discounts. Because of their size, PEOs can offer benefits at rates that small companies can't access on their own.
However, as your team grows, the cost savings on benefits are eclipsed by the limited flexibility and greater overall costs of the PEO. Some PEOs even have contracts in place with the insurance company that prevent them from offering you lower rates than you had with the PEO, even if you're eligible for them.
Example
The following examples are based on real quotes for nearly identical plans.
When AcmeCo has 10 employees, premiums for nearly identical plans are about 12% less through the PEO.
The PEO reduces their average per-employee cost from $800 to $700 per month. This represents insurance savings of about $12,000 per year for their 10 empoyees.
However, by the time AcmeCo reaches 50 employees, they would be eligible for the same insurance rates without a PEO, reducing their insurance savings to $0. As their headcount grows, their PEO fees continue to rise with each employee while their insurance savings dwindle.
Headcount | 10 | 25 | 50 |
Annual insurance savings per employee | $1,200 | $600 | $0 |
Total annual insurance savings | $12,000 | $15,000 | $0 |
Annual PEO cost per employee | $1,841 | $1,841 | $1,841 |
Total annual PEO cost | $18,410 | $46,025 | $92,050 |
Total annual PSP cost | $1,440 | $3,600 | $7,200 |
Extra annual cost of PEO (compared to PSP) | $4,970 (137%) | $27,425 (247%) | $84,850 (1,278%) |
No matter how small the headcount, the insurance savings are not enough to offset the overall price of the PEO model. By the time AcmeCo reaches 50 employees, they are no longer saving on insurance and are spending almost 13x as much on the PEO fees as they would on a PSP.
Some business owners justify the extra cost of a PEO by comparing it to the average salary of a full-time HR person without accounting for the time it will take to manage the PEO. In my experience managing both PEO and PSP payroll systems for dozens of companies from 1-100 employees, the average PEOs takes at least as much time to manage as a PSP.
💡Did you know that commissions for small group plans are the same, no matter who your broker is? A lousy broker earns the same commission as a great one. So why not find the broker that works hard for you and your team?
Your Business, Your Way
Most payroll processes are identical whether you use a PEO or a PSP. The difference in user experience becomes more pronounced over time as your company develops internal processes around your payroll system. As your team grows, a PEO requires that you adapt your workflows to accommodate their requirements while a PSP gives you the freedom to adapt to your way of working.
In a sense, a PEO is a way of outsourcing your company's relationships with its team. Is handing off responsibility of those relationships in your business's long-term best interest?
A PEO will determine important functions of your company culture, turning onboarding, offboarding, benefit support, and payroll corrections into an impersonal experience. Over time you may feel more like passengers than captains of your People Operations. A PSP puts you in control of the decisions that impact your team.
If your business falls on tough times, the PEO may also restrict your options. They may veto some cost-saving measures simply because the PEO's systems don't support them.
Many new employers are intimidated by the complexity of payroll, but is handing those decisions to a vendor who doesn't have a vested interest in the success of your team really the answer?
When a PEO makes sense
The above examples assume that your team will grow year over year and/or have a certain amount of turnover. If you have a small team and don't plan to increase headcount over time, a PEO might be a good choice. Especially if it spares you from hiring a full time PeopleOps specialist.
A PEO might be the right one solution for:
Agency and professional service firms with low headcounts and little turnover.
Workplaces that include physical labor or hazards may use a PEO to get more affordable worker's comp plans.
A PEO that charges a percentage of payroll could be an advantage if your workers earn lower wages, especially if there is high turnover.
If building your own People processes around onboarding, offboarding, timecard processing, and PTO tracking are putting a strain on your business.
Some entrepreneurs have more aptitude for the non-People parts of their business. It's okay to know your weaknesses and play to your strengths.
But who will manage my payroll without a PEO?
We help startups and small businesses set up and run their payroll, benefits, and PeopleOps functions for a fraction of what a PEO charges. Back Office MVP meets you where you are and customizes your systems to fit your way of working.
When you're ready to hire someone in-house, we ensure a smooth transition by working with your team, not against them. Click the button below to find out more about how we can help your business.
Want to learn more about the benefits and pitfalls of different payroll models? Check out these related articles:
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