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Payroll Fraud

Definition

Payroll fraud refers to the manipulation, deception, or abuse of an organisation’s payroll processes to illicitly obtain funds.

It involves falsifying employee records, inflating compensation, creating fictitious employees, misrepresenting working hours, or diverting legitimate salary payments for personal gain.

In AML/CFT contexts, payroll fraud is both a predicate offence and a mechanism for disguising illicit proceeds through the formal wage-payment ecosystem.

Payroll fraud can be perpetrated internally by employees or externally through collusion with third parties such as contractors, vendors, or payroll service providers.

Because payroll systems interface directly with financial institutions, fraudulent payments often appear legitimate, making early detection challenging.

Explanation

Payroll fraud exploits vulnerabilities in HR, finance, and payroll operations.

Organisations rely on accurate employee data, timekeeping, compensation structures, and approval workflows.

Criminals manipulate these systems by introducing falsified entries, altering pay rates, or creating ghost identities.

In AML/CFT terms, payroll fraud produces illicit proceeds that can quickly enter the financial system through routine salary disbursements.

These funds are then layered through personal accounts, cash withdrawals, transfers, investment purchases, or business expenses.

Because payroll transactions typically exhibit consistent patterns and institutional legitimacy, they can evade early detection unless supported by strong anti-fraud controls, segregation of duties, and anomaly detection.

Regulators consider payroll fraud a significant integrity and financial crime risk because it intersects with money laundering, corruption, embezzlement, and internal control failures.

Payroll Fraud in AML/CFT Frameworks

AML/CFT frameworks recognise payroll fraud both as a predicate offence and as a laundering channel.

Key intersections include:

  • Predicate offence classification under fraud, corruption, and misuse of corporate assets
  • Use of payroll accounts and salary disbursements to integrate illicit proceeds into the legitimate financial system.
  • Vulnerabilities in corporate KYC, onboarding, workforce verification, and contractor management.
  • Challenges detecting anomalies because salary payments appear routine and fit expected transaction behaviour.
  • Obligations for reporting entities to detect, monitor, and file STR/SARs where payroll anomalies, ghost employees, or unexplained spikes in payroll activity indicate potential laundering.

Key Components of Payroll Fraud

Common Schemes

Payroll fraud typically manifests through one or more of the following approaches:

  • Ghost employees: Where nonexistent workers are created in payroll systems and their salaries diverted.
  • Inflated hours or rates: Through manipulation of timesheets, overtime, or pay-grade adjustments.
  • Commission fraud: Involving inflated sales entries or falsified performance metrics.
  • Falsified contractor payments: Through duplicate invoicing, misrepresented services, or collusion.
  • Payroll diversion: By changing bank account details to divert salary payments.
  • Buddy punching: Where employees clock in or out for absent colleagues.

Contributing Internal Weaknesses

Payroll fraud thrives where internal controls are weak.

Common gaps include:

  • Lack of segregation of duties between HR, payroll, and finance.
  • Poor access-control hygiene, allowing unauthorised changes to employee records.
  • Ineffective onboarding verification for employees or contractors.
  • Limited audit trails or manual processes prone to manipulation.
  • Insufficient periodic payroll reconciliations.
  • Overreliance on a single payroll administrator.

Risks & Red Flags

From an AML/CFT perspective, indicators of payroll-related financial crime include:

  • Sudden payroll increases without corresponding workforce growth.
  • Multiple salary payments routed to the same bank account.
  • Employees receiving full salaries despite extended absence or no activity.
  • Frequent adjustments to pay grades, overtime, or allowances without justification.
  • Payroll disbursements to employees not appearing in HR records.
  • Contractors receiving repetitive or inflated payments inconsistent with contract terms.
  • Regular cash withdrawals immediately after salary credits.
  • Mismatches between reported workforce size and operational outputs.

Common Methods & Techniques for Misuse

Criminals may exploit payroll structures for laundering or fraud through:

  • Use of shell companies to generate fake payroll expenses and move illicit funds.
  • Collusion between HR and payroll staff to register fictitious employees.
  • Layering through multiple bank accounts using payroll disbursements as legitimate-looking inflows.
  • Manipulating enterprise resource planning (ERP) systems to alter employee and salary records.
  • Contractor management abuse by inflating invoices and routing proceeds through payroll-style payments.

Examples of Payroll Fraud Scenarios

Ghost Employee Network

A payroll administrator creates 12 fictitious employees and distributes salaries to accounts controlled by the fraudster.

Over time, these funds are layered through transfers, credit card payments, and investments.

Collusion-Based Contractor Fraud

A procurement officer and external vendor collude to create repetitive payroll-coded payments.

The vendor provides no actual services, and the inflated invoices mask illicit proceeds.

Corporate Account Takeover

A criminal alters payroll bank details for legitimate employees, diverting salaries for several pay cycles before detection.

Use of Payroll to Launder Illicit Business Proceeds

A shell company creates a fictitious workforce and issues monthly salary payments to criminal associates.

The associates withdraw or move funds, presenting the income as legitimate employment earnings.

Impact on Financial Institutions

Payroll fraud exposes institutions to financial, regulatory, and reputational risk.

Consequences may include:

  • Filing of SARs/STRs where anomalies suggest predicate crimes or laundering.
  • Regulatory penalties if inadequate monitoring fails to detect suspicious payroll flows.
  • Misuse of corporate banking channels for fraud or laundering.
  • Loss of trust from corporate clients impacted by payroll breaches.
  • Increased investigation and remediation costs for repeated anomalies.
  • Broader network exposure if fraud intersects with mule accounts or shell entities.

Challenges in Detecting & Preventing Payroll Fraud

Key detection challenges include:

  • Payroll transactions often mimic legitimate salary flows.
  • Lack of beneficiary-level context when salaries are aggregated.
  • High transaction volumes in large organisations masking anomalies.
  • Insufficient integration between HR, payroll, and banking systems.
  • Limited visibility for financial institutions into employer-side processes.
  • Sophisticated collusion between internal and external actors.

Effective fraud and AML controls require behavioural analytics, anomaly detection, multi-source data integration, and periodic KYC refresh for corporate clients whose payroll activities present elevated risks.

Regulatory Oversight & Governance Expectations

Regulators expect organisations and financial institutions to implement:

  • Strong internal controls over payroll access, authorisations, and segregation of duties.
  • Workforce verification, including periodic employee headcount reconciliation.
  • Contractor vetting, onboarding verification, and contract-performance validation.
  • Independent internal audit coverage of payroll processes.
  • AML/CFT monitoring models tuned to detect payroll anomalies.
  • Immediate escalation and reporting where payroll-related suspicious activity is identified.
  • Governance frameworks ensuring management accountability over payroll integrity.

Importance of Addressing Payroll Fraud in AML/CFT Compliance

Mitigating payroll fraud is essential for institutional integrity and AML compliance.

Effective governance ensures that:

  • Illicit proceeds are not disguised as legitimate employee compensation.
  • Organisations prevent misuse of payroll infrastructure for fraud or laundering.
  • Financial institutions can detect anomalies, file STRs/SARs, and interrupt criminal flows.
  • Corporate clients maintain credible workforce structures supported by verifiable data.
  • Regulators view payroll governance as a strong line of defence against internal and external fraud.

Payroll fraud continues to evolve alongside digital payroll technologies, hybrid workforces, and third-party payroll platforms.

An intelligence-driven AML/CFT framework strengthens an institution’s ability to identify emerging payroll typologies and respond quickly.

Related Terms

  • Ghost Employee
  • Shell Company
  • Predicate Offence
  • Internal Controls
  • Contractor Fraud
  • Employee Embezzlement

References

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