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What Is a PEO? Here’s the 411 on Professional Employer Organizations

By Roy Rasmussen Reviewed By Mike Lucas
By Roy Rasmussen
By Roy Rasmussen Reviewed By Mike Lucas

What is a professional employer organization (PEO) and should you use one? Learn the essentials about these services and how to use a PEO effectively. 

We’ll cover what PEOs are, how they differ from staffing firms and how they work. Then we’ll review PEO benefits as well as typical costs and the pros and cons. Finally, we’ll examine some of the best practices for working with PEOs.

What Are PEO Services?

A professional employer organization is an outsourcing provider that helps small and midsize companies manage key human resources (HR) tasks. PEO human resources services may handle tasks such as:

The PEO assumes responsibility for some or all of these tasks, while the client company hiring them retains responsibility for hiring and managing employees and for all nonemployee tasks such as marketing, sales and customer service. For certain tasks such as employee training, the PEO and the client company it supports may assume joint responsibility.

Under the contract governing this arrangement, the PEO becomes the employer of record, with their employer tax identification number listed on payroll forms. This arrangement is known as “co-employment.”

PEOs vs. Staffing Agencies

The co-employment arrangement involved in working with a PEO distinguishes using a PEO from working with a staffing firm. A staffing provider acts as the employer for the workers it provides, retaining responsibility for hiring, work assignments, payroll and firing. Effectively, a staffing provider leases workers out to its client company.

In contrast, a PEO only assumes responsibility for managing specific HR tasks such as payroll, leaving other HR tasks such as hiring, firing and promotions in the hands of the client company it supports. This distinguishes a co-employment arrangement from a staffing agency arrangement.

A silhouette of a caped superperson with hands on hip stands on top of the giant letters HR. The symbol on the hero’s chest reads “PEO.”

How Do They Work?

A PEO arrangement is governed by a contract known as a client service agreement (CSA) which defines the relationship between the PEO company and the client company and their respective rights and responsibilities. A core component of a CSA is a document called a service-level agreement (SLA), which clarifies the exact services the PEO will provide, what amount of service will be provided and what performance thresholds the client can expect the PEO to meet.

For example, an SLA might specify the PEO is responsible for processing payroll and paying federal, state and local employment taxes. It might also specify what services the PEO doesn’t provide which the client remains responsible for, such as hiring.

The exact terms of PEO CSAs and SLAs will vary by company. Generally, the PEO will be responsible for tasks such as payroll, benefits and compliance, while the client retains responsibility for recruiting and managing talent.

When a PEO handles payroll and payroll tax filing, their employer tax identification number rather than that of the client is used to process payroll paperwork for tax filings. When a PEO administers benefits, their health-care options may define which plans employees can use. The PEO may assume some liability for services they administer, and will work with their own team to ensure compliance.

The client company retains responsibility for and control over all business functions not delegated to the PEO in their agreement. For example, employees still work for the client company even when a PEO payroll provider is processing their checks.

Who Is the Employer in a PEO?

The client company is the employer under a PEO arrangement. However, the PEO provider assumes some responsibilities normally handled by an employer, notably using their employer tax identification number to process payroll and accepting liability for items such as benefits administration. Because of this shared responsibility, the term “co-employer” is used.

However, this term shouldn’t be misunderstood to imply that employees work for the PEO provider in the same way they work for the client company. Employees still work for the client company in the sense that the client has the authority to hire and fire, set compensation levels, assign job responsibilities and fulfill other typical employer roles.

Because of the responsibility and liability the PEO assumes, the PEO may be treated as the employer in specific limited contexts, particularly for tax-filing purposes. In some cases, if a legal dispute arises with an employee, the PEO may assume the liability which normally would fall on an employer.

What Are the Benefits?

Using PEO for small business HR management can offer a number of benefits:

  • The PEO provider assumes the administrative burden for certain HR tasks, saving the client company time
  • The PEO provider lends its expertise to the client company, making it easier to comply with tax and regulatory requirements
  • The benefits resources a PEO brings to the table can save the client money on health care and workers’ compensation
  • PEO health-care plans can enable employers to offer more attractive compensation packages to employees
  • PEOs can shield employers from some liability over certain types of employment disputes involving areas that are the responsibility of the PEO

These benefits make PEOs appealing to some small and midsize businesses. Smaller companies that don’t have the resources to handle their own HR or offer competitive benefits packages may benefit the most from using PEOs.

A caped superperson with the symbol “PEO” lifts a small shop up, up and away in the air.

How Much Do PEOs Cost?

PEO pricing varies based on a number of factors, including:

  • The types of services provided
  • The size of the company
  • The number and type of employees

A couple of methods typically are used for billing PEO services:

  • A flat fee per employee (for example, $100 per employee per month)
  • A percentage of total payroll (for example, 8% of payroll per month)

When billing is based on a payroll percentage, costs can vary with payroll, which can make exact pricing difficult to predict. However, some providers are willing to negotiate pricing structures. You may be able to negotiate by calculating an annual fee using both flat fee and percentage methods and using the results as a basis for discussing options.

What Are the Pros and Cons?

PEOs offer significant advantages to some companies, but they have some drawbacks. Leading PEO benefits include:

  • Saving time on HR management
  • Ensuring compliance with the latest regulatory updates in complex areas such as payroll taxes, reporting, health-care insurance, worker compensation and unemployment insurance
  • Improving health-care options for employees
  • Reducing liability risks

These benefits represent the greatest advantage for smaller companies that would have difficulty maintaining the in-house team needed to manage complex HR needs efficiently. For example, if you lack the expertise to keep up with payroll requirement updates, a PEO can be a helpful solution.

Disadvantages

While PEOs can offer some major advantages, they also have some limitations:

  • If your provider uses a percentage-based billing method, your fees can vary from one month to the next as your payroll changes, making it difficult to predict your expenses accurately and potentially creating cash-flow issues
  • While PEOs may allow some companies to access better health-care packages than they could afford on their own, they may also lock you into whatever health-care providers they work with, limiting the options you can offer employees
  • Because of the large number of employees PEOs support, they may not provide a designated customer support person, making their customer service seem impersonal
  • Your PEO provider’s technology may have limitations, particularly if you require a high degree of customization
  • If you decide to leave your PEO provider, the separation process can be a hassle, requiring you to make tedious changes such as updating employer tax identification information on payroll paperwork

These potential drawbacks make it important to do a cost-benefit analysis before selecting a PEO provider. If you have very simple, straightforward HR needs, you may not find many advantages in using a PEO. If you plan to scale up quickly, you should check whether a PEO will save you money or whether hiring your own HR team would be more cost-efficient.

What Are Some Keys to Working With a PEO Effectively?

For a successful PEO relationship, you should follow a number of best practices when selecting and working with PEOs:

  • Look for providers who are certified by professional organizations such as the National Association of Professional Employer Organizations (NAPEO), an advocacy group representing the PEO industry
  • Read online reviews of the provider or ask for client references
  • Check that your prospective provider uses a third-party auditor to review their financial statements and operations
  • Ascertain whether your PEO candidate has the compliance expertise you require
  • Review what services the provider offers
  • Study CSA and SLA agreements carefully in consultation with your HR and legal teams before signing any contracts
  • Calculate fees to see if you’ll be saving money by using a PEO
  • If you won’t be saving money, consider whether other benefits still would make using the PEO worth your while
  • Ask your provider whether they’re willing to negotiate pricing

Use these tips to help you evaluate potential providers and negotiate favorable agreements.

Is a PEO the Right Solution for Your HR Needs?

PEOs reduce your HR burden by allowing you to outsource key HR functions such as managing payroll, benefits and tax withholdings. They differ from staffing firms in that you remain the employer.

Using a PEO can reduce your administrative workload and save you time, while helping you maintain compliance and mitigating your liability. Fees may be charged per employee or based on a percentage of payroll. Cons may include pricing variability and healthcare plan inflexibility.

A PEO works best for a smaller business with complex HR needs which would be more efficient to outsource. If you decide to use a PEO, seek an accredited provider with compliance expertise. Also, make sure you have a clear service-level agreement. Follow these guidelines to help you find the HR solution that’s right for your company.

Roy Rasmussen Contributing Writer for Fast Capital 360
Roy is a respected, published author on topics including business coaching, small business management and business automation as well as an expert business plan writer and strategist.
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