Contractor vs employee: Key differences for your business

Published Thursday 8 January 2026

Table of contents

• Understanding the legal difference
• How to classify workers correctly
• Your tax and compliance obligations
• Benefits of hiring employees
• What to bear in mind if you're hiring permanent employees
• Advantages of independent contractors
• Common classification mistakes to avoid
• Making the right choice for your business
• FAQs on contractors vs employees

Key takeaways

• Apply the ATO's classification tests by evaluating control over work methods, financial risk, ability to delegate, payment basis, and exclusivity to correctly determine whether a worker is an employee or independent contractor.
• Recognise that employees require you to withhold tax, pay superannuation, provide leave entitlements, and maintain workers' compensation insurance, while contractors typically handle their own tax and super obligations.
• Avoid common misclassification mistakes such as assuming an ABN, contractor agreement, or invoice submission automatically makes someone a contractor, as the ATO assesses the entire working arrangement.
• Consult your accountant or lawyer before classifying workers and act quickly if you suspect misclassification, as penalties can include fines, back-payments for entitlements, and court proceedings.

Understanding the legal difference

Employees are workers you control and direct in their daily tasks. You determine how, when and where they complete their work.

Independent contractors complete specific projects without ongoing supervision. They control their own methods and schedules while delivering agreed results.

Correct classification is legally required in Australia. The ATO enforces strict guidelines that determine:

• Worker entitlements: Pay rates, superannuation, and leave benefits
• Your obligations: Tax withholding, insurance, and compliance reporting, which for certain industries may include a Taxable payments annual report (TPAR)
• Penalty risks: Fines and back-payments for misclassification

Consult your accountant or lawyer before you decide how to classify a worker.

How to classify workers correctly

Worker classification affects your cash flow, legal compliance, and operational flexibility.

Classification testing helps you avoid ATO penalties and determine correct worker status. Answer these questions to classify your workers correctly:

• Control over the work: Do you have the right to direct how the work is done? An employee is generally directed, while a contractor has a high level of control.
• Financial risk: Does the worker bear the financial risk? Contractors are responsible for their own profit or loss and usually provide their own tools and equipment.
• Ability to delegate or subcontract: Can the worker pay someone else to do the work? This is a strong indicator they are a contractor.
• Basis of payment: Is the worker paid for the time worked, or for a result? Employees are typically paid a regular wage, while contractors often quote for a job.
• Exclusivity: Does the worker only work for your business? While not definitive, contractors are usually free to work for other clients.

Your tax and compliance obligations

Your responsibilities change depending on whether you hire an employee or a contractor. Getting this right helps you stay compliant and avoid penalties.

For employees, you're generally required to:

• Withhold tax (PAYG) from their wages and report it to the ATO
• Pay superannuation contributions into their nominated fund
• Provide entitlements like paid leave and minimum wage
• Cover them with workers' compensation insurance

Independent contractors are typically responsible for their own tax and super. However, you may still need to pay super for a contractor if your contract is mainly for their personal labour and skills, specifically when more than half the contract's value is for their labour.

Benefits of hiring employees

Employee benefits include loyalty, consistency, and lower hourly costs. Key advantages:

• Business knowledge: They understand your processes without ongoing training
• Lower hourly rates: Employees typically cost less per hour than contractors
• Guaranteed availability: They're always available during busy periods
• Business continuity: You can take time off knowing operations continue

What to bear in mind if you're hiring permanent employees

Employee obligations require ongoing investment and compliance management:

• Training costs: Professional development and licensing requirements
• Guaranteed pay: Wages due regardless of business performance
• Payroll compliance: Tax withholding and superannuation contributions
• Administrative burden: Ongoing record-keeping and reporting requirements

With employees, you have specific legal payroll compliance requirements. You need to withhold your employees' taxes and handle other deductions. All of this takes time, effort and money.

Advantages of independent contractors

Contractor advantages include flexibility, specialised skills, and reduced administrative burden:

• Quick access:Hire immediately without lengthy recruitment processes
• Specialised expertise: Access specific skills without training costs
• No ongoing costs: Pay only for work completed, no benefits or salary commitments
• Easy termination: End contracts without employment law complications
• Reduced compliance: No payroll taxes, superannuation, or leave entitlements

However, there are downsides. Contractor disadvantages include higher costs and reduced control:

• Higher hourly rates: Contractors typically charge more per hour than employee wages
• Limited loyalty: Less commitment to your business long-term success
• Reduced control: Cannot dictate working methods or schedules
• Variable availability: No guarantee they'll be available when you need them
• Skill gaps: May need different contractors for different projects

Common classification mistakes to avoid

Misclassifying an employee as a contractor to avoid paying entitlements is a common but risky mistake. The consequences can be significant, including penalties from the ATO and Fair Work, plus having to back-pay entitlements like super and leave.

Some common myths include thinking that having an Australian business number (ABN), signing an agreement that calls the worker a contractor, or asking them to submit invoices automatically makes them a contractor. Courts and the Australian Taxation Office (ATO) look at the whole working arrangement.

Recent High Court judgments confirm that this overall assessment is based on the legal rights and obligations in the contract, not just one factor. Always assess the arrangement against the key indicators to reduce your risk.

Making the right choice for your business

Your business needs determine the right workforce mix. Consider your budget, control requirements, and compliance capacity when choosing between contractors and employees.

Correct classification protects your business from ATO penalties and legal disputes. Misclassification can result in fines, back-payments, and court proceedings.

Act quickly if you suspect you’ve classified someone incorrectly. Talk to your accountant or lawyer, and review the ATO’s guidance on using contractors, including taxation rulings and practical compliance guidelines.

Choosing the right mix of contractors and employees helps you run your business with fewer surprises. Try Xero for free to streamline your payroll and worker payments from day one.

FAQs on contractors vs employees

Here are answers to some of the most frequently asked questions about the differences between contractors and employees.

Is a contractor an employee in Australia?

No, a contractor is not an employee in Australia. Contractors run their own business and are hired to perform a specific service, while employees work within someone else's business under their direction and control.

Do contractors get paid super?

Sometimes. If a contract is principally for the individual's labour, you may be required to pay superannuation for them, even if they are a contractor. It's important to check the specific rules with the ATO.

Does a contractor get annual leave?

No, independent contractors are not entitled to paid leave such as annual leave or sick leave. These are entitlements reserved for employees under the National Employment Standards.