The difference between tips and service charges can be confusing for employers, but it is critical that they make the correct distinction. Whether a gratuity is a tip or a service charge impacts how employers calculate their employees’ wages and how income is reported by employers and employees for tax purposes. A mistake in characterizing these two forms of compensation can subject employers to penalties under the Fair Labor Standards Act (FLSA) and the Internal Revenue Code (IRC). To assist employers, the IRS issued an updated Fact Sheet (FS-2017-08) on April 25, 2017 outlining the key differences between tips and service charges.
When is a Gratuity a Tip?
The IRS sets forth four requirements in order for a gratuity to be considered a tip:
- The payment made must be free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiations or dictated by employer policy; and
- The customer has the right to determine who receives the payment.
Simply put, to be a tip, the gratuity must be completely discretionary, i.e., the customer decides (1) whether to provide the gratuity and (2) how much gratuity to provide.
Forms of Tips
Tips may appear in two forms: cash tips and noncash tips.
Cash tips are monetary tips received by the customer, whether in the form of actual cash or credit/debit charges. Cash tips also include monetary tips received from other employees under a tip-sharing arrangement. For example, waiters and waitresses often share a portion of their tips with hostesses, bussers and service bartenders. Employees who receive tips directly from the customer are known as “directly tipped employees.” Employees who receive tips from other employees, such as the hostesses, bussers and service bartenders in the above scenario, are known as “indirectly tipped employees.”
Noncash tips are nonmonetary tips, such as passes, tickets, or other goods and commodities.
Employees: Employees must report all tips received in their gross income for tax purposes. This includes both cash tips and the value of any noncash tips. Employees are also required to report cash tips (except for tips for any month that total less than $20) to their employer. However, the employee reporting requirement excludes noncash tips. For example, if a customer leaves a waitress an expensive piece of jewelry, the waitress must include the tip in her gross income, but is not required to report it as a tip to her employer.
Employers: Employers are required to keep employee “tip reports” in order to withhold income taxes, Social Security and Medicare taxes on reported tips from wages. Additionally, employers must pay their share of Social Security and Medicare taxes based on the total wages paid to tipped employees as well as the reported tipped income.
Tip Credit: Once an employee receives a tip from a customer, the tip goes into the employee’s pocket and can never become the property of the employer. However, the FLSA allows employers to take a “tip credit” towards their minimum wage obligation, equal to the difference between the federal minimum wage ($7.25) and the required cash wage ($2.13), or $5.12 (the maximum tip credit an employer can claim). Any tip credit claimed by an employer can never exceed the actual amount of tips received by the employee. Additionally, the tip credit cannot be applied unless the employee has notice that the employer is taking a tip credit.
When is a Gratuity a Service Charge?
The IRS Fact Sheet reminds us that “automatic gratuities,” or gratuities imposed on the customer, are not tips. Simply put, a gratuity included in a bill is not a tip. Examples of service charges include an 18 percent gratuity imposed on a table of 10 or more, an event fee imposed on a customer who rents out all or a portion of a restaurant for a rehearsal dinner, bottle service charges or even corkage fees.
Employers may keep these service charges or pay a portion to their employees. If distributed to an employee, service charges constitute non-tip wages paid to the employee and should be treated as regular wages for tax withholding and filing purposes.
Sums distributed to employees for service charges may be used to satisfy an employer’s minimum wage and overtime obligations under the FLSA. Overtime must be paid based on the employee’s regular rate of pay, including all service charges, commissions, bonuses and other enumeration received. Under certain circumstances, an employer may be able to claim an additional overtime tip credit. Where the employer takes a tip credit, overtime must be calculated on the full minimum wage, not the lower cash wage payment.
Employers should familiarize themselves with IRS Fact Sheet FS-2017-08 as well as FLSA Fact Sheet 15, regarding tipped employees, to ensure compliance with federal wage calculation and income reporting requirements. A helpful chart identifying the differences between tips and service charges is displayed below.
Type of Gratuity/Compensation
Cash, Debit or Credit Charges (Cash Tips)
Tickets, Passes, Goods, Commodities (Noncash Tips)
Employee must report cash tips to employer and all tips as income
Employer must withhold tip income from wages
If distributed to employee, reported as regular (non-tip) wages
About the Authors
Annette A. Idalski is a shareholder and chair of the Employment and Labor practice at Chamberlain Hrdlicka (Atlanta). She defends employers nationwide against multi-plaintiff and single plaintiff lawsuits involving independent contractor status, wage and hour compliance, alleged discrimination involving sex, race, age and disabilities, sexual harassment, restrictive covenants, whistleblower actions and traditional labor matters. She may be reached at (404) 658-5386 or by email at email@example.com.
Mary Claire Smith is an attorney in Chamberlain Hrdlicka’s Labor and Employment practice. She defends employers in federal and state courts and administrative proceedings involving claims alleging discrimination, harassment, retaliation, wage and hour issues and disability and leave claims under the Family and Medical Leave Act (FMLA). She may be reached at (404) 658-5474 or by email at firstname.lastname@example.org.