What Is a Tip Credit and How Do They Work?

Confusion Around Wage and Hour Law Can Be Costly for The Restaurant Owner.

Most restaurant owners know that federal wage law (“FLSA”) permits employers to take a “tip credit” and pay employees who traditionally receive tips—such as servers and bartenders— wages that are less than the federal minimum wage as  long as the tips make up the difference. And it goes without saying, following all other legal requirements is mandatory. The FLSA defines a “tipped employee” as “any employee engaged in an occupation in which he customarily and regularly receives more than $30 a month in tips.” For many employees, tips make up a significant part of their earnings. The onset, new hires should be informed whether they will be classified as tipped employees and advised of all applicable legal requirements

Truth be told, many restaurant owners fail to correctly uphold this preliminary law “assuming” that they (and their tipped employees) know the requirements, however, their assumptions are frequently erroneous. Part of this failure is simply because the law is complicated, contradictory and requires knowledge of the regulations at both the federal and state levels.    

Federal wage and hour law (FLSA) generally requires covered employers to pay employees at least the   current $7. 25 per hour federal minimum wage. As an employer, you may take a tip credit as an allowance against your minimum wage obligation as long as you accurately calculate your employees’ wages. An employer may take a tip credit only if, among many other requirements, the tipped employee retains all the tips he or she receives.  

Tip Pooling

An employer taking the tip credit is, however, allowed to require tipped employees to participate in a mandatory, “traditional” tip pool in which tipped employees share their tips with other employees who “customarily and regularly receive tips. ” At all times the employee must retain a sufficient amount of tips to make up the difference between the minimum tipped cash wage paid and the minimum wage.  Worth noting, most tipped employees retain considerably more than the minimum wage even when required to participate in a tip pool. 

Under the U. S. Department of Labor’s 2020 Final Tip Rule: 

  • Employers, managers and supervisors cannot keep employees’ tips under any circumstances including tip pools;         
  • An employer that pays the full minimum wage and takes no tip credit may also allow   employees who are not tipped employees (for example, cooks and dishwashers) to participate in the tip pool. 
  •  An employer that collects tips to facilitate a mandatory tip pool must fully redistribute the tips within the pay period; and,
  • Employers that do not take a tip credit, but collect employees’ tips to operate a mandatory tip pool, must maintain and preserve payroll or other records containing information on the weekly or monthly amount of tips reported by the employee. 

Federal vs. State Laws

While federal law will always set the minimums for compensating tipped employees (assuming that the federal government has jurisdiction), the states can still set higher minimum standards. 

In recent years, this duality complicates compliance as many states have elected to override federal minimums with higher minimum standards. A restaurant owner’s compliance with all applicable FLSA requirements may easily run afoul of the state law where the restaurant operates. For example, California Labor Code Section 351 prohibits employers and their agents from sharing in or keeping any portion of a gratuity given to one or more employees by a patron. Furthermore, it is illegal for an employer to make wage deductions from gratuities or use gratuities as direct or indirect credits against an employee's minimum wages. It should be understood that, under the circumstances, the restaurant owner should not make any assumptions.   

In 2019, New Jersey scheduled annual minimum wage increases while limiting the amount of the tip credit that an employer may take. For 2022, the minimum wage was set at $13. 00, the minimum cash wage for tipped employees at $5. 13 and the maximum tip credit at $7. 87. These amounts will increase in 2023 to $14. 00, $5. 13 and $8. 87 respectively. 

So, what should a responsible restaurant owner who wants to comply with both federal and state laws do to stay out of trouble? 

  • First, where permitted, inform all tipped employees they are classified and paid as “Tipped Employees” properly applying  all of the rules  with no room  for mistakes;
  • Tip pools are generally permitted but banned in some jurisdictions like California. However, if the rules are violated even unintentionally,  this negates any tip credit and payment of lower cash minimums. When this happens, applicable employees will be owed the balance of the minimum wage without regard to tips received, plus interest and penalties;
  • Management employees can never share tips with tipped employees; it is important to carefully classify employees and managers as a tip pool payment to a management employee will negate the entire tip credit. 
  • Generally, those persons working in the kitchen cannot share in the tip pool (but see above where the federal law 2021 exception is noted)   
  • For many years, New Jersey complied with Federal law permitting the employer to deduct the credit card fee attributable to the tip pool, however, New Jersey no longer permits this deduction. 

Other Important Facts to Consider

Employers can never take any portion of tips paid to employees under any circumstance as tips are the property of the employees exclusively; but “service charges,” which are not tips, can be applied by employers much differently (again, the rules vary considerably from state to state). 

The payment of overtime for tipped employees is another complicated area; many employers make significant mistakes in calculating and paying overtime to tipped employees. 

Care must be given where the tipped employee spends more than 20 percent of work time performing non-tipped work; similar complications arise when an employee mixes activities from tipped work to non-tipped work in a work week. Under a final rule which took effect in December 2021 under the Biden administration, an employer loses the tip credit if a tipped employee spends more than 20 percent of their weekly hours performing work that is not tip-producing or  directly supports tip-producing work.  This rule also requires employers to pay tipped employees the full minimum wage when they spend at least 30 continuous minutes on secondary duties that don’t generate gratuities.

Where an employee works in more than one restaurant owned by the same or similar owners (defined as being a “controlled group” in the Internal Revenue Code), care must be given to wage compliance and calculations of overtime.  

Besides the obvious complications and challenges  of compliance with wage and hour laws, the restaurant and hospitality industries are increasingly exposed to legislative divergence. This is not an area where amateurs thrive. You need to know the law and apply it properly or pay the consequence! Getting the right help from legal professionals experienced and knowledgeable with FLSA laws will alleviate unnecessary complications and severe penalties.