A service charge can provide a welcome boost to a business’ bottom line, but employers must manage and mitigate the risk of lawsuits, disgorgement and damages.

Recent developments across the nation serve as a reminder that employers in the hospitality industry should carefully consider applicable limitations and requirements before adding mandatory service charges to guest checks and event contracts—especially in states such as New York, California and Washington.

Alleged Improperly Disclosed Service Charge Leads to Large Settlement in Washington

In December 2018, a former employee of a large and prominent Seattle-based restaurant group filed a class action lawsuit, claiming principally that the defendants violated a Washington statute (RCW 49.46.160) requiring that an employer imposing any “automatic service charge related to food, beverages, entertainment, or porterage provided to a customer must disclose in an itemized receipt and in any menu provided to the customer the percentage of the automatic service charge that is paid or is payable directly to the employee or employees serving the customer.” The group allegedly included the following disclosure on its receipts and menus: “20% service charge: 100% of these funds are distributed to our team in the form of wages, sales commissions, benefits and revenue share” or “20% Service Charge Added. 100% of these funds are distributed to our team.” According to the plaintiff, this disclosure was inadequate, as service employees allegedly did not receive 100% of the proceeds from service charges.

Following mediation, and without any determination by the court that the language was inadequate, the defendants recently agreed pay $2.4 million to settle the claims of 1,360 class members and to also give class members $200 gift cards—a steep price for one allegedly misleading sentence.

Service Charges May Now Qualify as Gratuities in California

On October 31, the California Court of Appeal issued a decision concerning a 21% service charge that a ballroom in San Francisco added to food and beverage bills for its banquets and allegedly retained in part. The question before the court was whether this practice complied with a California statute (Labor Code 351) that prohibits employers and their agents from retaining any part of a gratuity—specifically, whether the service charge qualified as a gratuity under the statute.

Breaking with the apparent rule of prior court decisions and guidance from the Labor Commissioner, the court held that a service charge may qualify as a gratuity, the entirety of which would then have to be distributed to service employees. Because of how the case reached the court on appeal, the court declined to provide further definition as to precisely when a mandatory service charge might qualify as a gratuity. Employers now find themselves in a risky limbo where the legality of retaining a service charge is unclear.

Disclaimer Language Should Be on All Documents Listing Service Charges in New York

In New York, as in California, employers and their agents may not retain gratuities in whole or in part (Labor Law § 196-d). For the hospitality industry, this means that service charges—defined as those “in addition to charges for food, beverage, lodging, and other specified materials or services”—are presumed to be gratuities. One way to overcome this presumption is to include disclaimer language meeting very specific requirements on menus and bills. The model language provided by the Department of Labor explains that the service charge “is for administration of the banquet, special function, or package deal, is not purported to be a gratuity, and will not be distributed as gratuities to the employees who provided service to the guests.”

In Ahmed v. Morgan’s Hotel Group Management, LLC, the Appellate Division held that employers can defeat the presumption that a service charge is a gratuity so long as a “reasonable customer” would understand that the service charge is not a gratuity—regardless of the omission of disclaimer language. However, recent court decisions have refocused attention on the disclaimer language, indicating that an employer may have a hard time overcoming the presumption unless adequate language is included on all documents shared with the customer and not just on menus and bills.

Additional Risks: Taxes and Overtime Calculations

Employers should exercise caution for additional reasons outlined in a previous alert that discusses taxation issues surrounding the distinction between tips and service charges. First, per a Revenue Ruling, the Internal Revenue Service does not consider money paid by a customer to be a tip unless the payment satisfies four factors:

  1. The customer presents the money free from compulsion.
  2. The customer has the unrestricted right to determine the amount.
  3. The amount is not the subject of negotiation or dictated by employer policy.
  4. The customer can dictate and determine the recipient.

Clearly, a mandatory service charge fails this test on several counts. There are a few resulting undesirable effects, including loss of the FICA tip credit and treatment of the service charge as income to the employer.

Second, because mandatory service charges are not treated as tips under the Fair Labor Standards Act (and the labor laws of certain states), the portion of the service charge passed on to each employee must be factored into their “regular rate,” which is used to calculate their overtime rate. A large distribution to an employee from a mandatory service charge has the potential to significantly increase their overtime rate, which the employer must remember to recalculate and pay accordingly or else face liability for un(der)paid overtime.

The Takeaway

With laws and court decisions varying by state, it is crucial to know and understand the requirements and limitations placed on service charges under federal law and applicable state law. Though the safest strategy is an optional gratuity, in an amount chosen by the customer, and that is distributed wholly to the service staff, service charges can be used to the employer’s advantage when done right. Exercising caution and consulting counsel can help mitigate a number of risks and can help position businesses to increase revenue.