Hospitality employers nationwide continue to be hit with class action lawsuits alleging failure to properly pay/distribute tips, as well as failure to correctly characterize service charges and automatic gratuities. These lawsuits have the potential to result in verdicts or settlement amounts more costly than virtually any other employment-related matter. As a result, it is important to periodically review what is or is not permissible under the law is it relates to tips, service charges, and automatic gratuities.

Most employers are familiar with the basic premise that a tip is a voluntary amount a guest leaves for an employee over the amount due for the goods sold or services rendered, while a service charge is an amount agreed-upon in advance by a venue for services provided, often in connection with large pre-planned events. However, service charges are treated differently than tips for tax and other purposes, and automatic gratuities add an extra complicated layer in this analysis. A brief synopsis of the differences of these terms from a legal perspective is set forth below:

  • Tipped Employees” – customarily receive more than $30 per month in tips for services provided to customers. The FLSA allows an employer to pay less than the minimum wage to tipped-employees through the tip credit, assuming the following:
    • The wage amount the employee will be receiving (at least $2.13 per hour);
    • The amount the employer will claim as a tip credit (cannot exceed $5.12 per hour);
    • The tip credit claimed by the employer cannot exceed the amount of tips received by the employee; and
    • All tips received by the employee are retained by him, except if he participates in a valid tip pool.
  • A tip pool occurs when tipped employees are required to pool a portion of their tips together, and then divide and redistribute the pooled money according to a pre-arranged system.
    • Who can participate in a Tip Pool? Non-exempt employees who “regularly and customarily” receive tips.
    • Who Cannot Participate in a Tip Pool? Persons who do not customarily and regularly receive tips.
    • DOL Regulations state that “back of the house” staff cannot participate in tip pools – e.g., chefs, cooks, and dishwashers.
  • Service Charges and Proper Disclosures
    • The FLSA regulates service charges, but distinguishes them from tips in several major respects.
      • No customer discretion
      • Service Charge belongs to the employer
      • Service Charge is not counted as tips
    • Disclosures of Service Charges
      • Mandatory service charges should be (i) directly paid to employees; or (ii) notice should be provided to customers that the money is not going to the employee.
      • Several lawsuits have resulted in an employer’s failure to follow these requirements.
      • Many states have strict laws relating to disclosure of service charges.
        • Should be factored into regular rate of pay
      • Banquet, catering menus, BEO’s and contracts must include language explaining who will receive (and retain) gratuity, service charge, and other fees.
    • IRS Treatment of Automatic Gratuities
      • Since January 2014, the IRS has enforced its treatment of automatic gratuities as service charges for purposes of taxation.
      • Automatic gratuity will only be considered a tip if:
        • The payment is made free from compulsion;
        • The customer has an unrestricted right to determine the amount of the payment;
        • The payment is not the subject of negotiation or dictated by employer policy; and
        • The customer has the right to determine who receives the payment.
      • If customer does not use its discretion, gratuity will be considered service charge and taxed as regular wages.
    • Recommendations for Compliance
      • Evaluate whether any practice in your current system would constitute an automatic gratuity;
      • Treat automatic gratuities as service charges or non-tip wages for purposes of calculating regular rate of pay, overtime wages, and tax liability;
      • One suggestion as a best practice: include suggested tip amounts on the bill instead – 15%, 18%, 20%.

The application of the laws relating to tips, service charges, and gratuities is constantly evolving. Thus, while it is imperative to be familiar and comply with the laws as set forth above, it is equally important to be on the lookout for any changes that occur to these laws, so that you don’t find yourself on the wrong end of a class action lawsuit.