It is quite common in the hospitality industry for employers to pay tipped employees a cash wage that is less than the required minimum wage. This practice is permissible under the Fair Labor Standards Act’s (FLSA) tip credit provisions. The philosophy underlying the tip credit is that the tipped employees are receiving compensation in the form of tips from customers, thereby relieving the employer of some of the burden associated with paying the full minimum wage.

This article discusses the history of the tip credit, tip credit requirements, recent changes to tip credit law, and potential pitfalls for employers paying a tip credit wage.

History of the Tip Credit Wage

The tip credit provision first became part of the FLSA in connection with the 1966 amendments to the statute. At that time, the tip credit was equal to 50 percent of the minimum wage. Thus, an employer could take a tip credit by paying a tipped employee only half the required minimum wage under the assumption that the tips the employee received from customers would make up the other half of the minimum wage.

In 1991, the minimum tip credit wage was set at $2.13 per hour—tied to 50 percent of the then-current minimum wage of $4.25 per hour.

Amendments to the FLSA that were implemented in 1996 modified the tip credit wage provisions so that the minimum tip credit wage would remain at $2.13 per hour, even as the regular minimum wage was scheduled to increase over time. It has remained at $2.13 per hour since then.

Tip Credit Requirements

Employers may apply the federal tip credit provisions only to employees who qualify as tipped employees. The FLSA defines a tipped employee as an employee who customarily and regularly receives more than $30 per month in tips. Typically, this includes employees like servers, bartenders, and bussers.

For the tip credit to apply, the employer must pay a cash wage of at least $2.13 per hour and the employee must be allowed to retain all tips received except for those tips subject to a valid tip pool. In addition, the employer must give tipped employees notice of application of the tip credit. While this notice can be verbal, employers may want to put the notice in writing and have tipped employees provide a signed acknowledgment that they received such notice.

A valid tip pool involves the sharing of tips received from customers between and among tipped employees. For example, in a tip pool, a server may share a portion of the tips he or she received during a shift with the busser who was assigned to bus and clean his or her tables and the bartender who made the drinks for the server’s customers. A tip pool that includes paying a portion of tips to nontipped employees—like cooks and dishwashers—typically will not qualify as a valid tip pool.

Many states have their own wage and hour laws that include tip credit provisions that differ from those in the FLSA. These state requirements could include mandating a higher cash wage component or prohibiting use of a tip credit altogether.

Recent Developments Regarding the Tip Credit

In 2011, the U.S. Department of Labor (DOL) issued a regulation that extended the tip pooling requirements to tipped employees who were receiving the full minimum wage on the basis that tips received by a tipped employee are that employee’s property, regardless of whether the employer takes a tip credit. Subsequently, several courts held that regulation to be invalid, although the DOL maintained the validity of the regulation until recently.

In December 2017, the DOL proposed to rescind that regulation.

On March 23, 2018, President Donald Trump signed into law a bill that included the Tip Income Protection Act of 2018. The law amended the FLSA, providing that “[a]n employer may not keep tips received by its employees for any purposes, including allowing managers or supervisors to keep any portion of employees’ tips, regardless of whether or not the employer takes a tip credit.” It further provided that violations of the law would result in employer liability for the amount of any tip credit taken and all tips unlawfully kept by the employer, plus liquidated damages.

In addition to these legal developments, some restaurant employers have been experimenting with eliminating tips altogether and paying employees at or above the minimum wage. These experiments have had mixed results.

Common Tip Credit Pitfalls

The following is a discussion of common tip credit pitfalls that may result in employers losing the tip credit, in whole or in part, and otherwise subject employers to liability—more often than not, on a collective action basis. If an employer loses the tip credit, it has lost the ability to take the tip credit at all for the period in which the violation occurred as to those employees affected by the violation. Additionally, the employer will need to pay the difference between the tip credit wage and the federal minimum wage for that period as damages. This can have significant consequences, as it could result in the employer having to pay $5.12 per hour for every hour the affected tipped employees worked during the two- or three-year limitations period, plus liquidated damages.

Failing to Give Notice: If an employer fails to give proper notice of application of the tip credit to tipped employees (or cannot prove that it did so), the employer will lose the tip credit altogether.

Failing to Account for and Remedy Tip Shortfalls: Where an employee fails to earn enough tips to fill the gap between the cash wage and the federal minimum wage, the employer needs to increase the employee’s cash wage to make up the difference. This is designed to ensure that tipped employees are receiving at least the minimum wage. In order to assess this, an employer can have a system in place to account for tips received (this is also required by Internal Revenue Service regulations), calculate whether the tips are sufficient, and provide for payment of any shortfalls. Failure to have such a system in place and to timely remedy tip shortfalls could result in potential liability for those shortfall amounts.

Invalid Tip Pools: As noted above, a valid tip pool generally involves a sharing of tips between and among tipped employees only. A number of cases have involved allegations that managers were requiring tipped employees to share tips with them or employers were requiring the sharing of tips with nontipped employees. As with the failure to give notice of the tip credit, a finding that an employer required an invalid tip pool will invalidate the tip credit altogether. Moreover, under the recently passed legislation regarding tip pooling, the employer also will be required to compensate the employee for any tips illegally retained.

Taking Deductions From Tips/Pay: A number of cases have involved allegations that employers required tipped employees to pay for things such as customer walkouts (where the customer leaves without paying the check), cash register shortages, food or drink mistakes, and broken plates or glasses. Tipped employees are considered to be minimum wage employees—even if they make hundreds or thousands of dollars in tips during the workweek. Thus, any deductions from their pay for these types of expenses are considered deductions that drop their pay below the minimum wage and violate the FLSA.

Incorrect Overtime Calculations: Calculating overtime for tipped employees is a little tricky, and mistakes are made when those responsible for calculating payroll do not understand this. A common mistake is to use the tip credit wage to calculate overtime. In fact, the overtime rate is calculated at one-and-one-half times the applicable minimum wage, less the basic tip credit. For example, where the minimum wage is $7.25 per hour, the overtime rate is generally $10.875 per hour. However, for a tipped employee, the employer would be obligated to pay a cash overtime wage of $5.755 per hour ($10.875 minus $5.12).

Key Takeaways

It appears that the tip credit is here to stay. Employers that take the appropriate steps to ensure they have the correct infrastructure in place to utilize the tip credit can minimize the risk of potential FLSA liability associated with tip credit employees.

A version of this article was previously published on Law360.