Upsetting what many considered settled precedent, a California Court of Appeal has held that a mandatory service charge may qualify as a “gratuity” under California Labor Code Section 351 that must be distributed to the non-managerial employee(s) who provided the service.

In O’Grady v. Merchant Exchange Productions, Inc., No. A148513, plaintiff, a banquet server and bartender, filed a putative class action against their employer for its failure to distribute the entirety of the proceeds of an automatic 21% fee added to every food and beverage banquet bill to the non-managerial banquet service employees who staffed the event, alleging a violation of California Labor Code Section 351, as well as intentional interference with advantageous relations, breach of implied contract, and unjust enrichment.

Section 351 prohibits an employer or agent from taking a gratuity left for an employee by a patron, including but not limited to a tip paid by credit card, or otherwise crediting or deducting such gratuity against/from the employee’s wages. According to plaintiffs, customers would have reasonably believed that these charges were remitted in full to service staff based on the depiction of these charges as a mandatory, preset “service charge,” as well as industry custom. The trial court found for defendant, relying on two California court of appeals decisions – Searle v. Wyndham International, Inc. and Garcia v. Four Points Sheraton LAX – each holding that a mandatory service charge is not a gratuity for purposes of California Labor Code Section 351.

Reviewing the trial court’s decision de novo, the Court of Appeal analyzed the statutory definition of “gratuity,” which is “any tip, gratuity, money, or part therefor that has been paid or given to or left for an employee by a patron of a business over and above the amount due the business for services rendered or for goods, food, drink, or articles sold or served to the patron.” The court also looked to the legislative intent behind the statute (i.e., protecting employees from employers who used their positions to unfairly command a share of the employee’s tips).

Upon its review of the statute, legislative history and precedent, the court found that the definition of “gratuity” is amorphous and vague enough to encompass a mandatory service charge, which is added to the cost of food and drink, thereby rendering it “over and above the actual amount due….” The court further reasoned that defendant’s practice, if accurately depicted, would be inconsistent with the purpose of Section 351, namely, ensuring that employees, not employers, receive the full benefit of gratuities that patrons intend for the sole benefit of those employees who serve them.

While the court acknowledged that Searle and Garcia held that mandatory service charges were not gratuities, it distinguished these decisions on the factual basis that in both cases the allegedly deceptive service charges were paid to employees, not retained by the employers. Furthermore, the court emphasized that “the notion of an involuntary gratuity has perhaps become more widespread and accepted than in the past,” thereby rendering the distinction between an involuntary and voluntary gratuity less meaningful. Without a more developed factual record before it (the case was dismissed early in the proceedings), the court was constrained to hold that a mandatory service charge may constitute a gratuity as a matter of law, and remanded the case for further proceedings.

Advice for California Employers

Given the apparent split of authority created by O’Grady, the California Supreme Court may well resolve the issue of whether, and under what circumstances, a mandatory service charge can or will be considered a gratuity. In the meantime, to mitigate risk, California employers in the hospitality industry should review any mandatory charges they impose on their patrons and determine whether such charges are distributed to service personnel.

With that said, O’Grady does not necessarily foreclose employers from retaining mandatory service charges and/or distributing them to managerial personnel. In O’Grady, there was no suggestion in the record that defendant’s customers were advised in any way that the mandatory service charge was not intended to be a gratuity and would not be paid to employees providing the service. In New York, employers who include prescribed language in their customer contracts disclosing that a mandatory charge is not purported to be a gratuity and will not be distributed to the employees who provided service to the guest are deemed to have met their burden of proving that a charge is not a tip. In such circumstances, the law presumes that a reasonable customer would not consider the service charge to be a tip. While there is no statutory analogue in California, the O’Grady decision suggests that the customer’s reasonable expectations regarding the nature of a service charge are relevant to the gratuity analysis. Accordingly, short of distributing all service charges to appropriate service employees, California employers seeking to retain service charges should include a disclosure similar to that required in New York.

We will continue to monitor O’Grady, as well as any guidance issued by the California Labor Commissioner, and will report on any significant developments.