Tips vs Service Charges: Navigating the Murky Waters of Restaurant Gratuities

4 Min Read By Annette A. Idalski and Mary Claire Smith

The difference between tips and service charges can be confusing for employers, but it is critical that they make the correct distinction. Whether a gratuity is a tip or a service charge impacts how employers calculate their employees’ wages and how income is reported by employers and employees for tax purposes. A mistake in characterizing these two forms of compensation can subject employers to penalties under the Fair Labor Standards Act (FLSA) and the Internal Revenue Code (IRC). To assist employers, the IRS issued an updated Fact Sheet (FS-2017-08) on April 25, 2017 outlining the key differences between tips and service charges.

When is a Gratuity a Tip?The IRS sets forth four requirements in order for a gratuity to be considered a tip:

 

The payment made must be free from compulsion; The customer must have the unrestricted right to determine the amount; The payment should not be the subject of negotiations or dictated by employer policy; and The customer has the right to…