Tips and Service Charges: Understanding the Differences
It’s important for those in service industries, such as restaurants, hair salons, and hotels, to understand the difference between tips and services charges. The two types of gratuities present employers with a number of payroll challenges, including wage calculation, employee reporting, and tax requirements.
Tips vs. Service Charges
The IRS has specific reporting and taxation rules for tips and gratuities. It defines tips as:
- Cash received directly from customers;
- Extra money from customers through electronic payment, including credit cards, debit cards and gift cards;
- The value of any non-cash perquisites, such as tickets or other items of worth; and
- Amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip-sharing arrangements.
Tips differ from service charges in that they are made without pressure or coercion; the customer has the unrestricted right to determine the amount; the payment doesn't result from negotiation or employer policy; and the customer generally has the right to determine who receives the payment.
Examples of service charges include:
- Automatic gratuities (usually 18 percent or more) attached to large dining parties;
- Banquet event fees;
- Cruise-trip package fees;
- Hotel room service charges; and
- Bottle service charges by nightclubs and restaurants.
Because some employers keep a portion of service charges, the IRS considers automatic gratuities to be revenue for the business and the dollars distributed to staff as non-tip wages.
Employees are responsible for reporting tip income to their employer, specifically all cash tips received, except for the tips from any month that total less than $20. Employees aren’t required to report non-cash tips from customers, but both cash and non-cash tips count toward workers' gross annual income and are subject to federal income taxes. Indirectly tipped staff — e.g., busboys and cooks — who share customer bonuses with tipped employees must also report tips to their employer.
For IRS purposes, employers must keep records of employee tips in order to withhold income taxes, social security, and Medicare taxes based on wages and tip income received. Employers are also required to pay their share of social security and Medicare taxes based on the total wages they pay to tipped employees, as well as the reported tip income.
Service charges distributed among staff, on the other hand, are treated the same as regular wages for the purposes of tax withholding and filing.
Tipping and service charges can complicate payroll taxes. The IRS, the U.S. Department of Labor, and payroll companies have many resources to assist employers.