What You Need To Know About Automatic Gratuity Laws In Restaurants

Automatic gratuity can come in handy in many situations, like when a table wants separate checks for each person, for banquets and other functions, or when you seat a large party (typically 6-8 or more). If you want to start implementing an auto gratuity policy via your restaurant POS system, there are a few things you need to know about both federal, and state laws before you get started. 

In this article we’ll cover the following:

• Automatic gratuities are technically considered service charges
• Is automatic gratuity legal?
• How do I report automatic gratuities to the IRS?
• Can restaurants charge automatic gratuity?
• How can restaurants handle large party gratuity?
• Do customers have to pay automatic gratuity charges?
• What do other restaurant industry professionals say about auto gratuity?
• 4 alternatives to traditional restaurant tips and automatic gratuities
• How to implement a new service model

Automatic gratuities are technically considered service charges

It’s important to understand that even though it’s called a gratuity, as far as the Internal Revenue Service (IRS) in the US is concerned, automatic gratuity charges are labeled a service charge. 

The IRS explains the main elements that distinguish tips from service charges by explaining what it takes in order to qualify as a tip:

• The customer can’t be required to pay it
• The customer gets to determine the amount
• It’s not the result of negotiations or decided by policy
• The customer determines who (usually the server) gets to receive the payment

On the other hand, the IRS defines service charges as including:

• Automatic gratuity placed on large dining parties
• Banquet event fees
• Cruise trip packages
• Hotel room service charges
• Bottle service charges

Is automatic gratuity legal?

Yes, automatic gratuity is legal in the United States. It’s often added to the bill in certain situations, like large parties at a restaurant or in high-end or specialty service settings. The reasoning behind automatic gratuity is to ensure that service staff receives a fair tip for their work, especially in scenarios where they’re serving a large group of people. 

It’s important to note that there are some regional variations and specific state laws that might affect how automatic gratuity is applied. For instance, some states have regulations on how these charges should be disclosed to customers, and there might be different tax implications for automatic gratuity compared to voluntary tips.

How do I report automatic gratuities to the IRS?

Automatic gratuity fees are not reported the same way that tips are. Any amount of the fee given to an employee counts as non-tip wages and is subject to tax withholdings and other filing requirements.

However, many bills at restaurants have a standard line for a tip that appears on the check even if automatic gratuity is added, allowing guests to tip their server in addition to the automatic gratuity if they choose to. 

Many automatic gratuities are around 15-18%, so those who prefer to tip 20% (or even 25%) will be happy with the opportunity to give their server the full amount they believe they deserve. Anything tipped to the server on top of the automatic gratuity is treated as the tipped wage that it is, and therefore should be reported the same way that any other tipped income would be.

Can restaurants charge automatic gratuity?

While all gratuity reporting is dictated by the IRS, (which means that every restaurant in the US is required to follow those rules) state laws can still have an impact on how automatic gratuity is carried out on the state level. It is legal to charge automatic gratuity on a federal level, but how it’s reported on taxes will vary state by state.

California automatic gratuity law, for example, has its own law about how service charges are taxed, but it’s essentially the same thing as the federal laws (the California law came first, actually). If you’re thinking about implementing one, have a look at your state laws anyway. It’s better to be safe than sorry.

How can restaurants handle large party gratuity?

Since automatic gratuity is most common for large groups, it’s helpful to implement guidelines and processes for large party gratuity. Here are some suggestions.

• Have a clear policy. Clearly communicate the gratuity policy for large parties on menus, websites, and at the time of reservation. This transparency helps avoid surprises when the bill arrives.
• Beef up your staff training if needed. Train staff to handle large parties efficiently and professionally. Good service often leads to better tips, even when gratuity is automatically included.
• Have tip distribution policies in place. Have clear policies on how gratuity is distributed among staff. This is crucial for staff morale and ensures equitable distribution of tips.
• Setup a feedback mechanism. Provide a way for customers to give feedback on their experience. This feedback can be valuable for improving service and handling any issues related to gratuity.
• Agree on special arrangements for events. For events like banquets or weddings, include gratuity in the overall pricing package. This simplifies billing and clarifies costs upfront.

Do customers have to pay automatic gratuity charges?

You might remember the 2013 scandal when a pastor in Missouri refused to pay the automatic gratuity charge given to his table at Applebee’s because it was a large group. Instead, he wrote on the check “I give God 10%—why do you get 18?” as Forbes reported.

Unfortunately for the pastor, the law was not on her side. As a columnist at the Belleville News-Democrat explains in an article that addresses whether or not diners are required to pay automatic gratuity, “Restaurants are still free to charge a mandatory fee if they wish.”

The article refers to the change that the IRS made to how automatic gratuity is reported. Before that, many restaurants were treating automatic gratuities as tips, but on January 1, 2014, that all changed, as outlined above. If you start implementing an automatic gratuity policy, there’s a chance that some people might still think of the charges in pre-2014 terms.

If you’re still on the fence about whether or not an automatic gratuity policy is right for your restaurant, consider asking your service staff. They’ll certainly have opinions about what works best for them. Also, most POS systems allow auto gratuity to be applied at the server’s discretion, which is a great way to let them best serve their tables.

What do other restaurant industry professionals say about auto gratuity? 

With changes to state minimum wages impacting restaurants across the country, many operators are shaking up the traditional tip model by experimenting with alternatives such as building tips into menu prices or charging service charges or fees in lieu of tips. “A lot of things are being tried,” says Anthony Anton, president and CEO of the Washington Hospitality Association. “It’s fair to say there’s not really a winner emerging yet.”

Like many restaurants, A Good Egg Dining Group in Oklahoma City used to charge automatic gratuity on parties of eight or more. However, they ended the practice several years ago. “We thought if the customer didn’t feel it was worth it, we’re not putting it on [their bill],” says Gary Sander, vice president of accounting for A Good Egg Dining Group. In his experience, “Instead of adding an automatic 18% gratuity, the guests will put more than that on themselves.”

However, the restaurant does charge a service fee for private parties and banquets, which is disclosed to the customer upfront. “We discuss ahead of time how many servers we would put on a party of that size and we charge a percentage of dollars per server,” Sander says. “A certain number of people equals a certain number of servers. Sometimes they’ll want more servers, or occasionally they’ll add a bartender because they want the bar to move faster.” 

4 alternatives to traditional restaurant tips and automatic gratuities

1. Tip sharing

Eater reports that last spring, the federal government amended the Fair Labor Standards Act to allow tip sharing between tipped and non-tipped employees. This change may not mean much to customers, but for restaurants, it means that back-of-house staff in many states can now share in tips, provided the restaurant pays the full minimum wage to all employees (seven states, mainly on the west coast, actually require employers to pay the full minimum wage before tips). However, some states including Massachusetts prohibit tip-sharing, even if all employees earn minimum wage.

2. Service charges

According to Anton, some restaurants now charge a service charge ranging from about 15-22%, which is meant to replace the tip. “In a service charge situation, the owner has complete control over the income,” he says. “The only requirement is to disclose how it gets distributed.”

3. Service fees

A service fee is similar to a service charge but it’s generally a smaller percentage. “It’s to offset the cost of the experience in a higher regulated city,” Anton says.

4. Service-included model

Instead of adding a service fee or service charge to the bill, some restaurants simply build it into their menu prices, similar to many restaurants outside the US. For instance, when Nordic restaurant Agern opened in New York City’s Grand Central Terminal in 2016, restaurateur Claus Meyer reportedly set prices high enough to cover a living wage, health insurance and paid parental leave for employees. 

But this model doesn’t always work because higher menu prices can alienate customers who aren’t used to the service-included (sometimes called “hospitality-included”) model. Meyer rolled back prices last year. The restaurant’s website now states: “Agern is no longer a service included restaurant and our prices have lowered to reflect this change. We remain committed to carefully sourcing our ingredients and correctly compensating our dining room and culinary teams.”

Unfortunately, there doesn’t seem to be a good one-size-fits-all solution. “What’s working well for a casual place doesn’t work well for fine dining,” Anton says.

How to implement a new service model

Communication with employees and customers is key when you’re changing your business model. It’s especially challenging to veer from traditional tipping when you cater to tourists or other populations who aren’t regulars because then you’re constantly having to explain an unfamiliar model.

“If you’re in a situation where most of your customers are repeat customers, for the first month or so, have extra management hours available,” Anton says. “Putting the servers in the middle of the conversation is not necessarily a win for the business. Having management be extra available and keeping the employee from that awkwardness has been a best practice as I’ve witnessed it.”

Still, despite the growing pains, Anton predicts that this is where the industry is headed long term. “We know the model has to change,” Anton says. “The question is, what’s going to be the biggest win for [everyone]? It wouldn’t surprise me if we stay in this model for a couple more years until we find that right answer.”

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FAQs

What is the IRS law on automatic gratuity?

The IRS considers automatic gratuity a service charge, not a tip. Service charges are treated as regular wages and must be reported for payroll taxes. This differs from voluntary tips, which are reported differently for tax purposes.

Why do restaurants add gratuity for large parties?

Restaurants add gratuity for large parties to ensure fair compensation for servers who often exert extra effort and time to accommodate larger groups. This practice also helps in evenly distributing tips among the service staff.

What is gratuity violation?

A gratuity violation typically occurs when an employer improperly withholds or misappropriates tips intended for employees. This can include not paying out tips correctly, keeping a portion of tips, or distributing them in a manner not compliant with state laws.

Do you tip on top of 20% gratuity?

Tipping on top of a 20% automatic gratuity is not required. The automatic gratuity is intended to cover the customary tip. However, if you feel the service was exceptional, you are welcome to tip additionally.

What is the difference between a gratuity and a tip?

A tip is a voluntary amount a customer leaves for service, while a gratuity is usually an added service charge, often automatic and predetermined, like for large groups in restaurants.

Is automatic gratuity calculated before or after tax?

Automatic gratuity is typically calculated on the pre-tax amount of the bill. The calculation is based on the total cost of the services provided before any sales tax is added.