Payroll 101: A few tips on tips

July 8, 2022
Jim Kohl

Head of Payroll Operations

Jim Kohl

We’ve all been out to dinner with friends. The bill comes and everyone scrambles to throw their credit card into the pot. The bill is broken up and each guest gets a receipt to sign and add a tip. What happens to that tip? When does the server get that tip? How does it impact the server's taxes? 

Let’s take a look at how tips drive a massive piece of the payroll world and offer a great segue into the value of an embedded payroll solution.

What makes a tip, a tip?

A tip (sometimes referred to as a gratuity) is additional compensation paid to an employee voluntarily by customers. For workers classified as “tipped employees”,  tips may be considered taxable wages. The word “voluntarily” is very important when determining what is a tip. Most commonly, a tipped employee will receive either a cash tip paid directly from the customer, or an electronic tip paid out through credit, debit, gift card, etc. 

If tipping is voluntary, why do we do it? Back in the 1960s, the U.S. Congress passed a “tip credit.” A tip credit allows the employer to pay a “tipped employee” under minimum wage as long as they earn tips to account for the difference. Essentially, the Federal Minimum wage is $7.25 (states and locals vary and take precedence). That means an employee needs to, at minimum, make that amount per hour of work. If the employer is paying the server $2.13 per hour worked, then they need to make the equivalent of $5.12/hr in tips to meet the minimum wage threshold. If an employee fails to make the difference over the course of their pay cycle, the employer is on the hook to fund the difference. In the food industry, tipping isn’t just good manners, it may help servers reach minimum wage (in locations where tip credit is permitted).

Tip vs. Service Charge. What’s the difference?

But wait, what if my bill already has the tip included? Gratuity for large parties is considered a “service charge” and would not be the same as a tip. Those amounts may still be given to the server, but they would not be reported as tips. This logic holds for all baked-in charges (ex. banquet fee, all-inclusive resort fees, hotel service charge, bottle service, etc.) 

Where your payroll system can make an impact

Most electronic tips are recorded through a point-of-sale system. Then, the amount must also be captured, and then determined if it must be taxed and included on the employee's paycheck. Employees need to report cash tips (in excess of $20.00) to the employer monthly. Those tips are then recorded as imputed income on the paycheck and taxed accordingly. The server receives their credit tip amounts on their paycheck at the end of their standard pay cycle, but they will walk home with cash tips when received. 

Point-of-sale systems and other vertically integrated software used for tracking tips have a leg up on traditional payroll software when it comes to managing tips.  This is where embedded payroll can make a real impact.  Instead of taking the hours and tips and moving them to a non-native payroll system, payroll can be embedded directly into the software to make paying tipped employees much simpler.

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