I touched on this issue when the “junk fee bill” was passed, and especially now that bars, restaurants, and some other industries are exempt and can still include service charges and surcharges. But it is worth taking a deeper dive into the difference between tips (gratuities) and service charges because in this situation, language is important. And many people, including courts, attorneys, even the state of California, get confused. Because THEY get confused, we sometimes get judges and the Labor Commissioner issuing bad rulings. But the IRS and California Franchise Tax Board understand the difference, as do the appellate courts. So, let’s walk through this together.
Tips (or Gratuities) – A tip is money paid by a patron or guest directly to your employees. It may be paid by way of cash left for them, either individually or in a “tip jar,” money added to a credit card bill or by way of a contract, or even an app. It is taxed, as most of you know, and must be reported by both the employee and employer for income purposes. It can be included on a paycheck, or may not be, but it should be reported and taxed nonetheless.
A tip belongs to the employee. It is their property. California Labor Code Section 351 makes this clear, and it is true in most states and under federal law as well. Notwithstanding this legal premise, both federal and state law permit employers to implement and require participation in a reasonable tip pool or tip sharing arrangement, so long as NO MEMBER OF MANAGEMENT takes and keeps any of the tip distribution. (See, Leighton v Old Heidelberg and Jameson v Five Feet Restaurant). Both California and federal court decisions provide some guidance as to the parameters of these tip pools, and these cases suggest the limits on what servers (or other directly tipped employees) must tip out to other employees (indirectly tipped employees) under an employer mandated tip pool or share. In 2018, the FLSA amended federal law to permit tip pools to include back of the house employees, something California law has allowed since 2009.
The case law has also suggested that employees with some management duties may receive direct tips, and in the Chau v Starbucks decision, a California appellate court held that shift supervisors who worked the line with other employees may share money left in the tip jar. The court ruled that patrons left money in the jar for workers who had served them, which included the shift supervisors, and therefore, the shift supervisors were directly, not indirectly, tipped. Based on this logic, a manager who fills in for an absent server may keep the tips directly left to them and even tip out to support staff. However, a bar manager, who also acts as a bartender, may not receive indirect tips from servers. In keeping with the Starbucks case, bar managers MAY keep the tips directly left for them by patrons of the bar but may not receive a tip share or indirect tip from other employees, including servers and bartenders.
Service Charges and Surcharges – Now let’s distinguish a “service charge” from a tip/gratuity. As many know from all the attention surrounding this issue with the new law, a service charge or surcharge is an amount charged patrons BY THE BUSINESS/EMPLOYER (restaurant, caterer, delivery service) in addition to the cost of the food/service provided. The new “junk fee law” (SB 478) prohibits many businesses from continuing to add these charges, but the last-minute passage of SB 1542 exempts bars and restaurants and allows this continuing practice, under certain conditions (See my prior MMB on this issue).
Because the service charge or surcharge is a MANDATORY charge by the business, that money is treated as income to the business, and in most cases, the property of the business. They must pay SALES TAX on this surcharge as well as income tax. Some jurisdictions, such as Santa Monica and West Hollywood, have legislated that all this service charge money MUST be paid to employees, with clear communication about how the money is distributed amongst staff. But in other locations, employers are not required to pay all this service charge income to their workers. They may retain some portion, pay some portion, and use the money to pay managers. However, California requires that restaurants and other businesses who mandate a service charge CLEARLY COMMUNICATE how this service charge money is used, whether it is paid to employees, or retained by the business, or split. And if that service charge or surcharge is retained, the employer must clearly communicate to its consumers how the money is being used, and then, actually use the money for that stated purpose.
Then there is another wrinkle. IF the service charge or surcharge is paid to non-exempt staff, it is a wage paid to the employee that impacts their regular rate of pay, for purposes of overtime, break pay, and sick pay. I have spent extensive time in prior MMBs discussing the regular rate of pay issues and calculations, so I will not go into it here. And many of you reached out in response, thankfully.
So, in a nutshell, a tip is money paid by the patron directly to the employee(s) and it is the property of the employees. While it is considered income and wages for certain tax and benefit purposes, it does not impact the regular rate of pay. Service charge and surcharge income belongs to the employer, and when it is paid out to employees, translates into wages paid by the employer for all purposes, including impacting the regular rate of pay.
If you are confused, you are in good company. This analysis is highly technical, and as I said, we have seen trial courts, attorneys, and the California Labor Commissioner get it wrong.
But there is one thing you all can do to hedge some of the confusion. STOP USING THE TERM “AUTO-GRATUITY!” Just, stop. Read above. If you are charging an automatic fee to your patrons, for example, for a large party or event, it is a SERVICE CHARGE. To call it anything else throws everyone for a loop. And we have seen many, many lawsuits from employees who claim restaurants are taking their tips, because the restaurant keeps all or some of the “auto-gratuity.” STOP THE MADNESS. Wipe the term “auto-gratuity” from your vernacular, and change it EVERYWHERE, on all your menus, websites, internal policies, paystubs, and anything else you publish. This is a service charge, and it is governed by the new rules in SB 1542. Keeping the distinction helps deter and defend lawsuits and government audits.
Finally, the above analysis applies to California, which does not permit a tip credit. For those of you who operate in states which allow the tip to be credited against the minimum wage, you are under a whole different set of rules.
