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Lessons From the Line: Service Charges and How to Use Them

August 31, 2023

Jurisdictions are enacting laws that shift the onus of employee compensation, previously provided as tips or commissions by customers, onto restaurants through increased base wages for front-of-house (FOH) personnel. To offset these added expenses, restaurants have devised various strategies, the most prevalent being the introduction of service charges – a mandatory fee, typically calculated as a percentage, added to every bill.

As an increasing number of restaurants implement service charges, it's crucial to understand their nature and implications. This article, our second on the topic, complements our earlier Wage Modeling webinar with RAMW, from May, which you can revisit here.

Service Charges Aren’t Tips – Regardless of the Label

In the realm of employee compensation, it's essential to recognize that, as per the Internal Revenue Code (IRC), service charges and tips are categorically different. The key distinction lies in their means of provision and receipt, irrespective of the restaurant's application of the collected service charge.

The tax code states: A tip is a discretionary sum offered by the customer without any obligation. The customer determines its amount and recipient.

Conversely, a service charge is a fee appended to the customer's bill by the restaurant. It isn't optional, and its value isn't dictated by the customer. This might manifest as automatic gratuities for large groups or event fees. If there's a charge on the bill, it qualifies as a service charge, regardless of its label.

Thus, irrespective of what or how the service charge funds are called, these terms are distinct in legal and accounting contexts. This distinction means restaurants cannot utilize service charge funds to fulfill the FLSA tip credit requirements.

Service Charges: A Restaurant's Revenue

Service charges, being determined and gathered by the restaurant, generally count as its revenue, carrying significant tax implications.

Mostly, these charges are subject to local sales tax. Hence, when determining total sales for tax obligations, service charges must be included in the taxable sum. Overlooking this can lead to miscalculations and possible legal issues. For instance, a restaurant with $1M in sales imposing a 5% service charge would generate $50,000. Failing to tax this amount in a 10% tax jurisdiction results in a $5,000 tax debt.

To navigate this complex landscape, collaborating with an accountant or financial advisor acquainted with local tax norms is recommended. To make it more confusing, some states might exempt service charges from sales tax, contingent on how the charge is allocated or even party size.

Appropriate Payroll Handling of Service Charges

The differentiation between service charges and tips isn’t merely terminological; it has profound payroll implications.

Service charges cannot be used to meet the Fair Labor Standards Act (FLSA) Tip Credit requirements. The FLSA permits employers to use a "tip credit", allowing them to pay tipped workers below the standard minimum wage if tips cover the difference. As service charges aren't freely given by patrons and don't go directly to staff, they can't be used for this credit.

While tips, generally given to employees, are viewed as their property (with minor exceptions), service charges don't fit this definition. This grants employers flexibility in allocation, emphasizing the importance of clear communication with staff about these charges.

Including Service Charges on Pay Stubs

Service charges, distinct from tips, must be clearly indicated on pay stubs to ensure transparency and adherence to regulations. Here's a recommended approach:

Distinct Line Item: Never amalgamate service charges with other earnings. They should be clearly marked, perhaps as 'Service Charges' or 'Automatic Gratuities'.

Year-to-Date Tracking: Offering a year-to-date (YTD) column for service charges helps employees monitor their yearly earnings from these fees.

Clear Descriptions: Merely stating amounts is insufficient. Include detailed descriptions, particularly if service charges have specific features, such as pooling among staff or being limited to large party bills.

Regular Communication: While pay stubs serve as official records, consistent communication about service charges, their distribution, and representation on pay stubs can preclude confusion.

Transparency in presenting service charges on pay stubs is essential, promoting clarity, preventing misunderstandings, and potentially avoiding future disputes.

Displaying Service Charges on Collateral

Restaurants must transparently disclose any service charges on customer bills, incorporating them into menus, receipts, and websites.

Clear announcement of these fees not only upholds trust and fairness but also aligns with consumer protection principles. In numerous jurisdictions, failure to inform or misleading customers regarding service charges could lead to legal repercussions under the municipalities’ consumer protection acts. Remember, unlike discretionary tips that reward service, service charges are pre-set fees, which might not always be shared among staff. Distinguishing these fees from voluntary tips can help restaurants circumvent legal complications, prevent misinterpretations, and maintain ethical standards. 

While it's prudent to seek legal guidance specific to your region, an effective guideline is displaying the charge in a consistent font at a conspicuous menu location, highlighting that it's not a tip.

Last Bites

August 2023

Important Deadlines for DC Clients:

A reminder for our DC Clients, the first deadline to complete Tipped Wage Worker’s Fairness Act (TWWF) Sexual Harassment Trainings for all covered employees is August 31st.  Compliance reports are due October 13th. More information can be found here and if you aren’t in DC it’s never a bad idea to use Labor Day as a deadline to ensure you are in compliance with all local continuing obligations.

The 90s are Back... Whatever.

Trend pieces, especially those based around vicennial nostalgia, are a refuge for those bankrupt of ideas. But given that every media outlet is writing the same story about service charges and the small subset of cranky diners who complain, let's tune out with the studied indifference that is the return of the 90s. Sex and the City, sun-dried tomatoesespresso martinis, the Orioles being good – let’s party like it’s 199_. A trend piece near and dear to our hearts was one singing the praise of the most misunderstood of pasta (mafalde being most overhyped) – angel hair. Nothing is better with a simple simmered late-Summer tomato sauce, so enjoy the last days of Summer and contemplate – would gentrifier Benny be a villain if Rent was made today?

Webinar on Service Charges

For those who want a tl,dr: service charges are complicated. We will be hosting a webinar with Matt in September on this topic to go into further detail and answer your questions. Stay tuned for an email with the signup details.