Key takeaways
- Service charges differ from tips legally, and have to be reported to the IRS in different ways
- Choosing to use a service charge depends on a number of factors, including your staff earnings, and could be the best choice for an equitable wage for all employees
- Restaurateurs should explain to diners why they’re using a service charge and how much will be charged, often written right on the menu for ease
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Tipping culture in the U.S. is certainly a controversial affair in the restaurant industry. While tipping has historically been a gratuity, or an additional payment made at the customer’s discretion, many restaurants have been adding a mandatory service charge. A tip would then be in addition to the required service fee. This could be confusing for customers, and it can be a hard decision for restaurateurs as well. So, how do you know if you should use a service charge vs tip model?
We’d love to tell you there’s one easy answer, but there isn’t. Much depends on the situation, including the style of your restaurant, the number of guests seated, your servers’ preference, and tax law. A service fee added to a customer’s bill is not legally the same as a tip, and some diners may not quite get it yet.
So to get definitions straight, make employer policy clear, and stay compliant with the IRS, let’s take a look at the difference between service charges vs tips.
What is a service charge?
A service charge is an addition to the customer’s bill that is mandatory to pay. This is in contrast to a tip, which is entirely discretionary based on good service, even if it’s socially required. Usually, a service charge amounts to the same addition as a tip would, i.e., somewhere in the realm of 15-25%. It’s added directly to the bill and appears as part of the total.
In some cases, it works as an automatic gratuity, and has traditionally been used in the case of large dining parties at restaurants to help ensure employees get adequate tips. However, recently, it’s become more common as a way to ensure employee income and other provisions.
Legal definition
Legally speaking, there are four things that distinguish a tip from a service charge. A tip depends on four specifications. As the Internal Revenue Service (IRS) notes, these four stipulations are:
- The payment must be made free from compulsion
- The customer must have the unrestricted right to determine the amount
- The payment should not be the subject of negotiations or dictated by employer policy
- Generally, the customer has the right to determine who receives the payment
Without any of these four conditions, an additional payment may not be considered a tip. Instead, the payment would be a service fee. Examples of service charges include automatic gratuity on a large party, a banquet event fee, a cruise trip package fee, a hotel room service charge, or a bottle service charge. These do not legally constitute a tip.
The difference here is significant: Service charges are reported as non-tip wages. These are paid to the employee. Employers may keep part of the fee, and only the amount given to employees are non-tip wages.
In the case of both tips and service charges, employees are subject to federal income taxes and Social Security withholding on their gross income. With service charges, employers are required to retain the information. However, the burden falls on employees to report their tip income to their employers.
When is it right to use service charges vs tips?
This is a tricky question, and one that many employees and employers alike feel strongly about. In some cases, a service charge can help guarantee a living wage for staff. In other cases, restaurant staff may feel shorted by service charges, which are not automatically distributed to staff.
A bartender, for example, can make significantly more money via tips than they would via service charges. A bartender or wait staff at a busy bar or restaurant can make quite a decent income that would be significantly undercut by customers thinking their tips are covered in the bill.
On the other hand, service charges can help raise the wages of all non-tipped employees. Bussers, kitchen staff, and hosts are traditionally not tipped, so the service charge can be shared by all employees.
So, deciding to use service charges is both a business decision and an employee-centered decision. Businesses that consistently get under-tipped can introduce a service charge, as can those who regularly entertain large groups. However, if this cuts into staff earnings, you may have a revolt on your hands.
Often, expensive areas rely on service charges to help guarantee their employee’s wages, but this can be a double-edged sword.
Generally speaking, if your employees are already earning good money via tips, it’s best to leave the system alone. If they’re not making enough to support themselves via tips, that’s a good time to introduce a service charge. But be sure to have this conversation with your employees first.
Note also that a service charge is not the same as a tip pool or tip-sharing arrangement. There are legal complications here as well—for example, an employer can legally collect from a service charge, but not from a tip pool.
How to explain a service charge to customers
Customers may be confused by a service charge, especially if it shows up unexpectedly. So, restaurateurs need to let customers know long before they order that a service charge will be included.
The best way to do this is to make it clear on the menu. For example, “For the health and well-being of our employees, a 15% service charge will be added to your bill.”
This should be printed towards the top of the menu, potentially in bold lettering, to prevent any confusion and possible upset from guests.
Many diners are familiar with the concept of mandatory service charges for large groups, though this should still be stated directly. However, if you’re going to include a service charge for all customers, you should make clear your intent. Is it to ensure a standard of living above minimum wage? To cover growing expenses due to inflation? To ensure good service? Whatever the case, this absolutely must be communicated to customers when they sit down, or you can be guaranteed at least a few customers will get upset.
Generally, customers will assume that if there’s a mandatory service charge, they’re not required to pay any additional tip. Most customers indeed will not pay an additional tip on top of a service charge.
Make service charges simple
Quick review: Service charges and tips are legally different. For service charges, the burden of tax reporting falls on the employer, whereas with tips the burden falls on the employee. Service charges legally belong to the employer and may be shared with employees at the business owner’s discretion, while tips are the earnings of the employee. Restaurateurs can rely on service charges to bolster employee tips when employees aren’t earning enough, but doing so may not always be a popular decision. It depends entirely on the situation.
Most restaurants who add service charges do so because they know their team works hard to execute fantastic service and meals night after night. Making sure employees are well compensated is one of the best ways to gather and retain the talent needed to make a restaurant run smoothly.
Another way to make sure your restaurant runs smoothly is to rely on top-tier front-of-house software like Yelp Guest Manager. It gives the team the necessary tools to get the job done right. Get ready for online waitlists, check-ins, and reservations; customizable floor management; and seamless integrations with delivery apps and point of sale software.
If you want to learn more about how Guest Manager works and to see if it’s right for you, reach out to us for a free demo.
