The Impact of Automatic Gratuity on Your Restaurant

By: David Scott Peters

4 Minute Read

Jul 20, 2017

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automatic gratuity

It has been normal everyday policy and procedure in the restaurant business to publish in your menu that for any parties of eight or more, an automatic 18% gratuity will be added to the customer’s check.

However, California has taken a different approach to this and published a tips, gratuities, and service charges law making the policy almost impossible to implement for restaurants, which seems to have set a standard for the IRS.

With recent tipping changes at Danny Meyer's restaurants and with California coming close to implementing a $15 minimum wage, many restaurateurs are tuning in to learn best practices to establish at their restaurant. Rather than the no-tipping model, let's take a look at the automatic gratuity model.

The Automatic Gratuity Policy

In 2012, the IRS announced a new ruling on how automatic gratuities would be handled starting in January 2014 (which mirrored very closely how the State of California handles them).

Before this ruling, automatic gratuities were a restaurant’s way of making sure their service staff was treated fairly when it came time to tip. The safeguard was in place because these bills can be split up, and serving them can be like serving more than eight tables at the same time. It was extra work and the argument from servers was that they get short changed in the tipping department because of it.

I never liked this policy because I am a believer in the idea that if you give great service, the automatic gratuity actually costs the server money because they might have more likely been tipped 20%. However, the guest feels like the decision has been made for them to tip less, so they stick to that automatic 18%.

Being a tipped employee for many years of my life, I know there will be times that without the automatic gratuity, the tipped employee will lose. I just like to think the times you win far outweigh the times you lose.

Is Automatic Gratuity Tip or Wage?

In January 2014, the IRS started classifying automatic gratuities as a service charge, instead of a tip. The IRS looks at service charges as regular wages that must be reported so that withholding taxes can be calculated and collected correctly.

Before the new ruling, tipped and indirectly tipped employees were required to report their tipped income to their employer at least monthly. Then the employer was required to deduct income and payroll taxes from the reported total. The new ruling changes it so that auto-gratuities now become a part of the employee’s pay. This basically makes it impossible for the employee to underreport tippable income on any tips that the restaurant requires the customer to pay.


It also came with a few other consequences:

  1. Additional paperwork and record keeping for accurate payroll records
  2. Higher payroll taxes for the employee and employer
  3. Since the automatic gratuity is now considered wages, the employee will receive these tips on their paycheck and would no longer take them home that evening.

In theory, this shouldn’t have been a big change at all if your tipped employees were already following the IRS guidelines for reporting 100% of the tips they collect and the fact you should be paying their credit card tips on their paychecks anyway. But we don’t live in a theoretical world now, do we?

A tip is a tip and not a service charge (wage) when:

  • A customer is not obligated or forced to leave a tip
  • The customer elects to leave a tip and can leave any amount they want
  • A tip is not subject to any negotiation or dictated employer policy
  • The customer has the choice to who gets the tip they leave behind

Caveat: Automatic Tips are Not Suggested Tips

suggested tipsI can tell you that I misunderstood the new ruling for a long time, thinking that suggested tipping on a guest check — like in the image shown — was a part of this new ruling. That is not the case. In fact, it’s the opposite!

Under the new ruling, printing a “Suggested Tip Guide” on the bottom of the guest check does not change it from a tip to wages because the customer still gets to choose what, if any, tipped amount they want to leave.

This means leaving a tip is not required and would not be subject to the new rule.

What Should Your Restaurant Do?

The way I see it, you have two choices:

  1. Continue down the path of automatic gratuities and understand the added requirements.
  2. Drop the practice all together.

If it were me, I’d drop automatic gratuities from my restaurant.

What would you do? What is the tipping structure at your restaurant, and why?

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