What Automatic Gratuity Means for Your Restaurant

In the restaurant industry, it's common practice to let your guests know that for any parties of eight or more, an automatic 18-20% gratuity will be added to the bill.  

According to Forbes, “the charges are meant to help shore up a restaurant industry that has long run on slim profit margins and now faces a host of challenges, including inflation, labor shortages, and an expectation — or mandate, in rising minimum wages — that workers get better wages and benefits.”

With many restaurants starting to forego tipped compensation structures, and a significant increase in many state’s minimum wages, restaurateurs are tuning in to learn new practices they can establish to support their staff and increase profitability.  

Let's take a closer look at the automatic gratuity model.

What are automatic gratuities?

Automatic gratuities are set service fees as determined by the restaurant added to the bill of a party. It is important to note that the Internal Revenue Service (IRS), along with various federal and state laws, considers an automatic gratuity to be a service charge, not a tip. This is similar to what you may see with delivery fees when ordering from a third-party delivery service. 

Note that different states can have different laws about automatic gratuities, including how they’re taxed, so be sure to research your state’s requirements and consult with an accountant or lawyer before making any changes at your restaurant. 

This charge can be a restaurant’s way of making sure their service staff is treated fairly when it comes time to tip. Traditionally, automatic gratuity policies are implemented for large parties, because serving a larger table requires extra work on the restaurant server. The auto gratuity ensures servers earn a set tip amount to avoid getting short-changed for the level of effort put into service for the party.

However, as mentioned above, many restaurants are finding that this system works for parties of all sizes.

Are automatic gratuities legal?

While automatic gratuities are a common practice in the industry, it’s always best to check federal laws, along with your state and local laws, before implementation to ensure legal compliance. Below are some pointers when implementing automatic gratuities:

1. If service charges are being distributed to employees, the IRS generally treats them as non-tipped wages.

2. Be sure to communicate the service charge to the guest at the beginning of the service since it is a restaurant policy, and not optional as with standard tipping.

The implementation of automatic gratuities can also impact both your employer and employee taxes since the IRS generally considers them to be a service charge as opposed to a traditional tipped earning. Managing taxes can be a daunting task, but there are many restaurant payroll providers who help manage these taxes automatically for you.

Are automatic gratuities a tip or a wage?

The IRS classifies automatic gratuities as service charges, not as tips. This means that automatic gratuities are a part of the employee’s non-tipped wages. This also means that the employee will likely receive the automatic gratuity on their paycheck instead of taking it home at the end of the night. The exception here is if your restaurant has implemented an early wage access system.

What makes a tip? Generally speaking, according to the IRS, additional money given on a restaurant bill is considered a tipped earning and not a wage (or service charge) if:

• A customer is not obligated or forced to leave any amount

• The customer elects to leave additional money, and can leave any amount they want

• The additional amount is not subject to any negotiation or dictated by employer policy

• The customer has the choice of to who gets the additional money they leave behind

In theory, while both service charges and tips are subject to taxes, there are different reporting obligations and treatments associated with each.

Automatic gratuities are not suggested tips

Some think that suggested tip amounts listed on a guest check counts as an automatic gratuity. That's not the case. In fact, it’s the opposite.

Printing a “Suggested Tip Guide” on the bottom of the guest check doesn't change it from a tip to an automatic gratuity because the customer still gets to choose what tip amount, if any, they want to leave.

Benefits of automatic gratuities

The option to provide automatic gratuities gives restaurants additional flexibility outside of traditional tipping, and below are a couple of key benefits:

1. Ensure standard tip compensation for large parties - With large groups where the bill is split half a dozen ways, servers can end up earning a lower overall tip percentage due to confusion across the table on who is tipping, or the amount to tip.

2. Ability to offset fixed costs - Automatic gratuities allow the restaurant to cover recurring, predictable fixed costs. As mentioned above, it can provide wiggle room in the budget for the employee benefits that staff today need, like health insurance and paid time off.

The downside of automatic gratuities

Automatic gratuity charges do have some anecdotal downsides. Say a server did an amazing job and would have been likely to be tipped 25% or more, an automatic gratuity of 20% means they’re not going home with that 25% in their pocket. Most guests will just pay the 20% since it's been automatically decided for them.

Additionally, as mentioned above, both the IRS and the Fair Labor Standards Act generally consider automatic gratuities to be non-tipped wages, so you will need to ensure your tipped employees meet the minimum wage requirements for any shifts and that these additional wages comply with other applicable wage & hour requirements.

How to write an auto gratuity policy

When implementing an automatic gratuity system in your restaurant, it's crucial to have a clear, well-written policy. You can keep this policy in your employee handbook. Here are a few tips to create an effective auto gratuity policy:

• Define the scope - Specify which checks will include the auto gratuity (parties of 8 or more, all checks, etc.) and state the percentage of the auto gratuity (typically 18-20%)

• Be transparent - Clearly state that an automatic gratuity will be added to the bill and explain that this is a service charge, not a tip

• Explain distribution - Clarify how the auto gratuity will be distributed among staff and mention if it's treated as a wage rather than a tip for tax purposes.

• Allow flexibility - State whether customers can adjust the gratuity amount (up or down) and explain the process for handling customer concerns about the policy.

• Legal compliance - Ensure the policy complies with local, state, and federal laws

• Train staff - Make sure your staff clearly understands the auto gratuity policy and is able to answer any questions a customer may have.

Image source

Weigh your automatic gratuity options

When it comes to automatic gratuity, restaurants have several choices:

1. Introduce automatic gratuities into your service model and develop an understanding of the tax and legal implications in your state.

2. Stick to the standard tipping structure, including suggested tip percentages on the check, with no automatic gratuity.

3. Forego tipping altogether and implement a larger service charge on all checks.

The decision to implement auto gratuity should align with your restaurant's values, clientele, and local regulations. As the industry continues to evolve, finding equitable solutions for staff compensation while maintaining customer satisfaction will be key to long-term success. Regardless of which option you choose, make sure it’s clearly communicated to your guests. You can do this by making your auto gratuity policy clear at the bottom of your menus.

If you’re ready to set up mandatory gratuity on your Toast restaurant POS system today, check out this article to help.

Related resources

• Tip Pool Calculator

• How Much Do Bartenders Make

• How Restaurant Guests Really Feel About Tipping In America

• Restaurant Tipping Guide: How to Adequately Tip at a Restaurant in 2024

• What You Need to Know About Restaurant Tip Management

• Tipflation and Its Impact on Restaurant Tipping

• Set Up Tip Options On Your Toast POS