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% gratuity will be added to the bill.  

In 2020, the restaurant industry saw an increase in service charges due to the impact of COVID-19 on restaurant revenue. Many restaurants implemented service charges as temporary solutions to help prevent closures and ensure they could help keep their teams employed. Restaurants relied on tips and gift card sales to offset employee earnings, and with the reduction in restaurant sales, the implementation of the service charge allowed them to offset some of these costs.

But others, like Thamee in Washington, DC, have kept service charges in place, using them to help provide a good, reliable wage for all their employees, as well as health insurance.

With many restaurants starting to forego tipped compensation structures, and with multiple cities and states seeing a significant increase in 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. 

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. 

What are Automatic Gratuities?

Automatic gratuities are a set fee as determined by the restaurant added to the bill of a party.  It is important to note that the 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. 

Automatic gratuities can be a restaurant’s way of making sure their service staff is treated fairly when it comes time to tip. Traditionally, they are implemented for large parties, because serving a larger table can be like serving more than eight tables at the same time. It's extra work on the server, and the automatic gratuity ensures servers earn a set tip amount to avoid getting short-changed for the level of effort put into service for the party, especially if the bill gets split up. But 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, prior to 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 requirement set by the restaurant, 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 likely means that the employee will receive the automatic gratuity on their paycheck and will no longer take them home that evening of the shift worked, unless 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 treatment 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 parties 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, and 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.

Downside of Automatic Gratuities

Automatic gratuities 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. 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.

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.