Automatic gratuities for large parties are commonplace in many restaurants, bars, and hotels throughout the country. However, as of January 2014, the Internal Revenue Service (IRS) now classifies these automatic gratuities as “service charges.” As a result, the automatic tips will be treated as regular wages and subject to payroll tax withholding.

According to the information contained in the IRS’s Topic 761 – Tips – Withholding and Reporting (which was last updated on January 8, 2014), service charges that the employer adds to a bill and requires customers to pay, when paid to an employee now constitutes non-tip wages. These non-tip wages are subject to social security tax, Medicare tax, and federal income tax withholding.

In addition, these non-tip wages cannot be used by employers in computing the credit available to employers under section 45B of the Internal Revenue Code (which regulates employer credit for portions of social security taxes paid on employee cash tips) because these amounts are not “tips.”

The IRS’s Tax Topic on tips lists the following as common examples of service charges (sometimes called “auto-gratuities”):

• large party charges (at restaurants),
• bottle service charges (at restaurants and night clubs),
• room service charges (at hotels and resorts),
• contracted luggage assistance charges (at hotels and resorts),
• and mandated delivery charges (on pizza or other retail deliveries).

The IRS now takes the position that because automatic gratuities are not voluntary, they are service charges. In determining whether a customer payment is a tip or service charge, the IRS uses several factors, including, whether the payment is made “free from compulsion” and whether the customer has the “unrestricted right to determine the amount.”

Impact on Employers

With the change in the way that the IRS classifies automatic gratuities, many service-based employers may choose to discontinue the practice of adding automatic tips to bills. Modifying such policies will alleviate the administrative burden of tracking and deciphering automatic gratuities versus tips. Moreover, should a restaurant or bar choose to maintain an automatic gratuity policy, those charges will likely need to be factored into the employees’ regular rate of pay for purposes of calculating overtime.