Waiter writing down the order of customer at the restaurant

With changes to state minimum wages impacting restaurants across the country, many operators are shaking up the traditional tip model by experimenting with alternatives such as building tips into menu prices or charging service charges or fees in lieu of tips.  

“A lot of things are being tried,” says Anthony Anton, president and CEO of the Washington Hospitality Association. “It’s fair to say there’s not really a winner emerging yet.”

Like many restaurants, A Good Egg Dining Group in Oklahoma City used to charge automatic gratuity on parties of eight or more. However, they ended the practice several years ago. “We thought if the customer didn’t feel it was worth it, we’re not putting in on [their bill],” says Gary Sander, vice president of accounting for A Good Egg Dining Group. In his experience, “instead of adding an automatic 18 percent gratuity, the guests will put more than that on themselves,” he adds.

However, the restaurant does charge a service fee for private parties and banquets, which is disclosed to the customer upfront. “We discuss ahead of time how many servers we would put on a party of that size and we charge a percentage of dollars per server,” Sander says. “A certain number of people equals a certain number of servers. Sometimes they’ll want more servers or occasionally they’ll add a bartender because they want the bar to move faster.”

The IRS now classifies automatic gratuities as service charges, not tips, because tips can only be freely given by the customer.

Alternatives to Traditional Tips

  • Tip sharing: Eater reports that last spring, the federal government amended the Fair Labor Standards Act to allow tip sharing between tipped and non-tipped (for instance, cooks or busboys) employees. This change may not mean much to customers, but for restaurant staff, it means that back-of-house staff in many states can now share in tips provided the restaurant pays the full minimum wage to all employees (seven states, mainly on the west coast, actually require employers to pay the full minimum wage before tips). However, some states including Massachusetts prohibit tip-sharing even if all employees earn minimum wage.
  • Service charges: According to Anton, some restaurants now charge a service charge ranging from about 15-22 percent, which is meant to replace the tip. “In a service charge situation, the owner has complete control over the income,” he says. “The only requirement is to disclose how it gets distributed.”
  • Service fees: A service fee is similar to a service but it’s generally a smaller percentage. “It’s to offset the cost of the experience in a higher regulated city,” Anton says.
  • Service included model: Instead of adding a service fee or service charge to the bill, some restaurants simply build it into their menu prices, similar to many restaurants outside the U.S. For instance, when Nordic restaurant Agern opened in New York City’s Grand Central Terminal in 2016, restaurateur Claus Meyer reportedly set prices high enough to cover a living wage, health insurance, and paid parental leave for employees.

    But this model doesn’t always work because higher menu prices can alienate customers who aren’t used to the service-included (sometimes called “hospitality-included”) model. Meyer rolled back prices last year. The restaurant’s website now states: “Agern is no longer a service included restaurant and our prices have lowered to reflect this change. We remain committed to carefully sourcing our ingredients and correctly compensating our dining room and culinary teams.”

Unfortunately, there doesn’t seem to be a good one-size-fits-all solution. “What’s working well for a casual place doesn’t work well for fine dining,” Anton says.

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Tax Treatment of Tips vs. Service Charges

There are some differences in the tax treatment of tips or gratuities versus service charges.

“[A service charge] is often used to pay for various employee benefits and higher wages which yield a corresponding deduction and may net to zero federal tax effect,” says Catalin Clarke, CPA, senior accountant at the Doty Group, P.S., an accounting firm in Tacoma, Washington. “However, certain state and/or local taxes may be based off gross income rather than net. For example, the Washington State Business & Occupation tax would consider a 20 percent service charge paid to a restaurant taxable income; however, not a 20 percent tip paid to a waiter.”

Clarke adds that “a portion of FICA taxes paid on tips are eligible as a federal tax credit to the restaurant, whereas FICA taxes paid on wages—even higher ones to offset the loss of tips—are only a deduction for federal tax purposes.” Tax credits are more advantageous to a business than tax deductions, because tax credits provide a dollar-for-dollar reduction of the taxes owed.

That said, the employee benefits and wages generated by service charges can be a useful tool to retain talent in a competitive labor market, adds Clarke. “The tax implications should be carefully considered when making any business decision, however they are not the only consequences to consider,” she says. Keeping up with federal, state, and local regulations can be tricky for any restaurateur, so she suggests consulting a CPA or business advisor who’s familiar with the rules in your jurisdiction.

How to implement a new service model

Communication with employees and customers is key when you’re changing your business model. It’s especially challenging to veer from traditional tipping when you cater to tourists or other populations who aren’t regulars, because then you’re constantly having to explain an unfamiliar model.

“If you’re in a situation where most of your customers are repeat customers, for the first month or so, have extra management hours available,” Anton says. “Putting the servers in the middle of the conversation is not necessarily a win for the business…Having management be extra available and keeping the employee from that awkwardness has been a best practice as I’ve witnessed it.”

Still, despite the growing pains, Anton predicts that this is where the industry is headed long term. “We know the model has to change,” Anton says. “The question is, what’s going be the biggest win for [everyone]? It wouldn’t surprise me if we stay in this mode for a couple more years until we find that right answer.”

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Austin, Texas-based freelancer Susan Johnston Taylor has written about food and business for publications including The Boston Globe, Civil Eats, Entrepreneur, FastCompany.com, Fresh Cup, and Pizza Today. She'd eat goat cheese on almost anything.