When dining out, many restaurants automatically add an 18% gratuity for large parties of six or more. However, restaurant owners must understand that this restaurant service charge is legally classified as a service charge rather than a tip under federal tax law, even if it is labeled as a tip on the customer’s receipt.
Distinguishing Between Tips and Service Charges
The Internal Revenue Service (IRS) determines classification based on substance rather than name. A true tip must be paid completely at the customer’s discretion, without compulsion, with the amount determined by the customer, and not subject to negotiation or employer policy. Because mandatory automatic charges fail these criteria, they are treated as service charges. If a customer voluntarily adds an additional 5% on top of the mandatory 18%, only that voluntary portion qualifies as a tip.
Sales Tax and Payroll Implications
California sales tax regulations generally treat mandatory automatic charges for large parties as taxable. Even if distributed entirely to staff, the mandatory service charge is included in the taxable sales base for taxable food and beverages. In terms of payroll, service charges are initially recorded as restaurant revenue and distributed amounts are treated as standard wages rather than tips. Consequently, employers must withhold taxes, report them on Form W-2, include them when calculating overtime, and they are ineligible for the FICA Tip Credit.
