IRS Now Enforcing Rule On How Restaurants Handle Automatic Gratuities

IRS rule on automatic gratuities

The Internal Revenue Service is cracking down to make sure restaurants comply with a 2012 rule change governing how servers’ gratuities are treated. The change may force restaurants to reconsider their policies on so-called “automatic gratuities.”   In an official IRS posting about the tax rules on reporting and withholding tips, the federal agency explains:

“Employees who receive cash tips of $20 or more in a calendar month while working for you, are required to report to you the total amount of tips they receive. The employees must give you written reports by the tenth of the following month. Employees who receive tips of less than $20 in a calendar month are not required to report their tips to you but must report these amounts as income on their tax returns and pay taxes, if any.”

But that’s not even the part that has restaurateurs perplexed and concerned.

The rule addresses how automatic gratuities are treated for tax purposes. Rather than simply divvying up these tips at the end of the night, all automatic gratuity tips will now be classified as service charges. So they will be taxed as regular wages and subject to payroll tax withholding.  According to the IRS, “These non-tip wages are subject to social security tax, Medicare tax, and federal income tax withholding. In addition, the employer cannot use these non-tip wages when computing the credit available to employers under section 45B of the Internal Revenue Code.”

What is the IRS Rule on Automatic Gratuities?

If you’ve ever dined with a large party, you’re familiar with how restaurants add a set amount on to the bill for the tip (typically 18% for parties of 6 or more).  It’s a common way to cut down on the work involved in calculating tips in a large party and helps ensure servers get gratuities in other situations.  Under the rule, restaurant owners and hospitality providers have two choices:

  • Add automatic gratuities to your wait staff’s wages.
  • Stop charging customers for automatic gratuities, if you want to avoid income tax complexities.

The IRS rule on automatic gratuities covers the following:

  • Large Party Charge (restaurant).
  • Bottle Service Charge (restaurant and night-club).
  • Room Service Charge (hotel and resort).
  • Contracted Luggage Assistance Charge (hotel and resort).
  • Mandated Delivery Charge (pizza or other retail deliveries).

Restaurant operators are concerned about the paperwork this rule will add to what they’re already juggling.

New IRS Tips Rule Finally Coming Into Play

The IRS automatic gratuities rule was originally announced in 2012. Restaurant owners and hospitality companies were given until this year to figure out how to comply.

Now, two years after it was first announced, the new rule is in force and concerns have intensified.  A representative of the National Restaurant Association, Christin Fernandez, told us here at Small Business Trends:

“While the IRS action regarding service charges does not change the law or initiate new policy, the ruling implies enhanced IRS enforcement. We expect some restaurateurs may, as a result, re-examine how they handle automatic gratuities in light of the rule going into effect January 1, 2014. For others, it may simply be business as usual (again, this is not a new policy and the ability for restaurateurs to determine auto-gratuity practices in their individual establishments has not changed in any way).”

Fernandez said that regardless of how individual restaurateurs respond to the IRS rule, it’s critical that operators maintain the flexibility to implement policies that make the most sense for their individual business, workforce and customers.

Gratuity Photo via Shutterstock


Susan Payton Susan Payton is the Communications Manager for the Small Business Trends Awards programs. She is the President of Egg Marketing & Communications, an Internet marketing firm specializing in content marketing, social media management and press releases. She is also the Founder of How to Create a Press Release, a free resource for business owners who want to generate their own PR.

25 Reactions
  1. This rule is a ridiculous one.

    More paperwork is not needed by servers and/or food-service businesses.

    A gratuity is a gratuity.

    Servers look at them as tips.

    Same thing.

    Who thought of this? I know; someone who has never been in the food business!

    The Franchise King®

    • I know, Joel. I’ll be interested to see how well they can enforce this. Cash is so easy to slip into that pocket…

    • With so much discussion about raising the minimum wage, living wages, etc. this seems counterproductive since most service industry employees receiving gratuities are in lower income brackets. Seems like an unnecessary burden to the business as well. #facepalm

    • You are right gratuity; gratuity is gratuity. It cannot be forced. According to the rule, in order for gratuity (a gift for service rendered) to be considered gratuity, it has to meet 4 rules: the payment must be made free from compulsion, the customer must have the unrestricted right to determine the amount, the payment should not be the subject of negotiation or dictated by employer policy, & the customer has the right to determine who receives the payment. Otherwise, it will be considered a service charge and will be taxed as regular wages. I will never agree that any type of “gift” should be forced. It’s voluntary! Also, waitress make more than you think. It depends on the restaurant in which they work. Many people will walk pass a homeless person , who isn’t making anything, but are so concerned with waiters not making much. There are other professions that don’t make as much either; do we “tip” them too? If it’s forced, it’s a service charge and not a tip. This burden should not be put on customers anyway. Customers should not be responsible for helping pay waiters their salary. Their boss should pay their wages, not the customer!

      • Only an ignorant person that isn’t in the service industry doesn’t want to tip. It’s an excuse. If you cannot tip because your cheap , or a rude person that probably runs their server into the ground and only comes out to dinner during happy hour and sits at a table for 2 hours Yeah us servers can get a job with higher wages. I’m in school and can only serve tables while in school. It’s an excuse not to tip. Us servers work super hard and give great service. I think people of a certain demographic or cheap take advantage of not tipping. Coming in late with huge parties right before closing, running the server and complaining non stop. Separate 20 checks then getting stiffed. We have to tip our bartenders, bussers, hosts. It’s super degrading. I’m going to school in south and people tend to be cheaper and ruder than Northerners tend to be the best tippers and appreciate getting served.

  2. Wow wee! Thanks Robert it is a burden. If people understood why and how to tip this auto grats wouldn’t be necessary. For you people, to keep food costs down I am paid $2.25 per hour. My tips should make up the remaining $5.25 and hour “minimum wage”. But certain groups have no idea how to be civil even if they are making great money like African Americans (10% or less), Internationals (0 to 5%), Arabic (50 cents to $1.00). I got $3.75 or a $90.00 tab last night working for 4 Arabic men for 1 hour!

    • Ask your employer to pay your wages. By federal law they have to pay the difference if you don’t receive minimum wage hourly in your tips. I am fine with higher menu prices and will never give arrogant, self entitled individuals such as yourself a gratuity. Have a nice day and quit being a racist. 😉

      • Paul, I prefer not to think of Jorge’s comment as racist, but as reflecting different cultural norms. Tipping is very different in the United States compared to the rest of the world. In many places tipping is not the norm. I’ve been to parts of the world where they look at you weird if you tip.

        And I’ve been in other places where tips were expected for things you’d never tip for in the United States.

    • Hi Jorge.

      You are being racist because you could have said the same message without specifying African Americans, I guess you chose specifically to do that which illustrates my point. Didn’t have to say some class of people, or some groups, and then identify African Americans as the first group – could have just said some people don’t tip well.

      Besides keep in mind, a tip is something extra, given for great service. Some of you provide attitudes, provide shitty service to us African Americans and then expect a tip. And as someone stated prior, instead of mentioning how African Americans don’t tip great, mention to your employer instead to pay you regular wage. Try that, combined with treating those African Americans you speak of with dignity, respect and hospitable, then enjoy the nice tips that you would get from doing that.

  3. I am a server at Bar Louie, a restaurant and bar run by corporate authority. From what I understand of this law, restaurants still have the right to add automatic gratuity if they undergo the proper procedures and do the correct paperwork. However, it seems that our corporate feels this is too much work and not worth dealing with, since they have taken away even our ability to add gratuity to tickets on our computer systems. Tonight, I watched a fellow server work her tail off taking care of a large party of about 30 people. This group was particularly rude and demanding. They were, in my opinion, acting with absolutely zero respect or class. These are the kind of people servers already expect a low tip from, if they tip at all. It is usually worth it having to deal with that kind of treatment from those type of people when you at least know you’ll be paid for your hard work due to gratuity. But thanks to Bar Louie corporate and the inability to grat that party, this poor girl received a a total $2 tip on a $400 tab. She wasted 4 hours of her life on these people who did not even have the courtesy to tip her. Along with tip-out for the bartender and bussers, she in theory would have paid the restaurant for her to serve that party. She left work in tears. As much as I love my job, it is sad to me that our corporate cares so little about their servers.

  4. My mother worked as a waitress most of her adult working life. She explained to me that a “gratuity” was meant to show you are grateful. Some of today’s server don’t exhibit that at all instead they are too busy texting or answering someone one on their phone, your glass sits empty while they clean tables or do other chores that they should take care of after serving their customers. I always tip………..according to the service I receive. Auto tipping sometimes makes that go down.

  5. Same thing happened to a co-worker. A ten top left a $10 tip. The waitstaff still has to tip out on their sales to the busser and the bartender. Our busser walked with more than the waitstaff.

  6. Hi all!

    At the end of the day, it is what it is. There is no way that Big Brother will change their course of action. So, we built something to start to make this process a lot easier.

    I’m Greg, the founder of Tip Network. We make it easy for restaurants, bars, nightclubs to easily track, manage, report, and distribute tips to staff and in between staff. You can use Tip Network from any browser and you do not need to integrate us with your Point of Sale. We can support over 1,000,000,000+ ways to track tipping.

    The way it works is really simple. You setup your store one time (adding employees, adding your tip out rules, and adding your banking details).

    Then on a day to day basis you (1) Setup Your Shift – Drag and drop which employees work in what role for that shift, (2) Checkout Employees- The manager can checkout an employee or the employee can checkout themselves (they always both need their 4-digit PIN number), and (3) Close Your Shift – Enter hours for those who part of a pool (we support hourly, evenly, weighted pools).

    We are in private beta right now but we are always accepting new customers. Feel free to reach out to be directly if you’d like to see a demo. Or, you can checkout some product screenshots here:

    We started Tip Network because we were bussers/servers/managers/operator ourselves. We think we are on to something and would love to share what we’ve built with you.


    – Greg

  7. The IRS obviously doesn’t like the idea of auto-grat because it is usually a large quantity of money that in a lot of cases goes unreported, and therfore untaxed. So they created this stupid legislature putting additional paperwork & burden on the employer. But in reality, it will just burden the server’s pockets because all the restaurant will do is say, “ok, no more auto-grat”. They don’t care, it’s not money out of their pocket so it’s not their problem. You think the restaurant owner would choose to do even one more page of paperwork to ensure their employees get a fair tip? Of hell no.

    • The auto-grat tips do not go unreported as income.
      In our area, the vast majority, (90%+) of all large parties pay by credit card.
      This is a record forever of the tip paid to the server.
      It seems like just another case of IRS run-amoks looking for revenue in the pockets of the working poor.
      They are skillfully making it look like it is the fault of the big greedy corporations.

      PS Give poor Bar Louie Corp a break, we use one of the nation’s largest POS systems for our sales and they, as of today in 2015, do not have the capability of conforming to the IRS rules. We would do it if we could but we don’t know how to comply, so we have no choice but to “86” auto-grat.

      • Has everyone that has replied here read the IRS rules regarding the 45b credit? And if so, do they understand it?

        I believe the reason that large corporate chain restaurants repealed the Auto-gratuity system is not because the reporting would be a costly confusing issue but because they would loose a tax credit they receive by the government on what they pay in as the employer portion of Social Security and Medicare tax.

        The IRS ruling change was that any auto gratuity charged to a customer needed to be classified as a “Service Charge” and would not be considered a “tip” anymore. So employers could no longer take a credit on these large auto gratuity amounts.

  8. For the record, it’s not the IRS singling out the lower income people (servers), the IRS is an equal opportunity tax collector. This is the reason the poor and ultra wealthy support high taxes, one gets something for nothing, the other feels guilty… The rest of us are stuck trying to make a better life for ourselves and our families while tax and spend politicians figure out how to take and spend more… Notice spending is never reduced… So servers have to take it in the rear like everyone else. It will never stop until we all say it must.

  9. You are right; gratuity is gratuity and cannot be forced. According to the rule, in order for gratuity (a gift for service rendered) to be considered gratuity, it has to meet 4 rules: the payment must be made free from compulsion, the customer must have the unrestricted right to determine the amount, the payment should not be the subject of negotiation or dictated by employer policy, & the customer has the right to determine who receives the payment. Otherwise, it will be considered a service charge and will be taxed as regular wages. I will never agree that any type of “gift” should be forced. It’s voluntary! Also, waitresses make more than you think. It depends on the restaurant in which they work. These are the same people that will walk pass a homeless person, who isn’t making anything, but is so concerned with waiters not making much. There are other professions that don’t make as much either; do we “tip” them too?

  10. Why can’t all the servers get together and do something about this Big corporation oligarch IRS ruling.
    There are enough of you to pull together to make the difference and make change in this ruling.

  11. As a server I don’t make minimum wage per hour. I depend on tips. That being said, we have been told by the bartender who is making more than 5xs the amount hourly I am and receiving tips, the amount daily we need to tip her depending on our dining room sales. Is this LEGAL?? I understand tipping out our bus boy as he doesn’t make min wage. Sounds fishy to me.

  12. while everyone else receives pay raises servers are stuck on a thirty year stand still hourly pay 2.13. It is a terrible thing honestly I read someone said why tip a server and not the homeless man if that is how you feel take your self to mcdonalds where you are not expected to leave a tip… We get up and go to work everyday and run our selves to the pint of having surgerys on our feets and wrist as a wrist from constant running and carrying items. I used to love severing tables until I started working where I am now! the guest act as though the workers are slaves and we are very unappreciated for our services, our credit card tips are withheld for a week and a half while the company draws interest off of their employs tips. Than we barley make a hundred dollar pay check even though we worked our 40 for 2.13 an hour and earned another hundred on credit tips. IF YOU WANT GOOD SERVICE TIP YOUR SERVERS OTHER WISE THEY WILL IGNORE AND NOT BRING YOU A REFILL AT HALF FULL!!!!!!!!!! And to be sure that your server receives the amount that you want too give to them leave it in cash so companies such as the one that I work for isn’t making tons of money and being greedy and making sure that they collect interest off of your servers credit tips!!.. We are people as well as everyone else and we do deserve to make our wages as everyone else does.. AND REMEMBER IF YOU SONT WANT TO TIP GO TO FAST FOOD. Even buffet servers at golden corral make 2.13 an hour…