What You Need To Know About Automatic Gratuity Laws In Restaurants

Automatic gratuity may be useful in many circumstances, such as when each table requires separate checks, banquets, and large parties (typically 6, 8 or more), or when there are multiple people at the table. You can implement an automatic gratuity policy by contacting your local insurance agent. restaurant POS systemBefore you can start, you should know a few basics about federal and state laws. 

In this article we’ll cover the following:

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Technically, automatic gratuities can be considered as service charges

It’s important to understand that even though it’s called a gratuity, as far as the Internal Revenue Service (IRS) in the US is concerned, automatic gratuity charges are labeled a service charge. 

The IRS explanationThese are the elements that differentiate tips from service costs. Let us explain what you need to be considered a tip.

  • The customer can’t be required to pay it
  • Customers decide the exact amount
  • It’s not the result of negotiations or decided by policy
  • The payment is made by the customer, usually the server.

However, service charges are defined by the IRS as the following:

  • Large dining parties receive an automatic gratuity
  • Banquet event fees
  • Packages for cruise trips
  • Charges for hotel room service
  • Charges for bottle service


What is the best way to report gratuities that are automatic to the IRS

Tips are reported differently than automatic gratuity fees. The employee receives a gratuity fee as non-tip wages. It is subject to taxes withholdings, and any other filing requirements.

Restaurant bills often have a standard tip line that shows on all checks, even when automatic gratuity has been added. This allows guests to tip their servers in addition to automatic gratuity, if desired. 

Most automatic gratuities average between 15-18%. Those who want to tip 20% or more will enjoy the chance to pay the exact amount that they think they are due. Any gratuity paid to servers in addition to automatic gratuity should be reported as tipped wages.


Can restaurants charge automatic gratuity?

The IRS dictates all gratuity reporting. This means every US restaurant must follow these rules. However, state laws may still impact how gratuity is handled at the state level. It is legal to charge automatic gratuity on a federal level, but how it’s reported on taxes will vary state by state.

California has its own automatic gratuity law. Service charges tax law, but it’s essentially the same thing as the federal laws (the California law came first, actually). If you’re thinking about implementing one, have a look at your state laws anyway. It’s better to be safe than sorry.


Customers are required to pay gratuity automatically

You might remember the 2013 scandal when a pastor in Missouri refused to pay the automatic gratuity charge given to his table at Applebee’s because it was a large group. Instead, he wrote on the check “I give God 10%—why do you get 18?” as Forbes reported.

Unfortunately, for the pastor the law did not favor her. Columnist for the Belleville News-Democrat explains in an article that addresses whether or not diners are required to pay automatic gratuity, “Restaurants are still free to charge a mandatory fee if they wish.”

This article refers specifically to the IRS’s change in how automatic gratuity reports are made. Many restaurants had been treating automatic gratuities in the past as tips. However, this changed on January 1, 2014. If you start implementing an automatic gratuity policy, there’s a chance that some people might still think of the charges in pre-2014 terms.

If you’re still on the fence about whether or not an automatic gratuity policy is right for your restaurant, consider asking your service staff. They’ll certainly have opinions about what works best for them. Also, most POS systems allow auto gratuity to be applied at the server’s discretion, which is a great way to let them best serve their tables.

Close up of a table setting with candles and flower vases.


How do restaurant professionals feel about gratuity in restaurants? 

Restaurant owners are trying out new ideas to replace the old tip model. Some operators have begun charging additional fees for service or adding tips to menu prices. “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.”

Similar to many restaurants A Good Egg Dining GroupOklahoma City was once known for charging gratuity automatically to parties with eight people or more. They ended this practice many years ago. “We thought if the customer didn’t feel it was worth it, we’re not putting it 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% gratuity, the guests will put more than that on themselves.”

The restaurant charges a fee to host private events and banquets. This is made known 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.” 


Four alternatives to automatic gratuities and traditional restaurant tips

1. Tip sharing

Eater ReportsThe Fair Labor Standards Act was amended by the federal government last spring to permit tip-sharing between employees who are tipped or not. While this may not have much impact on customers, for many restaurants it will mean that back-of the house staff from several states are now allowed to share tips provided they pay all employees the minimum wage.seven statesMost states, particularly those on the west side, require that employers pay the entire minimum wage before tipping. Some states include however MassachusettsTip-sharing is forbidden, regardless of whether all employees make minimum wage.

2. Charges for service

Anton says that some restaurants charge service charges ranging between 15-22%. This is to replace tipping. “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.”

3. Service charges

A service fee is similar to a service charge but it’s generally a smaller percentage. “It’s to offset the cost of the experience in a higher regulated city,” Anton says.

4. Service-included Model

Some restaurants don’t add any service fees or charges to your bill. Instead, they simply include it in their menu prices. You can see it in the example of when Nordic restaurant Agern was 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. 

Two people sit at a table with menus in hand, looking up at the server who is speaking to them.

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 reduced 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.


How to create 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.”

Anton believes that the future of the industry will be here, even with the current pains. “We know the model has to change,” Anton says. “The question is, what’s going to be the biggest win for [everyone]? It wouldn’t surprise me if we stay in this model for a couple more years until we find that right answer.”

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Cyndy Lane

Cyndy is business journalist with a focus on entrepreneurship and small business. With over a decade of experience covering the startup and small business landscape, Cyndy has a reputation for being a knowledgeable, insightful and approachable journalist. She has a keen understanding of the challenges and opportunities facing small business owners and is able to explain them in a way that is relatable and actionable for her readers.