How To Pay Tips To Employees: A Tip Management Guide for SMBs

a graphic showing an employee holding a tip jar
a tip jar

Wondering how to pay tips to employees? Gratuity payments are a central component of compensation for employees in certain industries. In the United States particularly, many members of the workforce generate a large part of their income from getting tips. In a lot of cases, tips are paid largely in lieu of salaries or hourly wages.

Of course, there are some important laws and protocols to follow when dealing with tipped employees. Reviewing these regulations will ensure that you properly compensate your staff while remaining compliant with taxes. Read on to learn more about how to manage employee tips.

What Is A Tipped Employee?

When we think about tipped employees, our minds immediately go to the restaurant industry. Indeed, serving and bartending are the occupations that rely most on gratuity. In fact, the average wait staff worker in the US makes almost sixty percent of their income from tips. 

Many other service industry workers receive gratuity on a daily basis. Hairdressers are often tipped by their patrons because they usually aren’t the ones that own the salon outright. Taxi and Uber drivers also receive tips quite frequently, especially for extra service and special circumstances such as loading luggage or making an extra stop.

Employees from several retail industries also frequently receive tips. One of the more obvious ones to come to mind is coffee shops. Busy coffee shops accumulate considerable amounts of tip income for baristas, cashiers, and, increasingly, kitchen staff.

Another retail industry that sees a decent amount of tips is cannabis. Budtenders often get tips from customers for making personalized suggestions and offering competitive discounts. Unsurprisingly, some clientele will return to a dispensary to get waited on by specific budtenders.

What Are Tip Credits?

In industries where the majority of money is made from tips, employers are given the option of using a tip credit deduction.

Here’s how it works. The federal minimum wage is $7.25 an hour. The Fair Labor Standards Act (FLSA) allows your business to deduct $5.12 per hour for tipped employees, bringing the burden for employers to $2.13 an hour. This is only allowed if employees are making more than the minimum wage via tips for a weekly or biweekly pay period.

Tipped Employee Hourly Wage Laws 

California and Minnesota stand out in that they don’t allow tip deductions at all. Other cities and states dictate their own minimum wage laws. For example, New York City’s minimum wage is $15 an hour. Tip deduction allowance in NYC is $5, meaning employers can pay their wait staff $10 an hour instead of $15, as long as that employee receives at least the remainder of $5/hour in tipped income. Should an employee not make that amount in tips for any particular shift, the merchant must pay them the difference through an increased hourly wage. Employers should be aware of the local minimum wage and tip deduction laws in order to process payroll, pay taxes, and avoid fines properly.

In most industries with smaller tip jars, such as coffee shops and other retail environments, employers will typically keep the wage the same and give the tips to workers as a bonus. Offering these monetary benefits increases staff retention and morale. Plus, it’s the right thing to do. If you want great service, pay your employees well and incentivize their performance with tip compensation.

a coffee shop counter

What Is Tip Pooling?

Tip pooling is a system in which employees put together all of their gratuity in a single pool to be fairly distributed upon the completion of each shift, day, or week. The money is then distributed based on hours. Sometimes this dispersal is computed using a points-based system. For example, one common system among restaurants gives servers and bartenders a higher percentage of tips than food runners and bussers. Recently changed laws have made it legal to include back-of-the-house employees in this pool.

Again, pooled tips are applicable to the aforementioned retail industries as well. Cannabis dispensaries typically have shared tip jars for budtenders.

Similarly, if you plan on opening a coffee shop, you will likely have more than one person working at a time. A predetermined system must be set up to distribute gratuity to compensate the cashier, barista, food prepper, and anyone working to serve customers. Remember, though, managers and ownership are not legally entitled to these tips. There are steep fines for violating this rule.

Payroll For Tips: Issuing Credit Card Gratuity

With a robust point of sale system, all of your credit card gratuity will be automatically pushed to your reports. These reports will then be given to payroll to ensure that employees receive the proper dispersal of credit card tips. KORONA POS will also calculate all necessary taxes on credit card tips. 

All credit card tips must be dispersed during the following pay period. Employers cannot wait until banks or credit clearing houses issue them money. However, employers can deduct all transaction and processing fees that credit cards charge retailers and restaurants.

Employers Must Pay Taxes On Tips

Your staff must report all of their tips to you. They are a part of the official income for your employees and must be treated as such. Businesses must keep records and tabs of all of their employees’ tipped income. Be sure to implement a standard operating procedure for officially reporting these tips.

Additionally, employers are required to retain portions of employee taxes and must perform all of their typical tax payment duties for tipped income. This includes FICA taxes, like Medicare and Social Security, and FUTA, or unemployment tax. Finally, tipped wage information must be filled out on all tax forms such as W2, W3, Form 951, and Form 941.

KORONA POS has exceeded my expectations in every way. It’s a powerful, adaptable solution that has transformed our operations for the better.

-James B.

Equip Yourself With Great Point Of Sale

Simplify your tip processing with a cloud-based point of sale. KORONA POS offers native gratuity management to make your work life easier and allow you to focus on running other aspects of your business. Our employee set up and work flow is straightforward and intuitive. Best of all, we offer 24/7 customer service from our in-house technicians. Give us a call today to learn more about our retail POS software!

FAQs: How To Pay Tips To Employees

Do employers pay payroll taxes on tips?

Yes, employers pay all typical payroll taxes for tipped income. This includes Medicare, Social Security, and unemployment taxes. Employers are also required to retain all employee tip records.

How do employee tips work?

Tips can be issued to employees directly from cash or through credit card payments. Either way these tips must be reported and taxes must be paid for them by both employer and employee. 

How do you separate tips between employees?

Many restaurants have their servers keep their own tips individually. Other businesses will “pool” their tips, collecting them in one big pot and then redistributing them based on hours worked. Some places will organize their dispersal based on tiered employee percentages, with servers making higher portions than food runners and bussers, for example. 

What is the difference between cash tips and paycheck tips?

Cash tips are directly taken from customers. Paycheck tips are generally credit card tips that are processed by the employer and distributed by payroll for tipped employees. There are some situations where restaurants will convert credit card tips into cash for daily dispersal. 

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Written By

Shane Ortale

As a history enthusiast, Shane loves reading and writing. He blogs about small businessmarketing and cloud based POS. He is also an avid bird watcher, and Liverpool FC fan.