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New IRS Rule Prompts Restaurants to Abandon Automatic Gratuity

In response to a new IRS rule which takes effect on January 6, 2014, some major restaurant chains are eliminating automatic gratuities from large party checks.

The New IRS Rule on Automatic Gratuities.

The new IRS rule requires restaurants to treat automatic gratuities as “service charges” rather than tips. The significance? Service charges count as regular wages, subject to payroll tax withholdings. Tips do not.

The rule change has significant, practical implications for both tipped employees and employers. For tipped employees, they will no longer be able to pocket automatic gratuities at the end of their shifts. Instead, the automatic gratuities will be added to the employees’ bi-weekly paychecks, from which payroll taxes will be deducted.

For employers, the rule change will almost certainly complicate payroll accounting. Currently, employers generally leave it to their employees to report their tips, including any automatic gratuities they receive. Going forward, employers will have to differentiate between regular tips and automatic gratuities, treating the latter as regular wages to be processed through payroll. This will, in turn, complicate minimum wage calculations since most employers utilize the “tip credit” to pay their employees a reduced minimum wage.

The Industry Response.

Some major restaurant chains have responded to the IRS rule change by eliminating automatic gratuities altogether. Texas Roadhouse has announced that it plans to phase out automatic gratuities by the end of the year. Darden Restaurants—which operates Red Lobster, Olive Garden, Longhorn Steakhouse, Seasons 52, The Capital Grille and other chains—has stopped including automatic tips at 100 restaurants in four cities. Instead, it is testing a new system in which it lists three suggested tip amounts (15%, 18% or 20%) on all customer bills, regardless of party size. Industry experts expect more restaurants to follow suit by eliminating automatic gratuities.

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