Group Sales Contracts, Service Charges, and Tips - What's in a Name?
By John R. Hunt Attorney, Stokes Wagner Hunt Martez & Terrell, ALC | September 23, 2018
This article is co-authored by Ashley S. Nunneker
In negotiating any kind of contract covering a group event, the use of the appropriate contract language to describe how those employees who serve the food and beverage functions will be compensated is essential on the part of a hotel or restaurant. Often, standard form contracts take this compensation for granted or use the terms "gratuity" and "service charge" interchangeably. This confusion can result in unintended consequences, including claims for back wages and overtime, lawsuits under state "tip" statutes, and even class actions. The following attempts to add some clarity to this area and identify best practices.
Gratuities are Voluntary
Hospitality guests historically have used gratuities to acknowledge excellent work performed by a hotel or restaurant's service staff. Servers, bartenders, buspersons, and other employees have come to expect and rely on gratuities as a major part of their compensation. At the same time, hotels and restaurants often will impose mandatory service charges in connection with certain events and functions. The simultaneous use of the terms "gratuity" and "service charges" by a business can lead to confusion. In consequence, an appreciation for the distinction between the two concepts is important.
Simply put, the difference between a gratuity and a service charge is that a gratuity is a voluntary amount paid by a guest in recognition of the service performed while a service charge is a mandatory fee imposed by a hotel or restaurant that usually is a fixed percentage of a customer's bill. In the case of gratuities, the amount is left to a customer's discretion and its payment is completely optional. Because the decision of whether to leave a gratuity is inherently voluntary on the part of the guest, the term "automatic gratuity" can be a misnomer. Although the terms "tip" and "gratuity" generally are synonymous, "gratuity" is preferred as the industry standard.
Properly classifying a payment as a gratuity is essential for two fundamental reasons. First, certain states do not subject gratuities to sales tax. These states include some of the more popular locations for conventions and meetings, such as Arizona, California, Florida, Georgia, Massachusetts, New York, and Washington.
Second, whether a payment is a gratuity or a service charge also can have a direct impact on an employee's compensation. For example, an employee's receipt of a sufficient amount of gratuities may allow an employer to offset its minimum wage liability through the use of a "tip credit." In many states, an employer may pay a cash wage of $2.13 per hour as long as it ensures that the employee also has received an additional amount in tips that renders the total amount equal to or greater than the federal minimum wage of $7.25 per hour.
Similarly, many employees participate in "tip pools" in which all gratuities received during the course of a shift are pooled and then distributed. The questions of which employees may participate in a tip pool and to what extent have become the subjects of a substantial number of lawsuits in recent years. In some cases, courts have found that even servers and bartenders cannot spend more than twenty percent of their time on "non-tipped" activities, such as general cleaning and food preparation, making them ineligible to participate in a tip pool. Other courts, however, have held that the twenty percent limit is not supported by the underlying federal law. Accordingly, the subject remains an open issue and identifying which employees are eligible to receive gratuities is an important aspect of compliance and litigation avoidance.
The following are key traits of a gratuity or tip:
- The customer determines the amount;
- A tip or gratuity is not subject to sales tax or income tax on the part of the employer;
- The employer is responsible for withholding taxes only from those gratuities it administers through payroll (i.e. credit card tips and tip share);
- A tip or gratuity is not included in the calculation of an employees' overtime rate of pay; and,
- Neither is considered a "sale" by the Employer and they are not reported in the employer's calculation of gross revenues.
Best practices to limit exposure:
- Present the bill to the guest with the gratuity area left blank, so the guest may voluntarily write in the amount. Take this opportunity to also inform guests that gratuities are optional;
- A restaurant or hotel may include "suggested gratuity" calculations on the check, provided that the guest ultimately decides the amount; and,
- Be sure to use terms consistently on all payroll records to dispel any uncertainty about the nature of the payment. For example, if a business administers credit card gratuities or tip share through its payroll, it should use the term "gratuity" on employees' paystubs if that is the term used on guest bills.
Service Charges are Mandatory
As noted above, a service charge is a compulsory fee imposed by a hotel or restaurant on a guest's bill, usually as a percentage of the overall amount. Unlike gratuities, guests are not given discretion to determine the amount or the recipients of a service charge. To further complicate matters, some businesses refer to service charges as "auto-gratuities" on bills. Nevertheless, if the guest lacks discretion in determining the amount of the payment and who will receive it, the payment cannot be treated as a gratuity.
The most common examples of service charges in the hospitality industry are those charges imposed in connection with banquets, weddings, and other group functions. Further examples of service charges in the hospitality industry can include large-party charges at restaurants, bottle service charges at restaurants and night clubs, room service charges (for both a la carte and function service), and luggage assistance charges at hotels.
The proper identification of a particular payment as a service charge can be important for a variety of reasons. Among other things, service charges generally are recorded in an establishment's gross receipts and subject to income tax. Moreover, the receipt of service charges by employees may entitle an employer to take advantage of the exemption to the overtime requirements of the federal Fair Labor Standards Act. Under § 7(i) of the FLSA, an employer is not required to pay an employee overtime if the employee's regular rate of pay exceeds time and one-half the minimum wage and over half the employee's compensation during a representative period comes from commissions.
Both the federal courts and the U.S. Department of Labor have recognized that service charges received by hospitality employees can constitute commissions within the meaning of this law. In the seminal case of Mechmet v. Four Seasons Hotels, a federal court of appeals rejected an argument that only sales persons can earn commissions and held that banquet servers who receive service charges can come within the § 7(i) exemption if its requirements are met. Among other things, the court recognized that each banquet "is a big-ticket item, costing thousands of dollars and requiring a concerted effort by the banquet staff. And the demand for banquets at the hotel is irregular – it is, one might say, a matter of feast or famine.
Moreover, the length of a banquet cannot easily be gauged in advance, since it depends on how good a time the banqueters are having. It would be impossible in these circumstances to arrange things so that every banquet waiter worked 40 hours every week." Other federal courts have reached the same conclusion since Mechmet was decided and banquet as well as room service personnel can come within the § 7(i) exemption under the right circumstances. Thus, the proper designation of service charges and their distribution to employees can result in substantial savings in overtime compensation.
Key characteristics of a service charge include:
- The hotel or restaurant pre-determines the amount;
- The service charge is recorded in gross receipts and subject to income tax on the part of the business;
- If an employee does not qualify for the § 7(i) exemption, service charges are included in calculating overtime rates of pay; and
- Subject to employer and withholding taxes if distributed to employees.
Best practices for handling service charges:
- Some states and localities require employers to distribute 100% of service charges to customer-facing staff. For example, a Massachusetts law requires that a service charge may only be distributed to a waiter, waitress, bus person, counter staff or service bartender. New York and California also generally require that service charges be distributed only to service employees Other jurisdictions allow a business to decide whether to retain all or a portion of a service charge or to distribute some or all of it to employees (Georgia and Florida, for example). We recommend distributing service charges to the service staff, even if the hotel or restaurant is located in a jurisdiction that allows the business to keep a portion;
- If the business distributes a portion of the service charge to employees, it should assure that the employees are paid within the same pay period in which the service charge was earned;
- If an establishment decides to provide guests with the option to tip on top of a service charge, it should provide a blank line on the bill for the guest to write in an "optional gratuity" rather than "additional" gratuity. The word "additional" incorrectly suggests that the service charge is also a gratuity;
- State and local regulations vary on the requirements for communicating service charges to guests on menus and receipts. We recommend plain language and 12-point font to ensure compliance across state lines;
- Never merge a mandatory service charge with a gratuity on a bill into one amount. Each payment should be clearly and separately identified on the bill.
States also differ regarding other fixed charges like delivery fees. Some states consider a delivery charge to be a gratuity if a reasonable person would believe the charge would rightfully belong to an employee, while others firmly label these amounts as service charges.
In conclusion, a hotel or restaurant should consult with its counsel to ensure that its agreements use the appropriate language and the establishment's service charge and gratuity practices are in compliance with the laws where it conducts business.
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