Understanding Tip Credit: A Simple Guide for Employers

Cup with tag Your tips with cafe employee in the background, tip credit

This article is here to make sense of tip credit for you, in a way that's easy to understand.

What is a tip credit?

Tip credit is a rule that lets employers pay their tipped employees less than the minimum wage, as long as the tips the employees make up the difference. This means if you have staff like waiters who earn tips, you can count part of those tips towards meeting the minimum wage requirements.

The goal is to balance the earnings of tipped employees with those who don't earn tips, ensuring everyone makes at least the minimum wage.

Tip credit Vs. Tip pooling

While tip credit is about using tips to reach minimum wage levels, tip pooling is a bit different. Tip pooling involves collecting all the tips earned and then sharing them among a group of employees. This can help make sure that everyone, from the server to the kitchen staff, gets a fair share of the day's tips. It's important not to confuse the two, as each has its own set of rules and benefits.

How tip credits works?

Understanding how tip credits work requires looking at a few key aspects, including how they apply to wages, the role of tipped employees, and how to calculate them.

How tip credits apply to employee wages?

Employers can use tip credits by paying tipped employees a minimum cash wage directly, which is less than the full minimum wage. The difference between the minimum cash wage and the full minimum wage can be made up with the tips the employee earns.

This means, for instance, if the federal minimum wage is $7.25 per hour, and the minimum cash wage is $2.13, the maximum tip credit an employer can claim is the difference between the two, which is $5.12 per hour.

What is the qualifying criteria for tip credit?

A tipped employee is someone who regularly receives more than $30 per month in tips. To qualify for a tip credit, employers must ensure these employees are aware of the tip credit provisions and are allowed to keep all their tips (unless there's a valid tip pooling arrangement).

Additionally, tipped employees must earn enough in tips to make up the difference between the minimum cash wage paid and the full minimum wage.

Examples of calculating wages with tip credits

Let's break down a simple example. If a tipped employee's cash wage is $2.13 per hour and they work 40 hours in a pay period, their direct cash wages would be $85.20 for that period.

If the full minimum wage is $7.25 per hour for the same period, the total minimum wage obligation would be $290. Thus, the employee needs to earn at least $204.80 in tips during that period for the employer to meet the minimum wage requirements using tip credit.

Remember, the FICA tip tax credit allows businesses to claim a tax credit for the amount of social security and Medicare taxes paid on employee tips, further impacting financial considerations for employing tipped workers.

What are the pros and cons of tip credit?

Tip credit is a nuanced aspect of labor economics, especially within the service industry, where it has distinct advantages and disadvantages. Here's a straightforward look at the pros and cons of tip credit.


Lower labor costs for employers:

By utilizing tip credits, restaurant owners and other employers in the service industry can reduce their labor costs. This is because they are allowed to pay a lower direct cash wage to their tipped employees, under the expectation that tips will make up the difference to reach at least the federal or state minimum wage.

Potential for higher employee earnings:

Tipped employees often have the opportunity to earn more than the minimum wage through their tips. In busy establishments or high-end venues, the potential for earnings can exceed what the employee might earn in a non-tipped position at the same hourly wage.

Flexibility in payroll management:

Tip credit provides employers with flexibility in managing payroll expenses. This can be particularly beneficial for new or small businesses in the hospitality industry, where profit margins are often thin.

Encourages better customer service:

Since a significant portion of a tipped employee’s earnings comes directly from customers, there is an incentive for employees to provide excellent service to increase their tips.


Income instability for employees:

The amount of money a tipped employee makes can vary widely from day to day and season to season, leading to financial instability. Employees may find it challenging to manage their finances due to the unpredictability of their total earnings.

Complicated wage calculations:

Managing tip credits can complicate payroll calculations, requiring meticulous record-keeping and constant vigilance to ensure compliance with minimum wage laws. This complexity can be burdensome, especially for small business owners without dedicated HR departments.

Potential for wage theft:

If not properly monitored, there’s a risk that employers might not make up the difference if an employee’s tips plus the direct cash wage do not reach the minimum wage. This situation can lead to unintentional or intentional wage theft.

Useful Read: Employee Theft: Essential Prevention Strategies for Businesses

Dependence on customer behavior:

Employees’ wages are significantly influenced by customer behavior, which can be affected by factors beyond the employees' control, such as economic downturns, seasonal changes, or even the location of the establishment.

Regulatory compliance:

Staying compliant with both federal and state labor laws regarding tip credits can be challenging, especially as regulations may change or differ significantly between states. Non-compliance can lead to legal and financial repercussions for employers.

How to calculate tip credit?

Restaurant manager making calculations for restaurant accounting

Let's make sense of how to figure out tip credit, step by step. This part is for employers who want to ensure they're doing everything by the book but want it explained simply.

Step-by-step guide on how to calculate tip credit

  • Know the minimum cash wage: Start by knowing the direct cash wage you must pay your tipped employees. This is less than the full minimum wage and set by law.

  • Understand the full minimum wage: The full minimum wage is the regular minimum wage all employees should earn per hour. This varies by state but is at least the federal minimum wage.

  • Calculate the maximum tip credit: Subtract the minimum cash wage from the full minimum wage to find the maximum tip credit you can claim per hour.

  • Track hours and tips: Keep accurate records of the hours worked by tipped employees and the tips they receive.

  • Ensure tips meet the gap: Verify that the tips received, plus the direct cash wage paid, meet or exceed the full minimum wage for all hours worked.

  • Adjust for overtime: For overtime hours, ensure you pay at least 1.5 times the employee's regular hourly wage, minus the tip credit, for any overtime worked.

  • Notify employees: Make sure your employees know about the tip credit being claimed and their rights under the Fair Labor Standards Act (FLSA).

Laws governing tip credit

Navigating tip credit laws is crucial for staying within the legal lines. Let's look at what the federal government says about this.

Overview of federal laws regarding tip credit

The Fair Labor Standards Act (FLSA) is the big player here. It allows employers to pay a lower direct cash wage to employees who regularly receive tips, as long as their earnings with tips meet the federal minimum wage.

The FLSA sets the rules on the minimum cash wage, the maximum tip credit, and the obligation to inform employees about the tip credit. State laws can also come into play, sometimes offering higher protections for workers. Keeping up with these laws ensures you're not only fair but legal.

Tip credit’s impact on restaurant finances

Understanding tip credit is more than just legal compliance; it's about seeing how it fits into your restaurant's bigger financial picture.

Financial benefits of tip credit for restaurants

Tip credit can really help your restaurant financially. Here's how:

  • Lower direct wages: By paying a lower hourly wage to tipped employees (thanks to tip credits), your initial payroll expenses are reduced.
  • Flexibility in payroll management: The ability to count tips towards meeting minimum wage requirements offers flexibility in managing payroll costs.
  • Increased profitability: Lower direct labor costs can lead to improved profit margins, as long as service quality remains high and employees are motivated.
  • Tax benefits: The FICA tip credit can offset some of the payroll taxes on the tips employees report, providing a tax saving for your business.
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The tip credit system offers a blend of opportunities and challenges for both employers and employees in the service industry. It allows businesses to manage labor costs effectively while potentially enabling employees to earn more through customer tips.

However, the variability in income for workers and the complexity of managing and complying with tip credit regulations highlight the need for careful navigation.

Ultimately, understanding and thoughtfully implementing tip credit can lead to a more sustainable balance between profitability for restaurants and fair compensation for employees. Striking this balance is crucial for the health and success of the service sector.

Topic: Payroll EN
Rinaily Bonifacio

Written by:

Rinaily Bonifacio

Rinaily is a renowned expert in the field of human resources with years of industry experience. With a passion for writing high-quality HR content, Rinaily brings a unique perspective to the challenges and opportunities of the modern workplace. As an experienced HR professional and content writer, She has contributed to leading publications in the field of HR.


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