Service Charges vs. Tips: Which Payments Count as Commission Under FLSA 7(i)? (You Might Be Surprised)
This is one of the trickiest questions restaurant owners face. The distinction between tips and service charges is critical. Furthermore, it determines compliance with the Fair Labor Standards Act (FLSA). Specifically, this affects the Section 7(i) exemption for commissioned employees.
The direct answer is clear: mandatory service charges paid to employees may count as commission for the FLSA 7(i) overtime exemption, but tips paid directly by customers never count. This difference is a central point of confusion, and incorrect classification can lead to significant penalties. Let’s break down this complex FLSA rule.
The Confusion Point: Tips Versus Mandatory Service Charges
The FLSA defines tips and mandatory service charges very differently. This fundamental difference is key to understanding the Section 7(i) exemption.
A tip is a voluntary payment. It is an amount determined solely by the customer. The customer is under no compulsion to pay it. Furthermore, tips are the property of the employee, with some exceptions for valid tip pooling.
A mandatory service charge, however, is not a tip. It is a compulsory charge added to the customer’s bill. Examples include automatic gratuities for large parties or banquet fees. Because the customer is required to pay it, it is considered revenue for the business. Therefore, it is part of the employee’s gross wages when distributed.
The FLSA Section 7(i) exemption offers relief from overtime pay. This exemption is for employees of a retail or service establishment. It applies if an employee’s pay is largely based on commission.
| Payment Type | Customer Discretion | Employee Ownership | Can Count as Commission for FLSA 7(i)? |
|---|---|---|---|
| Tips | Yes (Voluntary) | Yes (Employee Property) | No |
| Mandatory Service Charges | No (Compulsory Fee) | No (Employer Revenue/Wage Source) | Yes (If other conditions are met) |
What Never Counts: Why Tips Are Excluded
The rule is absolute: tips paid directly by customers can never be considered commissions for the purpose of the FLSA Section 7(i) exemption.
Tips are defined explicitly as voluntary payments. They are given to the employee by the patron. The Department of Labor (DOL) guidance makes this very explicit. Tips are not a form of compensation generated by the employer’s commission plan. They are viewed as the property of the employee. Consequently, they do not satisfy the “commission” requirement under Section 7(i).
Therefore, restaurant owners cannot use tips to help meet the “more than half of total earnings” commission requirement. This remains true even if the tips are substantial. This critical detail is often misunderstood.
What Can Count: Mandatory Service Charges as Commission
The opposite is true for mandatory service charges. These charges are not tips. They are treated as part of the employer’s gross revenue. When paid out to employees, they are considered wages.
Mandatory service charges paid to employees may be considered commissions under the FLSA Section 7(i) exemption. This opens the door for classifying certain service staff as overtime exempt. However, simply having a service charge is not enough. Other specific conditions of Section 7(i) must be met.
The Three Key Conditions for FLSA 7(i)
To claim the exemption, all three tests must be satisfied:
- Retail or Service Establishment Test: The employee must work for a retail or service establishment. This means that 75% or more of its annual sales volume is not for resale and is recognized as retail sales or services in the industry. Restaurants typically meet this test.
- Regular Rate of Pay Test: The employee’s regular rate of pay must be more than one and one-half times the applicable minimum wage. This is calculated for any workweek in which the employee works overtime.
- The Commission Test: More than half of the employees’ total compensation for a representative period must consist of commissions. This period must be at least one month but no more than one year.
If a mandatory service charge is calculated as a percentage of the customer’s bill, the DOL often views the distribution of that charge as a bona fide commission on the sale. Therefore, this payment can be counted toward the “more than half” requirement.
In addition, structuring employee pay this way offers flexibility. It allows employers to reward employees based on sales performance. Furthermore, it provides a different path for compliance than the complex tip credit rules.
Actionable Advice for Restaurant Owners
Navigating these rules is challenging. Misclassification can lead to costly lawsuits. Therefore, clarity and documentation are paramount.
1. Differentiate Clearly
You must clearly distinguish between tips and service charges. Inform both your customers and your staff. The mandatory nature of the service charge is the deciding factor. Never call a compulsory fee a “gratuity.”
2. Treat Service Charges as Wages
Process distributed mandatory service charges through payroll. They must be treated like regular wages. Consequently, you must withhold income tax and FICA taxes. This also means you must include them in the employees’ regular rate of pay for any required overtime calculations.
3. Ensure Compliance with All Three FLSA 7(i) Tests
If you seek the 7(i) exemption, you must verify all three conditions are met. This ongoing assessment is crucial. For instance, the commission test requires careful tracking. Ensure the distributed service charges actually make up over 50% of the employee’s total pay.
For more on managing payroll taxes, see our guide on [Internal link to a related article, e.g., “Restaurant Payroll Tax Obligations”].
Stop Guessing About Which Earnings Count
The world of FLSA compliance is intricate. It’s challenging to manage these nuances while running a business. Mandatory service charges are a powerful tool. They offer a path to the Section 7(i) overtime exemption. However, their proper use requires absolute precision. Tips, on the other hand, provide no such benefit under this rule.
Ultimately, compliance hinges on accurate categorization of every payment source. Stop the costly guessing game about which earnings count. Our platform is pre-loaded with FLSA guidance. This system accurately categorizes employee pay sources for compliance.