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The tip credit reduces a tipped employee’s minimum wage to account for wages from customer-paid tips. Follow our guide to calculating your employees’ tip credits.
Tips make up a significant portion of the income of hospitality industry workers. Servers earn more than half of their wages from tips, according to a National Employment Law Project report.
Since a share of tipped employees’ earnings comes directly from customers, some states institute a tip credit to reduce employer-paid wages.
Overview: What is a tip credit?
In most states, tipped workers aren’t subject to the same minimum wage as non-tipped workers. A tip credit sets the state minimum wage for tipped workers, called a minimum cash wage.
Minimum Cash Wage = Minimum Wage – Maximum Tip Credit
For example, New Jersey has an $11-per-hour minimum wage and a $7.87 tip credit, so employers must pay tipped workers at least $3.13 per hour ($11 minimum wage – $7.87 tip credit).
Tipped workers’ pay comprises employer-paid wages and customer-paid tips, which should add up to at least the highest applicable minimum wage, whether it be the city, state, or federal minimum wage. When a tipped employee’s earnings don’t reach the applicable minimum wage, the employer must step in to cover the difference.
The Fair Labor Standards Act (FLSA) sets the federal minimum wage and federal maximum tip credit, which states defer to only when there’s either no state minimum wage or it’s lower than the federal minimum wage. With a $7.25 federal minimum wage and the $5.18 maximum federal tip credit, the federal minimum cash wage is $2.13.
FLSA tip law demands the following employers when paying tipped employees:
- You must pay a tipped worker at least the minimum cash wage.
- You must communicate the tip credit used to calculate paychecks. When you don’t, the tip credit doesn’t apply, requiring you to pay the regular minimum wage instead.
- Tips belong to the employee, not the employer. Tip pooling or sharing, where tips are divided among tipped employees, is allowed.
- Between the employer-paid minimum cash wage and customer-paid tips, an employee must earn at least the regular minimum wage.
A note on the last requirement: The takeaway is tipped employees must earn at least the minimum wage.
For example, a New Jersey restaurant waiter made an average of $6 per hour in tips. Since $6 per hour is less than the $7.87 NJ maximum tip credit, the restaurant needs to pay an additional $1.87 per hour. That way, the waiter earns at least $11 per hour ($7.87 tip credit – $6 tip per hour = $1.87 additional employer wage contribution). In other words, the restaurant owner can’t take the full $7.87 tip credit.
What are the state laws on tip credits?
Just as states can set their minimum wages, they also set their tip credits. The U.S. Department of Labor keeps a list of current tip credits and state minimum wage amounts.
The following states and territories don’t have a tip credit, requiring that employers pay tipped workers the same minimum wage as non-tipped workers:
- Alaska
- American Samoa
- California
- Commonwealth of the Northern Mariana Islands
- Guam
- Minnesota
- Montana
- Nevada
- Oregon
- Washington
Your state or territory’s labor department website will have the full rule book on paying tipped employees.
How to calculate a tip credit
The tip credit calculation can get a bit complicated, but that’s where your payroll software steps in. Follow these steps to calculate the tip credit manually.
1. Collect timesheets and tip records
Tipped workers should submit timesheets and tip income reports at least weekly. The IRS requires that employees keep daily tip records and share them with their employer at least monthly. Usually, a business will have a point of sale (POS) system to capture customer tips instantly.
Imagine that you own a diner in New Jersey, where Riley and Lenny wait tables. Your POS system and time clock software report the following information:
| Employee | Hours worked | Tips earned |
|---|---|---|
| Riley | 30 | $150 |
| Lenny | 30 | $600 |
2. Calculate average tips per hour
To calculate average tips, divide the total tip amount by the number of hours worked in the pay period. If your business pools tips, the entire tip amount is the employee’s share of tips.
Average Tips Per Hour = Total Tips Earned ÷ Hours Worked
Riley’s average tips per hour are $5 ($150 tips ÷ 30 hours), and Lenny’s are $20 ($600 tips ÷ 30 hours).
3. Compare average tips per hour to maximum tip credit
Your tipped employees’ average tips per hour cannot be less than the tip credit you claim on the employee’s wages.
Average Tips Per Hour ≥ Tip Credit Claimed
Since the diner is in New Jersey, we’re comparing Riley’s and Lenny’s earnings to the $7.87 maximum tip credit. Lenny’s average tips per hour -- $20 -- is well above the NJ maximum tip credit, so the restaurant can take the full $7.87 tip credit when calculating his wages.
Riley’s average tips per hour -- $5 -- are lower than the maximum tip credit, requiring one last calculation.
4. Calculate tip credit
When an employee’s average tips per hour are less than the state’s maximum tip credit, you can’t take the full tip credit.
Riley earned just $5 per hour in tips, which is below the NJ maximum tip credit. The restaurant will have to reduce the tip credit for Riley’s wages by the difference.
Employee Tip Credit = Maximum Tip Credit – Average Tips Per Hour
Riley’s tip credit is $2.87 ($7.87 NJ maximum tip credit – $5 average tips per hour). We already know that Lenny’s tip credit is the full $7.87.
FAQs
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When a nonexempt worker works more than a standard workweek, he or she is due time and a half overtime pay. The calculation gets tricky, but your payroll software can crunch these numbers the next time you do payroll.
Follow these directions to calculate tipped wages with overtime:
- Multiply the applicable minimum wage -- not the minimum cash wage -- by 1.5.
- Subtract the state maximum tip credit from the result of step 1.
- Multiply the result of step 2 by the number of overtime hours worked.
Multiply the applicable minimum wage by 1.5
Take a waiter who’s typically paid $2.13, the federal minimum cash wage, by his employer. The regular state minimum wage is $7.25, which is the base for the overtime calculation.
The waiter’s overtime rate must be at least $10.88 ($7.25 minimum wage ✕ 1.5 overtime rate).
Subtract the state maximum tip credit from the result of step 1
The maximum federal tip credit is $5.12.
The $10.88 overtime rate – $5.12 maximum tip credit = $5.76. Therefore, the waiter’s overtime rate paid by the employer must be at least $5.76.
Multiply the result of step 2 by the number of overtime hours worked
The waiter worked an extra 5 hours last week, meaning he must get paid at least $28.80 in a combination of cash wages and tips for overtime ($5.76 overtime rate ✕ 5 overtime hours).
Note that the FLSA says an employee’s tip credit cannot differ between overtime and regular pay in the same pay period. That means you can’t claim a $5.12 tip credit for overtime hours and a $4 for regular hours.
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In general, employer-paid cash wages and customer-paid tipped wages are taxed the same. All employee wages are subject to Federal Insurance Contributions Act (FICA) taxes and state, local, and federal tax withholding.
Employers in the food and beverage industry might qualify for a FICA tip tax credit, which gives you a break on the employer portion of FICA taxes paid on tips. Claim the FICA tip tax credit by filing Form 8846.
Tipped wages are also subject to employer-paid payroll taxes like Federal Unemployment Tax Act (FUTA) taxes.
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As an employer, you can deduct a reasonable amount of credit card processing fees from your employees’ tips.
The FLSA does not allow credit card fees to bring an employee’s earnings below the minimum wage. When you calculate your employees’ tip credits, make sure the total tip amount you use also deducts the credit card fees.
You can credit me for these tips
Understanding tip credits is fundamental to paying tipped workers correctly. Review your payroll register regularly to make sure your employees are being paid accurately and within the parameters of the law.
Our Small Business Expert
Ryan Lasker is an accounting writer with a penchant for breaking down complex topics and has work published in USA TODAY. He is a Certified Public Accountant (CPA) licensed in the District of Columbia, holds a Master of Accountancy, and specializes in small-business financial planning.
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