Full-service restaurants have long been comfortable applying automatic gratuities to their customer checks, especially for parties of six or more. A new ruling by the Internal Revenue Service  which takes effect this month  is likely to spell the death knell for automatic gratuity policies. Are you ready for the new policy? 

The standard practice of automatically adding a tip of 18 to 20 percent to a restaurant bill for large parties has been a hotly contested issue for some time. Frequently, patrons are disgruntled when faced with paying a forced gratuity on top of their bill. A few big-name restaurateurs are already getting ahead of the issue by taking their reforms a step further and abolishing tipping altogether. Instead, they are paying higher wages to servers and offsetting the increased labor costs by raising menu prices. As a byproduct of such a “wage over tip” model, operators can eliminate the pitfalls of the often complicated tip-credit rules, create more equality with staff who are not eligible for tips and, of course, avoid the implications of the IRS’s new ruling.

Still, with the economy slowly creeping toward recovery, most restaurant operators have stuck with the tipping model in order to keep menu prices stable. And tipping is big in the United States — full-service restaurant sales totaled more than $202 billion in 2012 according to the National Restaurant Association — likely resulting in $30 to $40 billion in tips. 

According to the IRS, gratuities that are automatically added to a restaurant bill will be considered service charges rather than tips for Federal Income Contributions Act, or FICA, tax purposes, and restaurant owners will need to treat them as wages. This new clarification by the IRS will have a major impact on the requirements for how restaurants and other hospitality businesses conduct their automatic and manual reporting systems. Those failing to comply could face significant penalties from the government and run the risk of costly class-action lawsuits brought by their employees. They could also face potential consumer protection issues.

To be considered a gratuity or tip for tax and wage purposes, a customer’s payment must satisfy four factors:

• The customer makes the payment free from compulsion;

• The customer has the right to determine the amount;

• The payment is not the subject of negotiation or dictated by an employer’s policy;

• Generally, the customer has the right to determine which employee receives the payment.

Taking these criteria into consideration, a restaurant’s policy of automatically adding 18 to 20 percent to a customer check results in a service charge, not a tip, because 1) the customer did not have the right to determine the amount, and 2) the customer did not make the payment free from compulsion. Thus, for FICA purposes, this service charge is considered a wage. 

One alternative practice that many restaurants have already implemented is to provide customers with calculations for 15 percent, 18 percent and 20 percent of the total check for tipping purposes. The restaurant is thereby suggesting a tip, but in the end leaving customers free to decide for themselves.