How Does A Tip Credit Work?

In theory, paying your employees shouldn’t be that complicated. They complete their job responsibilities and you issue a paycheck for the agreed-upon amount.

‍

But let’s face it: It’s hardly ever that simple. With things like overtime pay and payroll taxes, running payroll can feel far more complex than you’d like it to be. That’s especially true with employees who receive tips and something called a tip credit. Here’s what you need to know about tip credits and how they can impact your business and your payroll. 

What Is A Tip Credit?

The Fair Labor Standards Act (FLSA) established a number of employment standards, including overtime pay, rules about recordkeeping and child labor, and a minimum wage. 

The current federal minimum wage is $7.25 per hour. However, the FLSA states that employers can pay employees less than the standard minimum wage, provided the employee makes enough in tips to make up the difference. That difference between what the employee is paid and the standard minimum wage is known as a tip credit. 

The tip credit is something the employer claims toward their minimum wage obligations. Think of it as their hall pass for not paying the federal minimum wage, because they’ve claimed a tip credit. The idea is that the employee’s base minimum wage (known as a cash wage) plus their tips should add up to at least the standard minimum wage. 

How Does A Tip Credit Work?

To start, there’s a different minimum wage set for employees who receive tips. The FLSA states that the minimum cash wage needs to be at least $2.13 per hour, although states set their own minimum cash wage (many of which pay above that). 

The U.S. Department of Labor (DOL) has a breakdown of the minimum wages for tipped employees in each state. That sets the baseline that employees need to be paid before tips. Then, the money the employee makes in tips (that’s the tip credit) needs to add up to at least the federal minimum wage. Employees can claim tip credit every time payroll is run. 

For example, in Wisconsin, the minimum cash wage is $2.33 per hour. That means the maximum tip credit is $4.92 to add up to the federal minimum wage of $7.25. 

Do employers and employees like tips? For the most part, yes. One study conducted in 2017 found that 72% of managers were not in favor of ending tipped positions. 89% of employees also said they weren’t in favor. 

Tip credits usually end up being a good thing for both the business and the employee. Employers have lower labor costs, because the employee’s wage is supplemented by the customer rather than the employer. Plus, tipped employees generally make more with tips versus a flat minimum wage. 

If an employer doesn’t claim a tip credit, then they’re required to pay minimum wage. But, even if they do pay minimum wage, they still can’t keep any tips their employee receives (which we’ll dig into later). That makes minimum wage plus tips appealing to employees, but not so much for employers—which is why many employers won’t opt to do this, unless they’re required to. 

With that said, some employers who choose to pay their staff minimum wage will post signage stating that tips aren’t necessary. This means an employee’s hourly wage paid by their employer is higher, but they probably don’t receive many tips because customers are aware they’re being paid fairly already. 

Hence why many employees tend to prefer tip credits—they usually earn more than the flat minimum wage. Just think: If a waitress serves three tables in an hour and each one tips $5, she made $15 in an hour plus her cash wage. That’s far more than the federal minimum wage of $7.25 per hour. 

Which States Have Tip Credit?

Remember, while there is a federal minimum wage and minimum cash wage, states get to set their own rules. That means the maximum tip credit will differ from state to state as well.

Most states allow for a tip credit. However, as the Department of Labor states, several states do not. These include: 

• Alaska
• California
• Minnesota
• Montana
• Nevada
• Oregon
• Washington

In these states, employers are required to pay tipped employees the full state minimum wage before tips. You could conclude that tipped employees in these states will have higher earning potential, as they receive minimum wage and get tips. 

How Do You Calculate Tip Credit?

If you have tipped employees on your staff, you’re likely wondering how you go about calculating their tip credit. It’s not as complicated as you think it is—provided you’re willing to do some simple math. 

Here are the steps to calculate tip credit: 

1. Confirm a tip credit is legal in your state (here’s where you can check).
   
   
2. If a tip credit is allowed, decide on the hourly cash wage you’ll pay your employees. Keep in mind that this number needs to comply with both your federal and state minimum cash wages. Federal is $2.13 per hour, but many state minimums are above this. For the sake of an example, let’s say that you’ll pay a minimum cash wage of $2.13 per hour.
   
   
3. Inform your employees it’s a legal requirement that you explain to them that they’re receiving below the standard minimum wage because you take a tip credit.
   
   
4. Carefully document your employees’ hours and the amount of tips they receive each shift. These accurate records will be important for running payroll.
   
   
5. At payroll time, calculate the tip credit for that specific pay period. 

Let’s talk a little more about this calculation. Here’s the standard formula you can use to calculate the tip credit: 

Minimum wage - cash wage = tip credit

So, since the federal minimum wage is $7.25 and we set our cash wage at the federal minimum of $2.13 per hour, that means you’d figure out the tip credit like this: 

$7.25 - $2.13 = $5.12 tip credit

Now that you know your tip credit amount, you can use it to calculate the tip credit for that employee’s pay period. Imagine that in your two-week pay period, the employee worked 30 hours and earned $175 in tips. Start by calculating the total tip credit by multiplying your tip credit amount by the number of hours they worked: 

$5.12 x 30 = $153.60

This means that $153.60 is the maximum amount of tip credit you can claim for that specific pay period. Next, you need to add up your employee’s earnings to ensure their minimum wage plus their tips meets the mark for federal minimum wage.

Start by figuring out what they would have needed to earn during that pay period if they were paid the standard federal minimum wage (which again, is $7.25 per hour). Multiply that minimum wage by the hours worked in that pay period: 

$7.25 x 30 = $217.50

Okay, so your employee needs to have made at least $217.50 between their cash minimum wage and tips in order for you to claim a tip credit. Next, figure out their cash wage (the amount you pay them for that pay period, before tips): 

$2.13 x 30 = $63.90

They’re short of the minimum wage. But, when you add in their $175 in tips they received, they come in at $238.90 for the pay period. That’s above the $217.50 minimum wage, which means you can claim the full $153.60 in tip credits. 

What if your employee’s cash wage plus their tips didn’t equal at least the minimum wage? Then you as the employer must make up the difference. So, if the employee only received $150 in tips for that pay period, their total wages would equal $213.90. That’s $3.60 below the minimum wage for their hours worked ($217.50), so you’d need to add that amount to their paycheck when you run payroll. 

How Do You Calculate Overtime Tip Credit?

Things get a little trickier when a tipped employee works overtime (which is classified as over 40 hours per week). That’s because you can’t simply use one-and-a-half times their cash wage ($2.13 per hour, using our same example). 

Instead, Werman Salas P.C., an employment law firm, explains, calculating overtime pay for a tipped employee works like this. 

Start by multiplying the standard minimum wage ($7.25) by 1.5 to represent time and a half. 

$7.25 x 1.5 = $10.88

Now you know their overtime hourly wage if they were a typical, non-tipped employee. Next, subtract the tip credit (which is $5.12). 

$10.88 - $5.12 = $5.76

That represents what your tipped employees wage should be for any overtime hours that they worked, as you can’t use their normal cash wage for overtime hours. So, let’s say that your employee worked five hours of overtime. You’d multiply that overtime wage by their number of overtime hours. 

$5.76 x 5 = $28.80

Now you’ve calculated their overtime pay. But, you need to add it to their normal, 40-hour total. Get their normal cash wage total by multiplying their hourly cash wage ($2.13) by 40 hours. 

$2.13 x 40 = $85.20

You have their 40-hour total using their normal cash wage, as well as the total for their overtime hours. All that’s left to do is add them together.

$85.20 normal cash wage + $28.80 overtime pay = $114 

That means you’d need to pay your employee a total of $114 for that pay period where they worked 40 hours, plus five hours of overtime.

It involves a little bit of math, but it’s important that you get this correct in order to stay compliant with overtime and minimum wage requirements. 

Can an Employer Take Employees’ Tips? 

In general, no. Employees should retain all of their tips. However, there are a few notable exceptions and rules to be aware of: 

• Some businesses do a tip pooling arrangement, which is only allowed among employees who regularly receive tips from customers (like waitstaff, bartenders, etc.). Managers are not permitted to take money from a valid tip pool.
  
  
• Employers can take mandatory service charges (for example, automatically charging a percentage for a large party), but this is decided on a state-by-state basis.
  
  
• Employers might also subtract an appropriate amount of credit card processing fees from an employee’s tips, but only if the tip was left on a credit card. That subtraction can’t put the employee below minimum wage and some states (like California) don’t allow for this at all.

Even if an employer pays the full minimum wage of their state (and not just the cash wage), they still aren’t allowed to take the tips their employees make.

Take These Tips About Tips

Just when you think you have payroll figured out, it seems like there’s yet another requirement or regulation you need to comply with. The good news is that tip credits really don’t need to be that complicated—especially if you use the above answers to guide you. 

‍

Put this information into action, and you can ensure you’re paying your tipped workers fairly and maintain compliance with minimum wage laws.

‍

‍Want to take the pain out of running payroll? Start using Hourly today.