Tips Through Payroll: Managing Gratuity for Employers and Employees

When it comes to paying out your employees’ tips, you have two main distribution methods to choose from. In the first — paying tips instantly — your tipped staff members receive 100% of their tips in cash at the end of each shift. This option is one of the most commonly used within tipped industries and is a favorite amongst employees as it provides immediate access to cash earned.

You can also opt to pay tips through payroll. With this method, tips are withheld until payday and paid out to employees as part of their regular paychecks. Though less common, this approach to tip payout is gaining popularity amongst businesses in tipped industries. Keep reading to find out why and discover what you need to know about the practice.

Paying Tips Through Payroll: How Does It Work?

If you’re thinking about making the switch from instant payouts to distributing tips through payroll, you’re most likely wondering what the process entails. This method involves the following steps:

  1. Collecting non-cash tips on your employees’ behalf via your POS system (any tips paid in cash are still retained by employees)
  2. Transferring the funds to your payroll account
  3. Dividing gratuities earned between employees according to your tip distribution rules
  4. Processing applicable tax deductions
  5. Paying out the tips as part of employees’ paychecks

Pros of Tipping Through Payroll

As you might expect, receiving tips through payroll typically isn’t the preferred payout method for employees. Even so, this strategy comes with several benefits for both staff members and employers alike, including:

  • Providing more accurate tip reporting. When paying tips through payroll, all gratuities earned through credit card, digital wallet, or other electronic payment methods are tracked in your POS system. This ensures all tips are reported accurately, which is crucial for tax purposes.
  • Ensuring that proper taxes are withheld. In the eyes of the IRS, tips count as taxable income. With accurate reporting, it’s much easier to make sure that you’re withholding the correct amount for each employee, minimizing your risk in the event of an audit.
  • Increasing efficiency during payroll processing. Processing payroll is already a complicated task — especially if you rely on manual methods for tracking your employees’ earnings and calculating tips, taxes, overtime, and the like. Incorporating tip payments into your payroll via one centralized platform can help simplify the process.
  • Reducing cash reserves. When you pay tips instantly, you must keep enough cash on hand to cover what employees are owed at the end of the day. During busy times of the year and peak hours, this can be a significant amount. Choosing to pay tips through payroll instead means fewer trips to the bank and a lower risk of theft or other types of cash loss.
  • Saving time during daily operations. When tips are included in your employees’ paychecks, you eliminate the need to calculate totals and physically hand out cash at the end of every shift. This can mean significant time savings in the long run.
  • Helping employees with financial planning. Since tips are variable by nature, it can be difficult for your employees to make longer-term financial decisions and manage their money when they receive their tips instantly. Combining tips into a single paycheck results in a more consistent income and eliminates constant in-person cash deposits.
  • Protecting the bottom line. In the event of a dispute or adjustment, businesses that use instant tipping methods are on the hook for the refund amount. By paying out tips through payroll, businesses can avoid taking a financial hit when these disputes occur. 

Cons of Tipping Through Payroll

While there are certainly plenty of positives associated with payroll tipping, it’s hardly a perfect system. The following are some drawbacks to consider as you decide whether to make the switch from instant tip payouts.

With tipping via payroll…

  • It can be harder to attract talent. As we mentioned previously, payroll tipping isn’t always preferred by employees as many enjoy immediate access to their earned tips. Opting to include tips with payroll may make it difficult to hire new employees who would rather receive their tips instantly.
  • Current employees may become frustrated. Similarly, this method also impacts the employees a business already has. This is especially true for those businesses that are considering moving away from instant tip payouts, as strong opposition could lead to a degree of talent loss after the changeover.
  • Employers’ payroll liability increases. Payroll liabilities are the amounts that businesses owe to their employees, government entities, and other parties when they process payroll. When tips are included as part of that process, liabilities also increase, meaning that businesses have larger amounts of money to account for.
  • There’s less transparency. It’s much easier for tipped staff to keep track of how much they’ve earned in gratuities on a daily basis. So when tips are rolled into paychecks in one lump sum, it becomes much more difficult for employees to see how those totals come to be. This lack of visibility into the calculation process can result in a loss of trust between employees and employers.

The laws that govern compensation for tipped employees are the same whether you choose to pay out tips instantly or through payroll. And when it comes to staying compliant with these laws, it’s crucial that businesses with tipped employees understand what they require.

What Is a Tipped Employee?

In a way, this is the most important distinction that businesses need to make, as it determines who tipping laws impact and who they don’t. When you think about the types of roles that receive tips, the first examples that come to mind may be restaurant waitstaff, hair stylists, or hotel housekeeping staff. But what about the baristas, convenience store employees, and others who set a tip jar out on the counter — are they considered tipped employees in the eyes of the law?

Under the Fair Labor Standards Act (FLSA), staff members are only considered to be “tipped employees” if they regularly earn at least $30 in tips per month.

What Is a Tip?

While most people are familiar with the concept of tipping, there are certain guidelines that legally determine what a tip is and what it isn’t. Tips are sums of money given to a service provider as a token of appreciation for the provided service. This voluntary payment is separate from the cost of the service itself, and the amount of the tip and to whom it’s given are at the discretion of the customer.

While similar in principle, automatic gratuities are not classified as tips. Instead, these are considered to be service charges, and are reported differently to the IRS during tax periods.

Hourly Wage Laws for Tipped Employees

The FLSA allows employers of tipped employees to claim what’s known as a tip credit deduction, which essentially enables them to pay a lower hourly rate provided that the amount of tips staff members earn can supplement these wages to a level at or above the minimum wage. If the minimum wage threshold is not passed after tips are accounted for, employers must garnish base wages to compensate for the difference or risk penalties.

Because of this, it’s crucial for business owners in tipped industries to stay up to date on local and federal minimum wage and tip deduction laws.

5 Steps for Implementing a Payroll Tipping System

One way to maintain compliance with tipping laws is to implement a gratuity management system. With the right solution in place, you can set up customized rules that facilitate accurate reporting, allocation, and distribution. 

While selecting and implementing the right software for this task may seem intimidating, with the right roadmap, it doesn’t have to be. Here’s how you can ensure a smooth transition:

  1. Do your research, thoroughly vetting each option before selecting the tip distribution solution that aligns most closely with your business needs.
  2. Once you’ve made your choice, come up with a thorough implementation plan and assemble a dedicated team to be in charge of the transition and rollout.
  3. To make the transition as smooth as possible for the rest of your staff, it’s crucial to provide training on how to use the new system and to offer ongoing support as needed.
  4. Before going live with the new system, perform a test run to ensure the system works as intended and to iron out any unforeseen issues.
  5. Once the system is operational and being used as part of the day-to-day, continue to monitor and make adjustments where needed.

Common Challenges When Managing Payroll Tips

Like any other aspect of running a business, managing payroll tips isn’t without its challenges. Here are some helpful tips for overcoming some of the most frequently encountered hurdles:

  • Challenge: Providing transparency for employees 
    • Solution: When switching to payroll payouts, some staff members may have concerns about how their tips are calculated and distributed. To alleviate these concerns and maintain an environment of trust, choose a gratuity management system that facilitates accurate payouts.
  • Challenge: Software integration issues 
    • Solution: To avoid encountering compatibility issues, it’s crucial to confirm that the gratuity management software you choose is capable of integrating with multiple payroll systems or your existing setup specifically.
  • Challenge: Ensuring compliance with laws and regulations
    • Solution: Staying in line with all applicable laws and regulations is crucial. Choosing a gratuity management system that can automate processes such as reporting and calculating tip credits can go a long way toward maintaining compliance.

Choosing the Right Solution

With benefits like more accurate reporting, time savings, and increased efficiency, paying tips through payroll can make a significant difference for your business. And when weighing your options for a gratuity management system, it’s crucial to choose one that has the features you need to support this method.

Tips+Gratuities has been the number-one gratuity reconciliation solution in the hotel industry for nearly 20 years. With features like complete gratuity distribution automation, configurable rules and reporting, and unlimited distribution capabilities, you can rest assured that you’re choosing a tip distribution software solution that provides the support you need for your hospitality business.

Get in touch with our team to schedule a demo and see what Tips+Gratuities can do for you. Plus, our free eBook, The Win-Win of Automation, has everything you need to know about how automation in gratuity distribution benefits you and your employees. Download your copy today!