How Does Leaving a Tip on a Card Work?

When consumers pay for services using credit or debit cards, the process of adding a tip might seem straightforward. However, it involves a series of financial and administrative steps. Understanding these mechanisms reveals how digital tips are handled by businesses and processed through payment systems, ensuring the appreciation reaches its recipient while adhering to financial regulations.

Adding Tips on Card Transactions

Customers initiate the tipping process by interacting directly with the payment system after receiving a service. Many establishments provide a physical receipt slip where a customer can manually write in a tip amount, calculate the new total, and sign to authorize the charge. This traditional method requires the business to later adjust the transaction in their system.

Alternatively, modern point-of-sale (POS) terminals allow customers to add a tip digitally. These systems often present pre-set tip percentages (e.g., 15%, 20%, or 25%) or an option to enter a custom amount. This digital input immediately integrates the tip into the total transaction amount. Online or app-based payment platforms also streamline this process by prompting for a tip amount or percentage before finalizing the digital transaction. Regardless of the method, the customer’s action directly determines the gratuity amount that will be processed with the main payment.

Behind the Scenes Payment Processing

Once a customer adds a tip to a card transaction, financial processing begins. Initially, when a card is swiped or inserted, the system typically performs a pre-authorization for the base purchase amount, verifying sufficient funds. After the tip is added, manually on a receipt or digitally via a POS terminal, the merchant’s system updates the transaction to include the gratuity.

The full amount, encompassing both the original purchase and the added tip, is then finalized for settlement. The merchant’s point-of-sale system gathers all authorized transactions, including adjusted tips, into a batch. This batch is sent to the payment processor at the close of a business day or a set interval. The payment processor then facilitates the transfer of funds from the customer’s bank to the merchant’s bank account, typically within one to three business days. The tip amount is not a separate charge but an integrated part of the single, larger transaction transferred to the merchant.

Tip Distribution and Tax Reporting

After the merchant receives the total funds, including tips, the process shifts to distributing these amounts to employees and fulfilling tax obligations. Businesses commonly disburse card tips to employees through several methods, which may include inclusion on regular paychecks, direct deposit, or daily cash payouts. Employers cannot retain any portion of a gratuity, but they can deduct credit card processing fees from the tip amount before paying it out, provided this does not cause an employee’s wages to fall below the minimum wage.

Employers have specific responsibilities for reporting tips to tax authorities. All cash and non-cash tips, including those received via credit cards, are considered employee income and are subject to federal income tax, Social Security, and Medicare taxes (FICA). Employers must withhold the employee’s share of FICA taxes (currently 6.2% for Social Security and 1.45% for Medicare) from the employee’s wages or other funds, and also pay their own employer share of FICA taxes on these reported tips. Businesses must report total wages and tips for each employee on Form W-2 and file quarterly tax returns using Form 941. Large food or beverage establishments meeting specific criteria, such as having more than ten employees and customary tipping, must also file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips.

Employees are responsible for keeping a daily record of all tips received, including credit card tips, and reporting them to their employer by the tenth day of the month following receipt, if the total is $20 or more. This reporting ensures that the employer can accurately withhold taxes and report the income. If employees do not report tips to their employer, they must report these amounts as income on their individual income tax return using Form 4137 to calculate the Social Security and Medicare taxes owed. Tip pooling, where employees combine and redistribute tips, is permissible under federal law, but generally excludes managers and supervisors. Distinguishing between voluntary tips and mandatory service charges is also important, as service charges are considered business gross receipts and treated as regular wages subject to withholding, rather than tips.