How Tipping on a Card Works from Payment to Payout

Tipping with a card has become a common practice in many service industries, from restaurants and cafes to salons and delivery services. While convenient for customers, the process of how these digital tips move from a customer’s payment to an employee’s pocket, and the tax implications involved, often remains unclear. Understanding this journey provides insight into the financial systems that underpin a significant portion of service worker income.

The Journey of a Card Tip

When a customer adds a tip to a credit or debit card payment, the transaction initiates a series of digital communications. The Point-of-Sale (POS) terminal captures the total amount, including the tip. This device then sends the encrypted transaction data to a payment processor, an intermediary in the payment ecosystem.

The payment processor routes this request through a credit card network, such as Visa or Mastercard, to the issuing bank. The issuing bank, which provided the customer’s card, holds their account. This bank verifies that the customer has sufficient funds or credit to cover the full transaction amount, including the tip. Once approved, the issuing bank communicates this authorization back through the network to the acquiring bank, which is the business’s bank.

The acquiring bank then acquires the funds on behalf of the merchant. The full amount, encompassing both the service charge and the tip, is processed as a single charge and is initially deposited into the business’s general bank account, typically within one to three business days.

From Business to Employee

After the full transaction amount, including the card tip, is deposited into the business’s bank account, the business disburses these funds to employees. Businesses track and distribute the tips. Modern POS systems automatically record credit card tips, simplifying tracking.

Businesses use various methods for distributing tips. Some may allow individual employees to keep their specific tips, while others utilize tip pooling arrangements where all tips are collected and then divided among staff based on factors like hours worked or a predetermined percentage. Payout timing varies; some businesses may provide cash payouts daily, while others include credit card tips with regular paychecks on a weekly or bi-weekly basis. If tips are paid through a payroll system, they are typically added to the employee’s regular wages. Businesses may legally deduct processing fees from credit card tips in some jurisdictions, provided the employee’s wages do not fall below minimum wage after the deduction, though some states prohibit this practice.

Taxation of Card Tips

All tips, cash or card, are taxable income by the Internal Revenue Service (IRS). Employees must report all tips to their employer. Tips over $20 in a month require a written report to the employer by the tenth day of the following month.

Employers must withhold income, Social Security, and Medicare taxes from reported tips. These amounts are included in the employee’s gross wages on their Form W-2. Employers also have obligations to report these tip amounts to the IRS, summarizing total sales and reported tips on forms like Form 8027 annually for certain establishments. This comprehensive reporting ensures compliance with tax laws for both the employee and the employer.