How to Calculate Payroll for Tipped Employees

Calculating payroll for tipped employees involves unique considerations beyond standard hourly wages. Employers must navigate specific federal regulations to ensure fair compensation and meet tax obligations. Understanding these complexities is important for both compliance and accurate financial management.

Understanding Tip Income and Minimum Wage Requirements

A “tipped employee” is defined under federal law as an individual who customarily and regularly receives more than $30 per month in tips. This threshold establishes eligibility for specific wage rules that differ from non-tipped positions. The federal minimum direct cash wage for a tipped employee is $2.13 per hour, which forms the base of their hourly earnings supplemented by tips.

The concept of a “tip credit” allows employers to count a portion of an employee’s tips toward meeting the federal minimum wage obligation. The federal minimum wage is $7.25 per hour, meaning the maximum tip credit an employer can claim is $5.12 per hour ($7.25 – $2.13). Employers must inform employees of the tip credit amount and ensure the employee retains all tips, except for valid tip pooling arrangements.

Employers must ensure that the combination of the direct cash wage and tips equals or exceeds the federal minimum wage of $7.25 per hour for all hours worked. If an employee’s tips and direct wages do not reach this threshold, the employer must make up the difference. This ensures no tipped employee earns less than the federal minimum wage when their wages and tips are combined.

While federal law sets these minimums, states may have their own minimum wage laws for tipped employees, which can be higher or have different tip credit rules. Some states require employers to pay the full state minimum wage before tips, prohibiting a tip credit entirely. Employers must always adhere to the law that provides the greater benefit to the employee.

Employer Payroll Responsibilities for Tipped Employees

Employers have distinct responsibilities regarding payroll for tipped employees once tips are earned and reported. All reported tips, whether cash or non-cash, are taxable income subject to federal income tax withholding. Employers must also withhold FICA taxes (Social Security and Medicare taxes) on all reported tips. The employee’s share of FICA taxes is 6.2% for Social Security (up to an annual wage base) and 1.45% for Medicare.

The employer is also responsible for their share of FICA taxes on reported tips, which is also 6.2% for Social Security and 1.45% for Medicare. For food and beverage establishments, a FICA Tip Credit may be available. This credit allows employers to reduce their tax liability by the FICA taxes paid on certain employee tips, calculated on reported tips above the federal minimum wage of $5.15 per hour that was in effect on January 1, 2007.

Employees are required to report all cash and non-cash tips of $20 or more received in a calendar month to their employer by the 10th day of the following month. This reporting can be done using IRS Form 4070, “Employee’s Report of Tips to Employer,” or a similar written statement. Employees may use IRS Form 4070A, “Employee’s Daily Record of Tips,” to keep a daily log of tips for accurate monthly reporting.

Tip pooling or sharing arrangements are permissible under federal law, but strict rules apply. Employers cannot keep any portion of employees’ tips for any purpose, nor can managers or supervisors receive tips from a tip pool. If an employer claims a tip credit, tip pools must be limited to employees who customarily and regularly receive tips. However, if an employer pays the full minimum wage and does not take a tip credit, non-tipped employees like cooks or dishwashers may participate.

Calculating Regular and Overtime Pay

Calculating the regular rate of pay for tipped employees involves combining their direct cash wage with their tips, up to the federal minimum wage equivalent. The regular rate is the employee’s total compensation for a workweek, divided by total hours worked. For a tipped employee paid the federal minimum direct wage of $2.13 per hour, whose tips make up the difference, their regular rate for straight time is the federal minimum wage of $7.25 per hour.

To determine gross pay for regular hours, an employer first calculates the total hours worked and then applies the regular rate. For example, if an employee works 40 regular hours and earns enough tips to meet the federal minimum wage, their straight-time gross pay is 40 hours multiplied by $7.25 per hour, equaling $290.00. The employer’s cash wage obligation for these hours is 40 hours multiplied by $2.13 per hour, or $85.20, with the remaining $204.80 covered by the tip credit.

Overtime pay for tipped employees is calculated at 1.5 times their regular rate of pay for all hours worked over 40 in a workweek. This overtime calculation is based on the full minimum wage, not just the lower direct cash wage. For an employee paid the federal minimum direct wage, the overtime rate is 1.5 times $7.25 per hour, which is $10.875 per hour.

The tip credit claimed for overtime hours cannot be larger than the tip credit claimed for straight-time hours. To calculate the actual cash wage due for overtime, the employer subtracts the tip credit ($5.12) from the calculated overtime rate ($10.875), resulting in a direct cash overtime rate of $5.755 per hour. For instance, if an employee works 50 hours in a week (40 regular, 10 overtime), and their tips cover the full tip credit, their gross pay calculation would include $290.00 for regular hours and an additional $5.755 per hour for 10 overtime hours, totaling $57.55 in additional cash wages for overtime.

Recordkeeping and Reporting Obligations

Employers must maintain specific records for tipped employees to demonstrate compliance with federal labor laws. These records include the total daily or weekly hours worked by each employee, particularly distinguishing between tipped and non-tipped occupations if an employee performs both roles. Employers must also keep a record of the amount of tips reported by each employee.

Detailed payroll records should clearly indicate the direct wages paid to each tipped employee and the amount of tip credit taken by the employer for each pay period. It is also important to note on the pay records which employees have their wages determined in part by tips. These records are necessary to verify that employees receive at least the applicable minimum wage when direct wages and tips are combined.

Annually, large food or beverage establishments are required to report tip income to the IRS using Form 8027, “Employer’s Annual Information Return of Tip Income and Allocated Tips.” This form is generally required if the establishment customarily receives tips and employs more than 10 employees on a typical business day. Form 8027 reports the establishment’s gross receipts, reported tips, and any allocated tips if reported tips are less than 8% of gross receipts.

Allocated tips, which are reported in Box 8 of an employee’s Form W-2, are not subject to income tax or FICA tax withholding by the employer. Employees are generally required to report these allocated tips on their personal income tax returns. Maintaining accurate and detailed records throughout the year simplifies the process of preparing and filing Form 8027 and other necessary tax documents.