How to Calculate Tip Credit for Your Tipped Employees

The concept of tip credit allows employers to meet minimum wage obligations for tipped employees by combining a lower direct cash wage with tips. Established under the Fair Labor Standards Act (FLSA), this provision acknowledges the unique compensation structure of service industries. While federal law sets a baseline, individual states often have their own, more restrictive regulations regarding tip credit.

Key Conditions for Taking Tip Credit

Employers must satisfy several conditions before legally applying a tip credit against minimum wage obligations. Employees must be clearly informed in advance about the employer’s intention to use the tip credit. This notification should include the specific direct cash wage the employer will pay, the exact amount of tip credit they intend to take, and confirmation that all tips received by the employee are to be retained by them, except for valid tip pooling arrangements.

Employers must pay a direct cash wage of at least $2.13 per hour to their tipped employees under federal law. This amount serves as the base payment from the employer, supplemented by the employee’s tips. If an employee’s tips, combined with the direct cash wage, do not reach the full federal minimum wage of $7.25 per hour for all hours worked, the employer is responsible for making up the difference.

Another condition involves the handling of tips and tip pooling arrangements. For an employer to take a tip credit, all tips received by the employee, whether directly from customers or through a valid tip pool, must be retained by that employee. Valid tip pooling is permitted under the FLSA, allowing for the sharing of tips among employees who customarily and regularly receive tips, such as servers, bussers, and bartenders.

Managers, supervisors, and employers are prohibited from retaining any portion of employee tips, including through a tip pool, even if they pay the full minimum wage. The Department of Labor (DOL) guidance emphasizes that tips are the property of the employee, and any employer retention of these funds invalidates the employer’s ability to take a tip credit. Employers must adhere to these rules to lawfully utilize the tip credit provision.

Step-by-Step Tip Credit Calculation

After meeting the conditions for taking a tip credit, employers calculate the allowable credit. The basic formula for the maximum allowable tip credit is derived by subtracting the direct cash wage paid by the employer from the full federal minimum wage. For instance, with a federal minimum wage of $7.25 per hour and a direct cash wage of $2.13 per hour, the maximum allowable tip credit is $5.12 per hour ($7.25 – $2.13).

The tip credit taken by the employer must not exceed the actual amount of tips received by the employee for that specific hour or pay period. If an employee earns less than the maximum allowable tip credit in tips, the employer can only take a credit up to the amount of tips actually received. For example, if an employee only earns $4.00 in tips during an hour, the employer’s tip credit is limited to $4.00. They must pay an additional $1.12 per hour beyond the $2.13 cash wage to ensure the employee reaches the full $7.25 federal minimum wage.

To verify compliance, employers must continuously ensure that the employee’s total compensation, comprising the direct cash wage paid and the tips received, collectively meets or surpasses the full federal minimum wage for every hour worked. This calculation is performed on an hourly basis to account for fluctuations in tip income throughout a shift or pay period. If, at any point, the combined amount falls below the $7.25 federal minimum wage, the employer is legally obligated to make up the shortfall.

Consider an employee working 40 hours in a week. The employer pays them the federal direct cash wage of $2.13 per hour, totaling $85.20 for the week. If the employee generates $200 in tips during that week, their average hourly tip income is $5.00 ($200 / 40 hours). In this scenario, the total hourly earnings are $2.13 (cash wage) + $5.00 (tips) = $7.13. Since $7.13 is less than the $7.25 federal minimum wage, the employer must pay an additional $0.12 per hour ($7.25 – $7.13) for all 40 hours, amounting to an extra $4.80 for the week.

Alternatively, if the same employee generates $250 in tips over 40 hours, their average hourly tip income is $6.25 ($250 / 40 hours). The total hourly earnings would then be $2.13 (cash wage) + $6.25 (tips) = $8.38. Since $8.38 exceeds the federal minimum wage of $7.25, the employer can take the full $5.12 tip credit per hour, as the employee’s tips adequately cover the difference, and the total compensation exceeds the required minimum. This hourly reconciliation ensures ongoing compliance with FLSA requirements for tipped employees.

Essential Record Keeping for Tip Credit

Maintaining accurate records is essential for any employer utilizing the tip credit provision. These records serve as evidence of compliance with federal labor laws, particularly during an audit or wage dispute. Employers must document specific details for each tipped employee to demonstrate that all conditions for taking a tip credit have been met and that calculations are correct.

Required records include the employee’s full name, occupation, the regular hourly rate of pay, and the total hours worked each day and each workweek. Employers must also keep clear records of the total daily or weekly straight-time earnings, the total wages paid to the employee each pay period, and the specific amount of tip credit taken during that period. The record of tips received by each employee, typically from employee declarations, is also required. These detailed records collectively provide a transparent account of the employee’s earnings and the employer’s application of the tip credit.