What Is a Gratuity and How Is It Taxed?
Explore the meaning of gratuities, how they're used in practice, and the essential tax implications for both service earners and employers.
A gratuity, commonly known as a tip, is a payment voluntarily offered by a customer to a service provider as an expression of appreciation for service rendered. It functions as an additional amount beyond the established cost of a product or service, reflecting customer satisfaction.
Understanding Gratuity
A gratuity is a payment made in recognition of service quality, distinguishing it from the base cost of a transaction. It is a discretionary amount, meaning the customer freely chooses whether to provide it and determines its value. This payment is given directly to the service provider or through an employer for distribution.
The voluntary character of a gratuity, where the customer’s decision to pay and the amount are not compelled, differentiates it from mandatory charges.
How Gratuities Are Applied
Gratuities are applied in various ways, primarily as voluntary tips or mandatory service charges. Voluntary tips can be given in cash directly to the service provider, added to a credit or debit card payment, or through digital payment platforms.
Service charges are mandatory amounts added to a bill by the establishment, often for large parties, banquets, or specific services. Examples include an automatic 18% charge for a table of eight or more, or a fixed fee for room service in hotels.
Businesses in sectors such as restaurants, hotels, salons, and personal care services commonly implement these systems. While voluntary tips go directly to employees or are pooled among them, mandatory service charges are initially revenue for the business. If distributed to employees, these service charges are treated differently for tax purposes than voluntary tips.
Tax Implications for Individuals
Gratuities, whether received as voluntary tips or mandatory service charges passed to employees, are considered taxable income. Employees must report all cash tips totaling $20 or more received in a calendar month to their employer by the tenth day of the following month, using forms like IRS Form 4070.
All cash and non-cash tips are subject to federal income tax, and cash tips are also subject to Social Security and Medicare taxes. For 2025, employees contribute 6.2% for Social Security on earnings up to $176,100 and 1.45% for Medicare on all earnings. An additional Medicare tax of 0.9% applies to wages exceeding certain thresholds, such as $200,000 for single filers. These earnings impact an individual’s overall income tax liability, and Social Security and Medicare contributions fund future benefits.
Individuals are responsible for keeping a daily log of all tips received to ensure accurate reporting to their employer and the Internal Revenue Service (IRS). A recent legislative change effective for 2025 allows for a deduction of up to $25,000 in qualified tips from federal income tax, though these amounts remain subject to payroll taxes.
Business Reporting and Withholding
Employers have specific responsibilities regarding gratuities received by their employees. They must withhold federal income tax, Social Security tax, and Medicare tax from all reported tip income. This includes the employer’s matching share of Social Security and Medicare taxes, which is 6.2% for Social Security (up to the annual wage base) and 1.45% for Medicare.
For large food or beverage establishments, defined as those where tipping is customary, food or beverages are consumed on the premises, and more than ten employees work on a typical business day, there is an additional reporting requirement. These businesses must file IRS Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, annually. This form helps the IRS ensure that the total reported tips from employees equal at least 8% of the establishment’s gross receipts. If reported tips fall below this 8% threshold, the employer may be required to allocate additional tips to employees on their Form W-2.
Employers are required to maintain detailed records of employee tip reports and all payroll information for a minimum of four years. This comprehensive record-keeping supports accurate tax filings and ensures compliance with federal tax regulations. Form 8027 is generally due by February 28 if filed on paper or March 31 if filed electronically, for the preceding calendar year.