In this country, there are thousands of employees who earn their living off tips or gratuities they receive from customers. Over the last several years, there has been a movement afoot, particularly in the restaurant industry, to eliminate tipping from the workplace. Most recently, Joe’s Crab Shack became the first major restaurant chain to test a “no-tipping” policy at more than a dozen of its locations.  Servers, hosts, and bartenders at test locations of Joe’s Crab Shack are now being paid a higher, fixed, hourly wage well above the current federal minimum wage of $7.25 per hour. Joe’s Crab Shack is not the only restaurant experimenting with no-tipping policies. Union Square Hospitality Group announced earlier this year that 13 of its New York City restaurants will go to a no-tipping policy. “No-tipping” restaurants are still far from the norm in the United States but it is definitely a trend to watch.

One of the reasons for this trend is the increased pressure placed on employers to pay employees a “livable wage.” According to the Bureau of Labor Statistics, as of May 2014, the nationwide mean hourly wage for a server (including tips) was $10.40 per hour, well below the $15 per hour many groups have advocated should be the minimum wage. Doing away with tipping also allows employees to have a more predictable paycheck, since they are no longer dependent on tips, which can fluctuate from shift to shift, for the majority of their income.

Many tipped employees earn only $2.13 per hour plus tips. This is because § 3(m) of the Fair Labor Standards Act (FLSA) permits an employer to take a tip credit toward its minimum wage obligation for tipped employees. This “tip credit” equals the difference between the required cash wage (which must be at least $2.13 per hour under federal law) and the federal minimum wage (currently $7.25 per hour). The maximum tip credit that an employer can claim under the FLSA is $5.12 per hour ($7.25 minus $2.13). Several cities and states have raised the required minimum wage for both tipped and nontipped employees. For example, the City of Chicago recently mandated a minimum wage of $10 per hour for nontipped employees and $5.45 an hour for tipped employees whose employers utilize the tip credit. Effective December 31, 2015, New York will reduce the tip credit to $1.50 per hour off the state’s minimum wage of $9.00 per hour. With the benefits of the tip credit being reduced in some areas of the country, it is no wonder restaurants are beginning to look for other alternatives.

Restaurant employers are also looking at “no-tipping” policies as a way to limit their wage and hour liability. Wage and hour lawsuits continue to be on the rise, and restaurant employers continue to be targets for collective action lawsuits and DOL investigations alleging violations of the FLSA’s tip credit and tip pooling rules. These cases can be very costly because of their collective nature and the possible recovery of liquidated damages and attorneys’ fees. There are many ways a restaurant employer can run afoul of the FLSA with regard to its tipped employees. For example, failure to provide the required notices to tipped employees about the tip credit could result in the loss of the tip credit for the employer. If an employee’s tips combined with the employee’s reduced hourly wage do not equal the federal minimum hourly wage, the employer must make up the difference. An employer’s miscalculation or complete failure to calculate could result in liability. Other cases have challenged who can participate in a tip pool. Wage and hour cases have affected all sizes of restaurant employers, and even celebrity chefs are not immune. In 2012, Mario Batali’s restaurant company paid over $5.25 million to settle a tip pooling collective action.

Many people fear that a no-tipping policy will result in a decrease in customer service because servers will have little incentive to provide superior service if they are making the same hourly wage regardless of the service provided. Those on the other side of this argument contend that without tipping, customers would be more inclined to actually complain to management about poor service since they cannot let their tip do the talking. Some employers are utilizing sales-based incentives to try to eliminate this concern. For example, some restaurants are paying their servers $10 per hour or 20 percent of their sales, whichever is greater.

Before an employer considers doing away with tipping, it needs to run the numbers. The elimination of tipping and, therefore, the tip credit, will increase an employer’s labor costs. Those additional costs have to be made up somewhere for the restaurant to stay in business or stay profitable. Some restaurants have decided to pass this cost on to customers by increasing menu prices, which will also increase the sales tax charged to the customer. Other “no-tipping” restaurants have tried to offset their increased labor costs by reducing portion sizes and eliminating certain items to reduce food costs. Either way, the customer will feel the effect of a no-tipping policy, and only time will tell how customers will respond.

An employer considering a no-tipping policy will also have to consider what its front-of-the-house employees are actually making on a per hour basis including tips. The elimination of tipping will affect not just servers and bartenders but also anyone who participates in the tip pool. After crunching the numbers, a no-tipping policy may not be an option for some employers because they simply cannot afford to pay a high enough hourly wage to keep their best front-of-the-house employees from finding employment elsewhere.

Some restaurants are doing away with tipping in favor of a mandatory service charge. 29 C.F.R. §531.55 provides, “[a] compulsory charge for service, such as 15 percent of the amount of the bill, imposed on a customer by an employer’s establishment, is not a tip.” Under federal law, employers can choose how, or if, to distribute these mandatory charges to their employees so long as their employees earn at least the minimum wage. Some state laws, however, regulate how and to whom service charges must be distributed. Service charges paid to an employee are wages and, as such, affect overtime pay. Any hours worked above 40 in one week must be paid at an overtime rate of one and one-half the employee’s regular rate (which would include the hourly wage plus whatever service charge amount was paid to the employee). The IRS also treats these service charges paid out to employees as wages subject to payroll taxes, which are not eligible for the FICA tip credit. Thus, a service charge could result in higher tax liability for the employer than an equal tip.

If an employer chooses to eliminate tipping altogether, it will also lose the FICA tip credit. Employers are responsible for paying FICA (i.e., Social Security and Medicare) taxes on any tip amounts that employees report. The  Internal Revenue Code allows restaurants to take an income tax credit for their share of FICA taxes paid on most tips. Restaurants considering going to a no- tipping policy should consult with their financial and tax advisors to determine whether that policy makes financial sense in light of the corresponding loss of the FICA tip credit.

It is too soon yet to determine whether no-tipping policies will become the norm in this country the way they have become standard practice in other parts of the world. If a restaurant is considering transitioning to a no-tipping policy, it should consult with its tax and financial advisors to determine whether a no-tipping policy makes financial sense, and with its human resources and legal advisors to determine how best to draft and implement the policy to limit liability and reduce employee complaints and concerns. Such a drastic change in pay structure could cause some employees to head to the Department of Labor with questions about the legitimacy of how they were paid under the old system, so employers need to be prepared to field these types of concerns as well.

If you have any questions regarding this Alert, please feel free to contact the author, Rachel Ullrich, at rullrich@fordharrison.com, or any member of FordHarrison’s Restaurant Industry Practice Group. You may also contact the FordHarrison attorney with whom you usually work.