Tips or service charges, which is best for your restaurant?

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How restaurant service charges work:

In our last blog post, we discussed increases in the minimum wage being enacted in many cities and states in the US.  Wages, or compensation, is what an employee earns from providing the task or service the employer needs in order to run the business. In most professions this is a pretty simple transaction.

The food service business is a bit of an oddball, however. Many people are paid for providing the same service by both their employer and also by the customers that they serve. Since the late 1800s, tipping in the US has become so customary that, now, most waiters receive the bulk of their compensation from tips and not from wages. As we discussed in the last blog, the federal law (as well as many states) allows for a lower minimum hourly rate to be paid by the employer provided the employee is making at least the minimum wage via tips.  This is called a tip credit.

A lot must be accomplished with the money that each customer pays us for a restaurant’s products and services. First, the restaurant must be able to afford to purchase food, pay rent, pay for the food to be cooked, keep the lights on, and be able to pay the front of house staff a minimum wage that complies with the law.  The current system in most fine dining restaurants in North America (per the tip credit) is essentially charging the guest less than the true cost of the experience, and then asking the guest to pay for the service separately to make up the difference.

When the minimum wage is increased and/or tip credits are done away with, the relationship between all of this stops working. In states that don’t have a tip credit, the mandated increase in waiters pay means that now the restaurant and the guest are paying the server for the same job twice. The restaurant could raise prices to absorb this increase, but in the end the guests will need to still see the restaurant as a good value. The product has not changed; the guest is getting the same service, but now they are being asked to pay more for it.  Higher menu prices lead to higher tips. Higher tips lead to the guests paying more overall, and charging more may actually lead to a decline in overall business. 

Is there another way? Some restaurants do not allow tipping at all. Guests receive a bill with a service charge amount added to the total so that the entire staff may make a higher hourly wage. The guests pay this service charge, and the restaurant then distributes that income to pay wages as needed throughout the business; both in front and back of the house.

The benefits of the service charge system are pretty simple. A restaurant doing $2,000,000 in sales per year may have a total payroll of roughly $650,000 with about $300,00 of that going to the front of the house. In Los Angeles, the minimum wage will increase from $10.00 per hour to $15.00 per hour (a 50% increase). This would mean an increase in front of house payroll of $150,000, making the overall FOH payroll a whopping $450,000 per year! To cover this increase, another $150,000 must be found in a budget which includes a profit. The servers, bartenders and other tipped employees have just received a 50% raise to their hourly pay!  At this $2,000,000 per year restaurant, the guests are leaving between $360,000 and $400,000 per year in tips. Having a service charge means that this restaurant could essentially collect these tips itself, and then have $360,000 per year in new cash flow to be used to pay for the $150,000 increase to payroll (with the rest to be used to increase pay for the entire house)!

This all sounds pretty good, but there are still some problems with service charges. The first challenge is these new, higher wages for tipped employees must be paid regardless of how much the restaurant is selling. If you think you are eager to cut staff when it is slow now, just wait until waiters are making $25 to $35 per hour. Next, for the purposes of collecting sales tax, most states draw a distinction between tips and service charges. Generally, if the guest is required to pay the charge (and not all of the funds go to the server) then you must collect sales tax on that service charge amount. Depending on your state, this adds as much as 10% to the cost of adding the service charge to a check. Check with your state to know how service charges are considered with respect to sales tax. The sales tax, however, is not your real tax problem. Between the IRS, state taxing agencies, tipped employees and restaurants there is a sort of unspoken understanding which is that restaurant business will do what it can to compel tipped employees to declare tips as income. For many tipped employees not all tips are reported to the IRS. A restaurants share of state and federal payroll taxes is based on the total income the employee earns, including tips. When a service charge is collected and wages increase, the entire front of house income is now effectively normal pay, and most restaurants payroll taxes will likely increase. However, keep in mind that this may actually be beneficial as it could protect you and your staff from the potential of an audit in the future.

Perhaps the most difficult challenge to consider in switching to a service charge is that a service charge is, in effect, taking some of the tipped employees income and using it to pay for the increased minimum wage throughout the entire house. This is a hard thing to be the first restaurant in your market to do. If a server or bartender is told they will no longer make tips at your restaurant, they may just walk across the street and take a job at a restaurant that still accepts tips. In places like San Francisco and New York, a few high profile restaurants are beginning to explore service charges (ie; Danny Meyer). Generally the market tends to make these changes en mass when a tipping point is reached. It may be a good time to keep your eyes on what others are doing and understand how service charges and other changes will affect your business should you one day decide to make the switch.