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Is a 'Service Charge' a 'Tip'? Ask the IRS

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By Betty Wang, JD on May 29, 2013 5:46 AM

It's not uncommon for your bill at a restaurant to come with both a service charge and a tip. Sometimes there's no service charge at all, but still a line for a tip. Other times, neither are there, but one, or both, are expected of you.

To make matters even more confusing: While the service charge seems to be a number that's already calculated, the tip is there for you to calculate, but ... sometimes "suggested" tip amounts are also given.

Are service charges and tips the same? Not according to a fairly recent addendum from the IRS, which clarified the difference.

What Is a 'Tip'?

The IRS has set out the following traits as characteristic of a tip:

  1. The payment must be made free from compulsion;
  2. The customer must have the unrestricted right to determine the amount;
  3. The payment should not be the subject of negotiation or dictated by employer policy; and
  4. Generally, the customer has the right to determine who receives the payment.

Historically, it has been suggested that the term "tip" originated from an innkeeper's sign to ensure faster service. More currently, the general use of a tip remains the same. Customers have the option of tipping their server for punitive reasons (i.e., deducting if the service is bad) or as a reward (if the service is particularly outstanding).

What Is a 'Service Charge'?

Service charges will usually be clearly indicated as such. If any of the above listed traits for a tip are missing, however, then it is usually a service charge. In other words, a service charge is, when:

  1. The payment is mandatory;
  2. The customer does not possess the unrestricted right to determine the amount;
  3. The payment is the subject of negotiation or dictated by employer policy; and
  4. Generally, the customer does not hold the right to determine who receives the payment.

The IRS provides an example of a service charge occurring when a banquet hall charges at a pre-determined rate not negotiable by the customer. In most cases, that money is then distributed to employees who rendered the services that the hall required at that event -- for example, bartenders, waiters, and janitors.

Service charges are also common if you dine out in larger parties. They are set for the staff and facilities to be able to accommodate you and exert the additional service needed when there are more bodies.

Does It Really Matter?

But what's the big deal? While the "tip" versus "service charge" distinction may not seem too important to a customer, it may make a big difference to your server. That's because a "tip" belongs to the server, according to the IRS, while a "service charge" may not.

So next time you're dining out, take a close look at your bill. If you get to choose the amount you're leaving, then you're most likely leaving a tip. But if you don't get to choose the amount, then technically you're paying a service charge -- even if it's called a mandatory "gratuity" on the receipt.

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