How to Pay Tips to Employees and Stay Compliant

To pay tips to employees, add each worker’s reported tips to their regular wages for the pay period, then withhold federal income tax, Social Security, and Medicare on the combined total. You pay the employer share of Social Security, Medicare, and unemployment tax on those same tip dollars, and you send the employee the full tip amount — federal law does not let you keep any part of it, even to cover the taxes you owe on it.¹

Tips Belong to the Employee

Under the Fair Labor Standards Act, tips are the property of the worker who earned them. You cannot keep any portion, and you cannot require employees to hand tips to managers or supervisors. This holds even if you pay the full minimum wage and claim no tip credit.¹ Your role is to receive the tip information, run it through payroll, and deliver the money.

Collecting Tip Reports From Employees

Employees must give you a written report of their tips by the 10th of the month following the month the tips were received.² The IRS provides Form 4070 for this purpose, and a valid report includes the employee’s name, address, and Social Security number, the month covered, the total tips received, and the employee’s signature. You can accept the same information through your own electronic system or any written format that captures those details.

Encourage employees to keep a daily log — Form 4070A works well — with cash and credit card tips tracked separately.³ Keep every tip report with your standard payroll records.

Running Tips Through Payroll

Each pay period, use the reported tips to build gross pay and withhold the same taxes you withhold on regular wages:

Add reported tips to hourly wages to get gross pay for the period.
Withhold Social Security tax at 6.2% of the combined total, up to the 2026 wage base of $184,500.⁴⁵
Withhold Medicare tax at 1.45% of the combined total, with no wage cap.
Withhold Additional Medicare Tax at 0.9% on wages plus tips over $200,000 for the year. There is no employer match on this piece.⁴
Withhold federal income tax based on the employee’s W-4 and the total of wages plus tips.
Match the employee’s 6.2% Social Security and 1.45% Medicare from your own funds.
Pay FUTA at 6.0% on the first $7,000 of each employee’s annual wages and tips, reduced to an effective 0.6% after the standard state-unemployment credit.⁶

State unemployment tax also applies to tipped wages. Wage bases vary widely, so confirm the current threshold and rate with your state’s unemployment agency.

When the Paycheck Isn’t Big Enough to Cover Withholding

For a server whose income is mostly cash tips, the direct cash wage sometimes cannot absorb every tax you’re supposed to withhold. When that happens, withhold in this priority order:⁷

All taxes owed on the regular (non-tip) wages
Social Security, Medicare, and Additional Medicare tax on reported tips
Federal, state, and local income taxes on reported tips

If the check still isn’t enough, carry uncollected federal income tax forward to later paychecks through the end of the calendar year. For Social Security and Medicare tax you cannot collect by the 10th of the month after the employee reported the tips, stop trying to collect it. Report the uncollected amount as an adjustment on Form 941 and in the designated box on the employee’s W-2.⁷

Paying Out Credit Card Tips

Credit card tips must reach the employee by the next regular payday. You cannot hold the money while waiting for the processor to settle.¹

You may deduct a proportional share of the processing fee from the tip. If your processor charges 3%, a $20 tip can be reduced by 60 cents so the employee receives $19.40. Two limits apply. The deduction cannot exceed the actual fee percentage the processor charges, and it cannot pull the employee’s effective wage below the required minimum (including any tip credit you’ve claimed). Deducting more than the actual fee is a wage violation.¹

Service Charges Are Paid as Regular Wages

Mandatory service charges — automatic gratuities on large parties, banquet fees, and similar add-ons — are not tips. When you distribute them to employees, the IRS treats the money as regular non-tip wages, subject to the normal income tax, Social Security, and Medicare withholding.⁷

The IRS applies four tests. A payment is a tip only when the customer gives it voluntarily, the customer picks the amount, employer policy does not dictate it, and the customer chooses who receives it. If any of those is missing, the payment is a service charge.³ The classification also matters for overtime: because service charges are regular wages, they count toward the regular rate used in overtime calculations.

Meeting Minimum Wage and Paying Overtime

The FLSA lets you count part of an employee’s tips toward the federal minimum wage of $7.25 per hour.⁸ The maximum tip credit is $5.12 per hour, so the lowest direct cash wage for a tipped employee is $2.13. If tips plus cash wage do not reach $7.25 in any workweek, you must make up the shortfall.⁹

Before claiming the credit, you must tell each tipped employee, in advance, the cash wage you’ll pay, the tip credit you’ll claim, that the employee keeps all tips (except valid pool contributions), and that the credit does not apply unless proper notice was given. Skip the notice and you owe the full minimum wage for every hour worked.⁹

Several states, including Alaska, California, Minnesota, Montana, Nevada, Oregon, and Washington, prohibit the tip credit entirely. Others set a higher cash-wage floor than $2.13. When the state rule is more generous to the employee, it controls.

If a tipped employee also works in an unrelated non-tipped role, such as building maintenance, you cannot take the tip credit for those hours. Related side work within a tipped occupation — rolling silverware, brewing coffee, wiping tables — does not trigger a separate pay rate under current federal rules.¹⁰

Overtime pays 1.5 times the regular rate, which equals the cash wage plus the tip credit you claim; the tip credit continues to apply during overtime hours. The formula is (regular rate × 1.5) minus the tip credit equals the direct cash wage per overtime hour. At the $2.13 cash wage and full $5.12 tip credit, the regular rate is $7.25, overtime is $10.88, and after subtracting the $5.12 credit you owe $5.76 per overtime hour in cash. At a $4.00 cash wage with the same credit, the regular rate is $9.12, overtime is $13.68, and the cash owed is $8.56.¹¹

Tip Pooling

When you take a tip credit, tip pools may include only employees who customarily receive tips — servers, bartenders, bussers, and similar positions.⁹ If you pay the full minimum wage without claiming a tip credit, the pool may also include back-of-house workers like cooks and dishwashers.

Managers and supervisors never share in a tip pool, whichever structure you use.¹ For this purpose, a manager is someone whose primary duty is management and who directs at least two other employees.

Depositing and Filing With the IRS

Send withheld taxes and your employer share through the Electronic Federal Tax Payment System.¹² Your deposit frequency depends on total employment-tax liability during a lookback period covering July 1 of two years prior through June 30 of the prior year.¹³

Monthly depositor: $50,000 or less in the lookback period. Deposits due by the 15th of the following month.
Semi-weekly depositor: more than $50,000. Deposits due within a few days of each payday, following the IRS schedule.

File Form 941 each quarter to reconcile deposits with total wages and tips paid. Late deposits carry penalties of 2% for 1–5 days late, 5% for 6–15 days, 10% for more than 15 days, and 15% if payment is still outstanding after a final IRS notice.¹⁴

Reporting Tips on the W-2

At year end, report each employee’s tip income in these W-2 boxes:³

Box 1 (Wages, tips, other compensation): total wages plus all reported tips
Box 5 (Medicare wages and tips): same combined total
Box 7 (Social Security tips): reported tips subject to Social Security tax, separate from regular wages in Box 3

If you could not collect all Social Security or Medicare tax during the year, report the uncollected amounts in the designated W-2 boxes so the employee can account for them on their personal return.⁷

Large Food and Beverage Establishments: Form 8027

If you run a food or beverage establishment that typically employs more than 10 workers on a business day, file Form 8027 each year, reporting gross receipts and total tips reported by employees.¹⁵ If total reported tips fall below 8% of gross receipts, allocate the difference among tipped employees. Allocated tips appear in Box 8 of the W-2 but are not included in Boxes 1, 5, or 7, and you withhold no taxes on them; the employee handles that on their personal return.

For the 2025 calendar year, Form 8027 is due by March 2, 2026 on paper or March 31, 2026 electronically.¹⁵

Recovering Some of Your FICA: The Section 45B Credit

Food and beverage operators, and businesses offering beauty services like hair care, nail care, or spa treatments, may claim a tax credit for the employer-share FICA taxes paid on certain employee tips.¹⁶ The credit covers tips above the amount needed to bring an employee up to a baseline hourly wage: $5.15 for food and beverage employers, $7.25 for beauty service employers.¹⁷

Multiply the eligible tip amount by 7.65% and file Form 8846 with your annual return. You cannot both claim the credit and deduct the same FICA dollars.¹⁶

What the New Employee Tips Deduction Changes for You

Starting with the 2025 tax year, employees can deduct up to $25,000 in qualified tips on their personal federal income tax returns, phasing out above $150,000 of individual income ($300,000 joint).¹⁸ This is an employee-side deduction. It does not change your withholding calculations or your payroll tax obligations. Employees who expect to benefit may submit a revised W-4 to lower their income tax withholding, and you process those updates the way you would any other W-4 change.

1
U.S. Department of Labor. Fact Sheet #15: Tipped Employees Under the Fair Labor Standards Act (FLSA)
2
Office of the Law Revision Counsel. 26 USC 6053 – Reporting of Tips
3
Internal Revenue Service. Tip Recordkeeping and Reporting
4
Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
5
Social Security Administration. Contribution and Benefit Base
6
Internal Revenue Service. Topic No. 759, Form 940, Employers Annual Federal Unemployment Tax Return
7
Internal Revenue Service. Topic No. 761, Tips – Withholding and Reporting
8
U.S. Department of Labor. State Minimum Wage Laws
9
eCFR. 29 CFR Part 531 Subpart D – Tipped Employees
10
eCFR. 29 CFR 531.56 – More Than $30 a Month in Tips
11
U.S. Department of Labor. FLSA Overtime Calculator Advisor – Overtime Calculation Examples for Tipped Employees
12
Internal Revenue Service. EFTPS: The Electronic Federal Tax Payment System
13
Internal Revenue Service. Topic No. 757, Forms 941 and 944 – Deposit Requirements
14
Internal Revenue Service. Failure to Deposit Penalty
15
Internal Revenue Service. Instructions for Form 8027
16
Office of the Law Revision Counsel. 26 USC 45B – Credit for Portion of Employer Social Security Taxes Paid With Respect to Employee Cash Tips
17
Internal Revenue Service. Form 8846 – Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips
18
U.S. Department of the Treasury. Treasury and IRS Issue Proposed Regulations Around No Tax on Tips