A service charge and a gratuity look similar on a receipt but sit on opposite sides of federal law. A gratuity is a voluntary tip the customer chooses to leave, and it belongs to the employee. A service charge is a mandatory fee the business adds to the bill, and it belongs to the business. That single difference in who chose to pay changes who owns the money, how it’s taxed, and whether it counts toward a worker’s wages. When comparing a service charge vs. a gratuity, the label printed on the bill doesn’t decide the question; the customer’s freedom to say no does.
How to Tell Which One It Is
The IRS applies a four-factor test, and all four must be present for a payment to count as a tip:
- The customer paid free from compulsion.
- The customer set the amount.
- No employer policy or menu notation dictated the amount.
- The customer generally decided which employee received it.
Miss any one factor and the payment is a service charge, no matter what the receipt calls it. A restaurant that prints “18% gratuity added for parties of six or more” is imposing a service charge. The word “gratuity” on the check doesn’t control the legal classification.1U.S. Department of Labor. Fact Sheet 15 – Tipped Employees Under the Fair Labor Standards Act
Federal regulations define a tip as money the customer presents as a gift in recognition of service, with the decision to leave one, and how much, made entirely by the customer.2eCFR. 29 CFR 531.52 – General Restrictions on an Employer’s Use of Its Employees’ Tips Cash on the table, an amount written on a card slip, or money handed directly to a server all qualify. Automatic percentages on large parties, banquet event fees, hotel room service charges, bottle service fees, and cruise package fees do not.
Who Owns the Money
This is where the distinction hits workers hardest. Tips belong to the employee. Federal law states plainly that an employer may not keep tips received by its employees for any purpose.3Office of the Law Revision Counsel. 29 USC 203 – Definitions The business can run a tip pool and redistribute among eligible staff, but the money never becomes company revenue. Managers and supervisors are barred from taking a share.
Service charges work the opposite way. They become the business’s gross receipts the moment the customer pays. No federal law requires the employer to pass any of that money to the workers who served the table. Many restaurants distribute some or all of it, but that is a business decision, not a legal obligation. When an employer does hand service charge money to employees, it arrives as regular wages, not as tips.4Internal Revenue Service. Revenue Ruling 2012-18 A customer who sees “18% gratuity included” and assumes the server pocketed it may be wrong. The restaurant could legally keep every dollar.
How Each Is Taxed
Both are taxable income for the employee, but the mechanics differ.
Tips are treated as supplemental wages. Employees report tips to the employer, and the employer withholds federal income tax, Social Security tax, and Medicare tax on the reported amount. The Social Security wage base for 2026 is $184,500. Medicare has no cap and applies an additional 0.9% on wages above $200,000.5Internal Revenue Service. Publication 15 – Employer’s Tax Guide, 2026
Service charges distributed to employees are regular wages. The IRS is direct on this: “Service charges aren’t tips; therefore, withhold taxes on service charges as you would on regular wages.”5Internal Revenue Service. Publication 15 – Employer’s Tax Guide, 2026 The same taxes come out, but the money shows up on the W-2 as wages and never qualifies for tip-reporting treatment.
Effect on Minimum Wage and Overtime
The federal minimum wage remains $7.25 per hour in 2026. Employers of tipped employees can take a tip credit, paying a cash wage as low as $2.13 per hour and counting up to $5.12 per hour in tips toward the minimum wage obligation.1U.S. Department of Labor. Fact Sheet 15 – Tipped Employees Under the Fair Labor Standards Act Only actual tips count. Service charges distributed to workers cannot justify the lower $2.13 cash wage, because they are not tips.4Internal Revenue Service. Revenue Ruling 2012-18 Many states set higher cash-wage floors or don’t allow a tip credit at all, so the federal figures are a floor.
Overtime works differently too. Service charges paid to an employee must be included in the regular rate of pay when calculating overtime. Tips are excluded from the regular rate. A server who takes home $200 in distributed service charges during a workweek has a higher regular rate than a server who took home $200 in voluntary tips, which translates to higher overtime pay past 40 hours.1U.S. Department of Labor. Fact Sheet 15 – Tipped Employees Under the Fair Labor Standards Act
Tip Pool Protections That Service Charges Lack
Federal law lets employers require tip pooling, but with guardrails. When the employer takes the tip credit, only employees who customarily and regularly receive tips can be in the pool. Managers and supervisors are always excluded, whether or not the employer takes the credit.6eCFR. 29 CFR 531.54 – Tip Pooling Pooled tips must reach employees no later than the regular payday for the workweek in which they were collected.
None of that applies to service charges. Because the money belongs to the business, the employer can split it however it wants. All to servers. Split between front and back of house. Manager bonuses. Kept in general revenue. There is no federal rule requiring the money to reach the employees who served the customer, and nothing stops managers from taking a cut. A tip pool has legal guardrails; service charge distribution is at the employer’s discretion.
Sales Tax on the Bill
Sales tax is a state matter, so specifics vary, but a general pattern holds. Voluntary tips are typically not subject to sales tax because they aren’t part of the meal’s price. Mandatory service charges usually are taxable as part of the total transaction price. Some states carve out an exception when the charge is separately listed on the bill, labeled as a gratuity, and passed entirely to employees. If the business keeps any portion, or if the charge isn’t clearly identified, the full amount usually becomes taxable. Customers who see a mandatory “gratuity” line should check whether the tax on the bill has climbed with it.
Does the Business Have to Disclose the Charge
Federal law does not currently require restaurants to fold mandatory service charges into their advertised prices. The FTC’s 2024 final rule on unfair or deceptive fees covers live-event tickets and short-term lodging only; restaurants were explicitly excluded.7Federal Trade Commission. Trade Regulation Rule on Unfair or Deceptive Fees
That leaves disclosure to the states, and more are stepping in. Several now require businesses to build all mandatory fees into the displayed price or disclose them prominently before the customer commits. Statutory penalties range from a few thousand dollars to $25,000 per violation depending on the state. Colorado and Connecticut have fee transparency laws taking effect in 2026, joining California and Minnesota, which already enforce similar rules. A service charge that’s legal in one state can trigger a disclosure violation in another.
Even where the law is silent, clear labeling on the menu and receipt heads off the most common confusion: a customer who reads “gratuity” on the bill, believes the server has been paid, and leaves nothing extra, while the money in fact went to the house.