California Employers: Service Charges Can Lead to Costly Mistakes

Nondiscretionary bonuses must be included in an employee’s regular rate of pay

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When is a tip not a gratuity? When it's a service charge. In California, a worker's "regular rate of pay" must include any portion of a service charge that the worker receives. Otherwise, employers may be making costly wage and hour mistakes, particularly when calculating overtime and sick-leave pay.

Gratuities are voluntarily left by customers, and under California law, they belong to the employee, not the employer, said Christina Tellado, an attorney with Reed Smith in Los Angeles. Service charges, on the other hand, are mandatory amounts set by an establishment and charged to customers. 

Restaurant and hotel employers sometimes get confused about the difference. They may call a service charge an "automatic gratuity" that they add to bills for large parties, banquets or private rooms, said Nancy Yaffe, an attorney with Fox Rothschild in Los Angeles. "But once you make it nondiscretionary, you convert it from a gratuity to a service charge," she said.

Why does it matter? The federal Fair Labor Standards Act and the California Labor Code treat mandatory charges differently than discretionary tips. If an employer treats a service charge as a tip, it can get into trouble, because the employer will not be calculating, taxing or reporting wages properly, said Michelle Lee Flores, an attorney with Akerman in Los Angeles.

If businesses do add a service charge to tabs, the amount shouldn't be variable, noted Brandon Takahashi, an attorney with Hinshaw & Culbertson in Los Angeles.

Overtime Calculations

California has daily overtime pay requirements. Employees must be paid time and a half for hours worked beyond eight in a day and double time after 12 hours.

Overtime wages are based on an employee's regular rate of pay, which doesn't include discretionary bonuses—such as a holiday bonus or a tip—but does include nondiscretionary bonuses that are based on hours worked, production or proficiency.

Unlike tips, an employer generally may keep a portion of the service charge, Tellado said. However, some cities—such as Santa Monica, Emeryville and Oakland—require employers to distribute the entire service charge to the employees who performed the work for which the charge was collected.

If an employer does distribute service charges to employees according to a uniform policy, a service charge is really like a nondiscretionary bonus, Takahashi said.

Additionally, if a restaurant manager offers servers an incentive—such as a $2 bonus for every daily special sold—those payments need to be included in the calculation, Yaffe noted.

Miscalculations can be costly. "California has one of the highest number of wage and hour class actions in the nation, and these lawsuits can be big trouble for employers who are not using the proper rate to determine overtime for employees," Flores said. One of the most significant risks with wage and hour class actions is that employers may be required to pay the employee's attorney fees.  

Paid Sick Leave

California employers must also factor in any wages received from service charges when determining an employee's regular rate of pay for sick leave, Flores said. California law allows employers to pay sick leave at the employee's regular rate of pay for the workweek in which the leave is used.  Alternatively, employers can divide the total wages (excluding any overtime premiums) by the total hours worked in the full pay periods from the prior 90 days of employment.  

SHRM members-only how-to guide: How to Comply with California's Paid Sick Leave Requirements]

Employers should note that some cities in California have their own paid-sick-leave ordinances, which vary on how an employer must calculate the sick-leave rate. 

The Los Angeles hotel ordinance adds yet another layer of complication, Yaffe noted. Not only does Los Angeles have a minimum wage and paid-sick-leave law, but it also requires certain large hotels in the city to pay workers a higher minimum wage and to provide more paid time off.

"Variances between California state and local sick-leave ordinances reinforce that employers should work closely with counsel to ensure their pay practices are compliant," Tellado said.

The Society for Human Resource Management supports a bill that would pre-empt state and local paid-sick-leave laws. The bill would give employees more options and flexibility when taking time off to meet their individual and family needs, while providing predictability for employers who now face overlapping state and local requirements.

Best Practices

Restaurants and hotels need to be very clear about the purpose of any extra charges on a customer's bill. Customers should be notified that a mandatory set percentage will be charged and that it is not a gratuity, Takahashi said.

If a business wants to add a gratuity to a bill or service contract without converting it to a service charge, the details must be carefully worded, Yaffe said. For example, a banquet event order could have an option for customers to preselect the gratuity they would like to add and clearly state that they will have the opportunity to adjust the amount at the time of service.

Tellado recommends that employers do the following:

  • Clearly identify the service charges collected from customers.
  • Create a written policy spelling out how the service charges will be distributed to employees.
  • Implement a precise record-keeping process to track tips and service charges.
  • Confirm that the payroll administrator is properly calculating the regular rate to include service charges for purposes of overtime premiums and sick-leave compensation.
  • Continue to monitor state and local rules and guidance on the proper calculation of employees' regular rate of pay.

California employers must make sure that they are informed and understand the unique laws, regulations, ordinances and guidance that may apply in each of the California jurisdictions where they do business, she added.

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