What is a tip credit and what should employers know?

Running payroll for tipped employees can feel a lot like splitting the check after a chaotic group dinner. Someone always ends up owing more, no one agrees with the math and, no matter how many times you add it all up, the numbers never come out right. Unlike a friendly night out, though, payroll mistakes can lead to expensive compliance violations, uncomfortable conversations with the Department of Labor, and frustrated employees.

In this article, we’ll break down how tip credits work, what HR managers and small business owners need to know about tip outs, minimum wage laws, and payroll taxes, and how to avoid costly payroll mistakes. 

What is a tip credit?

A tip credit allows an employer to count a portion of a tipped employee’s earnings toward meeting federal and state minimum wage requirements. The tip credit reduces the amount employers must pay employees directly, which can help reduce the burden of payroll costs. 

Federal law allows employers to pay $2.13 per hour in cash wages so long as tips and gratuities bring the employee’s total hourly earnings up to $7.25. This means that, while the employee still receives the full minimum wage, part comes from their tips rather than the employer. Businesses must ensure that employees keep enough of their tips to meet wage requirements after distributing any tip outs to supporting staff.

How do tip credits apply?

Tip credits generally apply only to employees working in positions like waiters, bartenders, valets, stylists, and bellhops who receive more than $30 monthly in tips. The Department of Labor also specifies that employers can only apply tip credits to hours spent performing tip-producing work. When workers split shifts between tipped and non-tipped work, employers are responsible for the full minimum wage for the non-tipped hours.

Example: Alex works as a server and spends most of an eight-hour shift delivering dishes and recommending menu items. Throughout the night, satisfied customers leave tips that boost Alex’s hourly wage. At the end of the shift, Alex works an additional two hours reviewing wine lists and inventory with the restaurant sommelier. The bistro may apply a tip credit to Alex’s standard shift but not the time spent maintaining its wine supply, which is a non-service task.

The Fair Labor Standards Act (FLSA) designed the tip credit to help restaurants, bars, hotels, salons, and other types of businesses that rely on tipped employees to cut payroll costs but tightly controls how they can apply it.  Where a worker’s combined cash wage and gratuity don’t add up to at least the state minimum wage, the employer needs to pay the remainder. Businesses also can’t apply tip credits to service charges, as these are considered part of the business’ income and not the employee’s earned wages. 

How to calculate tip credits

Calculating a tip credit involves determining the difference between the applicable minimum wage and the cash wage an employer owes a tipped employee. Under federal law, the minimum wage is $7.25 per hour, while the required cash wage for tipped employees is $2.13. The tip credit therefore works out to $5.12.

Example: Morgan works 25 hours weekly as a bartender at Neon Lounge in Austin. Texas uses the federal minimum wage of $7.25 to calculate tip credits. Jordan earns cash wages of $53.25, which means their tips must equal at least $128 to satisfy federal and state minimum wage laws.

Here’s another example of a tip credit calculation in a state with a minimum wage higher than the federal threshold.

Example: Ryan works 30 hours per week as a bellhop at Boston’s Beacon Parking Service. Massachusetts allows tip credits but requires a higher minimum wage than federal law: $15.00. The state also requires a cash wage of $6.25 per hour for tipped employees. That means Ryan’s tips must meet or exceed $247.50, or Beacon Parking Service will need to contribute.

State and local laws for tip credits

Tip credit laws vary considerably across the U.S. A hotel in Texas, Utah, or Alabama can follow the federal rule, which means employee tips can count toward up to $5.12 of the required $7.25 minimum wage. At the same time, a bar in Alaska, California, Minnesota, Montana, Nevada, Oregon, or Washington would end up in hot water with the state Department of Labor (DOL) for applying a tip credit.

Other states, like Massachusetts and Illinois, allow businesses to apply a tip credit to wages but require a higher minimum wage. A Boston bellhop must earn a base pay of $6.75 per hour, while a Chicago stylist is entitled to a minimum wage of $9.

FICA tip tax credit 

The FICA tip tax credit allows certain businesses in the food and beverage industry to recover the employer portion of Social Security and Medicare taxes paid on their employees’ tipped income. Employers typically pay 7.65% of a worker’s wages in FICA taxes—6.2% for Social Security and 1.45% for Medicare—which can add up to a hefty sum for restaurants that often operate on a slim margin. The FICA tip tax credit works to alleviate some of the financial burden. 

Example: Taylor works as a server and earns a tipped minimum wage of $2.13 per hour. During the month of June, they also earn $1,000 in tips for a total of $1,213. The restaurant therefore needs to pay $92.79 in FICA taxes. Because Taylor’s combined hourly wages and tips work out to $12.13 per hour, however—more than the $5.15 floor set by the IRS—the restaurant can claim the FICA tip credit to recoup that money.

Why $5.15 and not the current federal minimum wage of $7.25? The law authorizing the FICA tip tax credit specifies that employers can apply it to the minimum wage in effect on January 1, 2007. 

For businesses that plan to claim the FICA tip tax credit, making sure employee tips are accurately recorded in payroll records is crucial. Documents showing how payroll deductions were calculated should also be retained. Finally, employers must complete and file Form 8846 as part of their annual tax return.

What is tip pooling?

Tip pooling is a system where tips from all employees are combined into a single ‘pot’ and redistributed according to a preset formula based on hours worked or roles performed. Many businesses, including restaurants, bars, salons, hotels, and valet services, use tip pooling to create fairness among employees who contribute to the customer experience but may not receive direct tips.

Example: Jamie works as a stylist at a salon alongside Jordan, the shampoo assistant, and Riley, the receptionist. Clients often tip Jamie directly, but Jordan, who preps clients and washes hair, rarely receives a tip. Riley schedules appointments and coordinates product deliveries to ensure the salon runs smoothly. The salon applies a tip pool to distribute gratuities across all three employees in recognition of their value to the business. 

The FSLA allows tip pooling, but only under specific circumstances. Supervisors and managers cannot participate in a tip pool, and employers are expressly prohibited from claiming any of the tip pool money or diverting it to non-tipped staff. All tips collected must be fully distributed on the regular payday for the workweek. If an employer can’t work out the distribution beforehand, those tips need to be paid as soon as possible in the new pay period.

Some state minimum wage laws don’t allow employers to implement tip pooling unless all workers receive the full federal minimum wage without a tip credit. Federal law likewise doesn’t allow traditionally non-tipped employees to participate in tip pools unless the employer pays everyone the full minimum wage. 

Employees must be notified of the tip pooling arrangement at the time of hire, including how much they’ll need to contribute and the formula for calculating distribution.

Pay tipped employees and automate payroll with Rippling

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Tip credit FAQs

What does tip credit mean on my paycheck?

A tip credit on your paycheck means that your employer counts some of your tips toward the federal minimum wage requirement. Instead of paying the full hourly wage, they pay a lower, tipped minimum wage, assuming that your tips will offset the gap. If your total earned wages, including tips, don’t meet the required wage rate, your employer must make sure that you’re paid at least the federal minimum wage. Be sure your pay stubs reflect both base pay and tip earnings in separate categories so you can track your compensation.

Is a tip credit good or bad?

Supporters of the tip credit argue that it keeps labor costs manageable for restaurants, while critics say it leads to challenging wage fluctuations and potential underpayment for employees. The impact depends on the strength of state regulations and enforcement of fair labor standards, including the requirement that restaurants compensate workers for the full minimum wage if tips fall short. 

How does a restaurant tip credit work?

A restaurant tip credit allows employers to count a portion of an employee’s tips towards federal or state minimum wage requirements. As long as tips bring a worker’s total earnings to $7.25 or more, federal law gives employers leeway to pay restaurant employees a base rate of $2.13 per hour. That said, if the worker’s tips aren’t enough to bridge the gap, the employer must make up the difference. Likewise, some states have higher minimum wage rates or prohibit tip credits, which means the restaurant bears responsibility for the full minimum wage payment.

What is the tip credit minimum wage?

The tip credit minimum wage is the lowest hourly wage an employer can pay a tipped employee after factoring in the allowed tip credit. Under the current federal minimum wage of $7.25 per hour, employers can pay as little as $2.13, assuming tips cover the difference. Note that individual state minimum wage laws may set higher rates, so it’s important to review your jurisdiction’s labor standards act.

This blog is based on information available to Rippling as of March 6, 2025.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.