If your employees earn money directly from customers—at a restaurant, salon, hotel, or bar—you already know how confusing tip reporting can be. The IRS draws a very specific line between tips and auto-gratuities (aka, service charges), and the difference affects payroll taxes, employee reporting, and even year-end W-2s.
Let’s break it down in plain English.
What Counts as a Tip?
A tip is any payment a customer gives voluntarily to an employee as a thank-you for good service. The IRS says a payment only qualifies as a tip if the customer:
- Freely decides whether to pay it
- Chooses the amount
- Chooses who receives it
If any of those conditions aren’t met, it’s not a tip; it’s an auto-gratuity or service charge.
Two types of tips
The IRS divides tips into two categories: cash tips and non-cash tips.
1. Cash tips
Cash tips include:
- Money handed directly to an employee
- Tips added to a credit or debit card payment
- Tips received through tip sharing or pooling arrangements
Bottom line: The tip is a “cash tip” if it can be deposited as money (even if it came from a card payment).
Employees must report cash tips to their employer if they total $20 or more in a calendar month. Once reported, the employer has to include those tips in payroll, withhold federal income tax, and pay Social Security and Medicare taxes, just like regular wages.
2. Non-cash tips
Non-cash tips are anything of value that isn’t money, for example, concert tickets, gift cards, or other personal items. These are still taxable income to the employee, but they aren’t subject to payroll tax withholding since the employer never handled the cash.
Employees report the fair market value of non-cash tips when filing their personal tax return.
Employers don’t need to include non-cash tips in payroll, but if an employee reports receiving them, it’s smart to document it internally. Keeping a simple note (“Employee reported $100 in gift cards on May 10”) shows that you’re maintaining accurate payroll records in case of an IRS inquiry.
So:
- A $50 bill left on the table? Cash tip.
- A pair of football tickets? Non-cash tip.
Both are taxable, but handled differently.
💡 Large food and beverage employers must report ‘allocated tips’ on employees’ W-2s if reported tips fall below the IRS minimum (usually 8% of gross receipts). These are estimated amounts, not actual cash tips or non-cash tips, and don’t affect payroll tax withholding or deductions.
What counts as an auto-gratuity (service charge)
An auto-gratuity, also called a service charge, is a payment added to the customer’s bill by the business, not the customer.
Common examples include:
- An 18% “gratuity” automatically added for large parties
- A banquet or catering fee
- A mandatory delivery charge
The IRS doesn’t consider it a tip if the customer had no choice in paying it or adjusting the amount.
When you distribute auto-gratuity funds to employees, those payments are treated as regular wages, not tips. That means they go through normal payroll and are subject to all the usual tax withholdings.
Auto-gratuities often confuse employers because they appear on the bill under “gratuity.” But from a tax standpoint, what matters isn’t the label. It’s whether the payment was mandatory. The IRS looks at facts, not menu wording.
And, the IRS may ask the employer to demonstrate how sales subject to service charges are distinguished from sales subject to tipping during an IRS audit. andYou, as the employer, will need to keep good records from your daily summary reports, or POS records.
Why the Difference Matters
Tips and auto-gratuities might look similar on paper, but they’re taxed differently—and the IRS expects you to treat and report them that way.
| Category | Who Decides? | Tax Treatment | W-2 Reporting |
| Cash Tip | Customer | Subject to income tax, Social Security, and Medicare employer withholding | Boxes 1, 5, 7 |
| Non-Cash Tip | Customer | Taxable to employee, not subject to employer withholding | Employee reports value on their income tax return |
| Auto-Gratuity / Service Charge | Business | Treated as regular wages: Subject to income tax, Social Security, and Medicare employer withholding | Boxes 1, 3, 5 |
Mixing them up can cause problems like wrong withholdings, W-2 errors, or even missed eligibility for the IRS federal tip credit (which applies only to true tips).
Patriot makes it easy to enter and report tips or auto-gratuities correctly so your payroll stays compliant and stress-free.
The bottom line
Don’t assume every “gratuity” line on a receipt is a tip. What matters isn’t the label—it’s who made the decision.
- If it’s voluntary, it’s a tip.
- If it’s automatic, it’s an auto-gratuity or service charge.
Get that part right, and your payroll stays clean, your employees’ W-2s stay accurate, and the IRS stays happy. For full details, see the IRS guidance on Tip Recordkeeping and Reporting.
How Patriot helps
Patriot Payroll® makes it easy to stay compliant with IRS rules. You can:
- Track employee-reported cash tips already received
- Track employee tips owed (credit card tips)
- Separate auto-gratuities from tip income in payroll
- Generate accurate W-2s that distinguish between wages, tips, and auto gratuity (aka, service charge) pay
Patriot makes it easy to follow the IRS reporting rules behind the scenes so you can focus on your business.
This is not intended as legal advice; for more information, please click here.
