A key feature in the food service industry today, allocated tips are distributed by management in addition to the gratuities workers receive and report directly.
What you’ll learn
What you’ll learn
Updated: May 14, 2025
Key takeaways about allocated tips
- Large food and beverage establishments (with 10+ employees) must allocate tips when employees report less than 8% of the establishment’s food and drink revenue
- Employers can use three calculation methods: hours-worked method, gross receipts method, or a good-faith agreement signed by at least two-thirds of tipped employees
- Employers should not withhold taxes on allocated tips but must report them in box 8 of employees’ W-2 forms and on IRS Form 8027
- Maintaining accurate tip records and implementing reliable tracking systems helps avoid common reporting mistakes and ensures IRS compliance
If you own or manage a larger food or beverage establishment, you will likely need to follow Internal Revenue Service (IRS) requirements to report any allocated tips annually. This employer’s guide explains what allocated tips are, reporting requirements, and common errors to avoid so that you can be organized and prepared ahead of next tax season.
What are allocated tips?
Simply put, allocated tips are what an employer assigns to employees — in addition to the tips that a given worker reported for the year. A dining establishment generally has to allocate tips to its workers if the tips an employee reported were less than their share of 8% of the organization’s food and drink revenue. Are allocated tips unreported tips? All tips should be reported, including informal tip-sharing arrangements and cash tips.
The IRS requires all large food and beverage establishments in the US to report the tips, including cash tips, that their employees earn. It defines these establishments as service organizations that have 10 or more workers on an average business day. A tipped employee is anyone who receives $30 or more in tips each month, although each state can have its own regulations.
When are employers required to allocate tips?
Employers are required by law to allocate tips in a few particular situations:
- Meeting IRS thresholds for reported tips: If the tips reported by team members at a large food or beverage establishment are less than their share of the eight percent of the organization’s sales, then your business is required to allocate tips to employees. These tips will appear in Box 8 of each employee’s Form W-2, Wage and Tax Statement. Food and beverage organizations can also appeal to the IRS for a lower rate than eight percent but not lower than two percent.
- Other special situations that require allocation: If your employees receive non-cash tips, such as tickets to events or other valuable items, tip allocation also comes into play.
The idea is that larger food and beverage organizations often have inconsistent tipping practices, so allocated tipping makes the entire process more equitable and fair for all of your employees. If you are uncertain whether your business requires tip allocation, you should check with your accountant.
Calculation methods for allocated tips
If you are allocating tips for your team members, it is critical to understand the various calculation methods for allocated tips. There are three key methods used today:
- Hours-worked method: If your establishment employs fewer than 25 full-time employees, you can allocate tips based on employee hours instead of sales. The advantage of the hours-worked method is that it prioritizes the hours that your employees put in, rewarding those who are willing to go above and beyond. However, it is less accurate than other options because it does not calculate the sales made during those specific employees’ work hours.
- Gross receipts method: This method involves all gross receipts minus tips. You multiply your annual gross receipts by 8%, then subtract the total value of tips that employees reported. While this method is generally fair to all employees, it requires some heavy calculations on your end, which creates room for error when they are done manually.
- Good-faith agreement: As it sounds, a good-faith agreement is an agreement between employers and employees on how tips will be allocated. A minimum of two-thirds of tipped employees must sign and agree to this arrangement. While this can spark arguments among team members who are in favor of or against this agreement, it also provides greater flexibility to meet your business’ unique needs.
Payroll tax implications
There are some notable payroll tax implications when it comes to calculating allocated tips. You should not withhold taxes from allocated tips; rather, your workers should use Form 4137 to determine appropriate taxes on their tips. Again, it is a smart idea to connect with your accountant to ensure all of your allocated tips and taxes are on the up and up.
Pro tip
“Some restaurants implement service charges, such as an extra percentage added to the bill for large parties. Because these service charges are required to be paid by customers who don’t control the amount, they are not considered tips and therefore should not be included in allocated tips. Instead, they are treated as non-tipped wages for employees.”
— Peggy James, CPA
Understanding all your tax obligations around allocated tips is something you’ll want to have on your to-do list, so let’s talk about those next.
Understanding tax responsibilities
It makes good business sense to know about:
- Impacts on employer and employee: It is important to understand the ins and outs of a tipped wage for both employers and employees. If you fail to pay appropriate taxes on allocated income, for instance, you will face fines and penalties from the IRS, as will your workers.
- Forms for reporting allocated tips: Employers are responsible for reporting allocated tips on Form 8027, the Employer’s Annual Information Return of Tip Income and Allocated Tips, while each employee’s individual allocation of tips is reported on Box 8 of their Form W-2, Wage and Tax Statement. Again, reporting allocated tips is required, not optional.
- IRS reporting requirements: Both you and your employees must meet annual IRS reporting requirements. Unreported tip income is not permissible. Employers must also provide their employees with a Form W-2 that shows the allocated amount in box 8.
Tax rules and regulations can be complex. Your business may benefit from working with a third-party vendor that excels at tax calculations, reporting, and management. You can also consult your attorney or accountant to make sure that your business remains in compliance.
Common reporting mistakes to avoid
When reporting allocated tips, there are several common mistakes your business will definitely want to avoid:
- Inaccurate recordkeeping: It is very important to track tips, employee hours, gross receipts, and reported income, among other key financials. This will ensure that your records are correct and in order if the IRS ever comes calling. If you do not already have a solid record-keeping system in place for your business, there is no time like the present.
- Process to track documents: Likewise, an organized system will make it easier to keep track of everything. You can organize allocated tips by employee which will go a long way toward meeting all the IRS reporting requirements.
- Failure to perform regular auditing and verification: Finally, you should perform regular audits and verification to ensure that your systems and reporting are accurate and in good working order. This is a best practice for accounting in general and allocated tips in particular.
If you can avoid these common errors, you will be ahead of the game and will be prepared if you are ever audited by the IRS.
Understanding tip allocation makes good business sense
Having a process for tip allocation can help employers streamline reporting, prevent issues with taxes, and keep in good standing with the IRS. This also goes a long way to make sure workers get the wages they are entitled to. There are a number of payroll solutions that make it easy to manage tip pooling, meet all of Uncle Sam’s reporting requirements, and pay employees allocated tips as well as the wages they’re owed, on time every time.
You may also find our free tip tax calculation tool helpful in making this entire process much easier. Best wishes as you bring your processes together, and if you are ever looking for a payroll software solution, we are here to help!
Please note all material in this article is for educational purposes only and does not constitute tax or legal advice. You should always contact a qualified tax, legal or financial professional, for comprehensive tax or legal advice.
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.