Running payroll accurately is one of the most important regulatory considerations for businesses of all sizes and in all industries. Payroll for tipped workers presents additional challenges and legal implications.
What you’ll learn
What you’ll learn
Key takeaways
- Managing payroll accurately is crucial if you want to run an ethical, successful, and compliant business in a service industry
- The Fair Labor Standards Act defines tipped workers as those who earn $30 or more in tips per month
- You and your employees must follow established standards and new “no tax on tips” laws in record-keeping and when filing taxes in order to avoid fines
If you run payroll for a small or medium-sized business, you can’t afford to cut corners. Making sure your payroll process for tipped employees is compliant and error-free is crucial if you want to avoid disputes, penalties, and fines.
Why payroll compliance is critical for tipped employees
Mishandling payroll for tipped employees does more than raise questions (even if that’s not your intention). It comes with serious legal consequences, which may damage your business financially and reputationally.
Non-compliance may result in unwanted (but avoidable) attention from the Internal Revenue Service (IRS) and Department of Labor. You could also face wage disputes from employees and significant back wages. It’s why being familiar with state and federal payroll regulations, particularly if you run a tip-centered business such as a restaurant, hotel, or salon.
Who qualifies as a tipped employee under federal law?
Under the Fair Labor Standards Act, tipped workers are defined as those who customarily and regularly receive $30 or more in tips per month. Examples include servers, valets, bartenders, and hair stylists.
In a nutshell, a tip is an additional sum of money that’s voluntarily gifted by a customer to an employee. Unlike service charges, which are automatically applied to a bill and determined by the business, tips are applied at the discretion of the customer and go to the worker rather than to the business as a whole.
The tipped wages system can benefit both workers and employers, but only when compliance and fairness are prioritized.
Tip credit and minimum wage rules employers must follow
Minimum wage laws need to be followed by all employers, but there are specific rules for tipped wages that payroll managers must understand to ensure fair compensation for all workers. This includes tip credits and allocated tips for large food and beverage businesses.
Calculating tip credits
The federal minimum wage is $7.25 per hour. However, businesses can take a tip credit of up to $5.12 for tipped workers, allowing a minimum wage of $2.13 per hour. It’s basically a must to inform your employee about the tip credit prior to hiring them.
Keep in mind that tip credits can never be used to shortchange employees. They’re only permitted if the worker’s combined cash wage and tips total to at least the minimum hourly wage. If your employee is not regularly receiving adequate tips to reach the federal minimum wage, you as an employer are responsible for making up the difference.
State-specific requirements
As you do a deeper dive, you’ll see that different states have their own minimum wage and tip credit laws.
- Some states (including California, Alaska, and Minnesota) do not permit a tip credit, meaning workers must be paid the full hourly minimum wage regardless of tips.
- Other states allow tip credits according to federal standards or state-specific rules.
Be sure to familiarize yourself with tip credit rules in your state and city to ensure full compliance. Moving on, let’s get into the details on how to document it all.
How to record and report employee tips properly
Responsibility is a two-way street, as both businesses and workers must follow legal tip reporting requirements. For business owners with employees who rely on tips for income, tracking is especially important for legal compliance and payroll accuracy.
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If you like, OnPay has a tip tax calculator to help you determine your tax obligations. But let’s also take a look at three key areas you need to manage.
Tracking cash tips
Cash tips tend to be the hardest to monitor because they’re usually handed directly to employees by customers. But even though it’s tricky to keep up with, you’re still required to report cash tips on paycheck amounts for tax purposes.
Here’s what you should know:
- Employee responsibility: If your employee makes $20 in tips or more in a month, they’re legally required to report all cash tips to you.
- Employer systems: You can use digital payroll tools or timekeeping cards to allow employees to enter daily tip amounts for more reliable tracking.
- Best practices: Provide training on why accurate tip reporting matters for fair wage calculations and tax-compliance purposes.
Reporting credit and debit card tips
You need to know the different rules for handling cash tips versus credit card tips. Tips on debit or credit card transactions are usually easier to track because they can be recorded automatically at the point of sale (POS). But you still have to follow certain requirements:
- Paycheck reporting: Card transaction tips must be included in your employees’ paychecks and reported as part of their gross wages.
- Deductions of processing fees: You may be allowed to deduct a proportionate share of processing fees from tip amounts, but you’re not entitled to keep any portion of tips for yourself or your business.
- Timely payments: Card tips must be paid promptly, ideally within the same pay period, to avoid wage violations.
Tip pooling rules
The practice of tip pooling involves collecting tips given to multiple employees and redistributing them according to a predetermined formula. Although the practice is legal, employers have to follow strict guidelines:
- Managers and supervisors cannot receive a share.
- The policy must be communicated clearly to all staff.
- The calculation method must be fair and consistent, focusing on a set metric such as hours worked or a percentage of sales.
The table below also breaks out this information to help you keep track of this information.
| Area | Key rules and best practices |
| Cash tips | Employees earning $20+ per month in cash tips must report all earnings. Use digital or paper logs for daily tracking. |
| Credit/debit card tips | Include card tips in paychecks and gross wages. You can deduct processing fees, but never keep any part of the tips. |
| Tip pooling | Allowed if fair and transparent. Managers and supervisors can’t participate. Distribute tips using a consistent method. |
Recent legislative updates and compliance changes
As of 2025, new rules apply to businesses that employ tipped workers. Under the One Big Beautiful Bill Act, tipped employees in some occupations may now deduct up to $25,000 in tip income from their federal taxable income.
The no tax on tips law applies to tips earned during tax years 2025 through 2028, including those received through tip pooling practices as long as they are voluntary, properly reported, and earned through occupations that are “customarily and regularly tipped,” according to IRS rules.
Some states are proposing their own tip tax reforms, which vary in scope. As of September 2025, Illinois and Massachusetts have each proposed independent bills to exclude tips from state income tax for certain workers.
Another notable change involves the FICA tip credit, which has long benefited businesses in the food and beverage industry. The credit is now being expanded to include beauty services, including salons and spas.
Moving on, let’s see what goes into figuring out the numbers.
“OnPay is the best online payroll resource. Fast, responsive customer service with tremendous flexibility in how people are paid—hourly, tips, commission—and fully automated tax calculation and payment. OnPay lets me focus on my business instead of worrying about payroll accuracy. I now spend 1-2 hours every two weeks on payroll instead of 4-6 hours.”
— Ray Nguyen, Charming Nails DC
Calculating wages and overtime for tipped employees
Overtime pay is required when an employee works more than 40 hours per week. Calculating the overtime pay rate involves multiplying the hourly wage by time and a half.
If you take tip credits, the base pay must be rounded up to the full minimum wage ($7.25). The tip credit ($5.12) is only subtracted after the overtime rate is established.
For example, let’s say you have a tipped employee whose wages are calculated using tip credits, so they earn $2.13 an hour. In this scenario, they’ve worked four hours of overtime.
So, you’ll calculate their wages using the federal minimum wage multiplied by time and a half:
- $7.25 x 1.5 = $10.88
Then you can apply the tip credit for each of the four hours they worked:
- ($10.88 – $5.12) x 4 = $23.04
Automated payroll tools such as restaurant payroll software can streamline overtime calculations to make sure all your bases are covered.
Strategies to prevent payroll mistakes and avoid fines
Though staying on top of obligations for tipped employees takes time, workers can feel good about their paycheck – and you’ll likely avoid the ire of Uncle Sam. The essentials come down to accurate tip tracking, proper tip credit application, and staying current on both federal and state-specific rules. Get these fundamentals right, and you’ll protect both your business and your employees.
OnPay’s automated payroll software provides everything you need for compliance, including tracking, tax filing, and overtime calculations. It can even connect directly to your POS system. We’re here to help and answer your questions!
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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.