Meet Joe Blow, the fictional operator of a fictional full-service restaurant called The Strudel Barn. His profits are being gobbled up by soaring labor and occupancy expenses. Though food costs are moderating, he’s considering the adoption of a service surcharge to ease the squeeze on his margins.
How is that going to change the way he does business?
The answer depends on where he’s operating. As with so much of the regulation that governs tipping, tip pooling or other compensation issues, the responsibilities and permitted actions of the business operator vary greatly from jurisdiction to jurisdiction.
If the Strudel prototype is located in California, for instance, Blow can tack a surcharge onto guests’ checks and use the money however he sees fit. The proceeds can be channeled to employees to cover their wages, or to buy a new piece of technology. Or he could just pocket the additional revenues. After all, it’s being taxed as sales and income like every other dollar he collects.
Unless, that is, the restaurant is in one of the handful of California cities that has its own regulations governing such fees. In Berkeley, Oakland and Santa Monica, for instance, the money can only go to employees, and the proceeds are essentially handled as if they were conventional tips.
If the Strudel Barn is located in New York, far different rules apply.
They pivot there on what customers are told about the surcharge. If a 10% add-on is flagged on menus as a service charge, the establishment pays sales tax on what’s collected, and the place can use the funds however it sees fit.
If the service charge is described as a fee that’s channeled directly to workers as part of their compensation, the place is spared income tax on the money, but has to calculate payroll taxes on the proceeds. In that situation, proceeds from the service charge are essentially treated as tips and are governed accordingly.
“To be honest, we’re all watching D.C. from an impact perspective. We’re looking at 2024 on the legislative side and the ballot initiative side, and there’s a fair amount of interest.”
If the revenues are split between employees and the house, the payments due to the government are broken down accordingly, with precise records required to justify the breakdowns.
That’s assuming the place isn’t in New York City, where surcharges are virtually forbidden. However, an extra charge is permitted in certain situations and forms, such as a plating fee for dividing one entree between two customers.
At least those jurisdictions have rules. In much of the country, the regulation of service fees is still a work in progress, a situation that has landed establishments ranging from Buffalo Wild Wings to fine-dining spots in litigation.
There is also the looming possibility of federal regulatory action. In his last State of the Union Address, President Biden blasted the surcharges tacked onto bills by businesses ranging from hotels to internet service providers, calling them "junk fees." The Federal Communications Commission has already proposed new full-disclosure rules for cable-TV companies, including a requirement that the actual cost to customers be clearly stated upfront.
So far, Biden's focus has not broadened to include restaurant surcharges, but there's no guarantee that situation will persist. Meanwhile, the Independent Restaurant Coalition is hoping to jump-start the regulatory process by asking Congress to legislate that proceeds from service fees should more or less always be regarded as tips, with all the money going to staff members.
As much of a patchwork as the current regulatory scene may be, labor-law experts warn the requirements could be further scrambled by what’s happening in Washington, D.C., a test market of sorts for service charges since a gradual elimination of the tip credit began May 1.
The district has become a hotbed for the add-on fees, with 70% of restaurants there either currently charging a service fee or considering one as the tip credit ebbs, according to the Employment Policies Institute. Right now, various estimates hold that about 250 restaurants in the 7-square-mile District have added one.
That transition came quickly. On the second Tuesday of November, residents passed a ballot proposal to phase out the tip credit by 2027. Less than six months later, after raising prices to cover other cost increases, the concession to employers had been cut appreciatively.
Instead of paying tipped employees $2.13 an hour if their gratuities bring them up to the District’s minimum wage of $17 an hour, they are now required to pay servers and bartenders $8 an hour directly. The required payment rises by $2 on the next four July 1sts.
Employees can still pocket whatever tips are left for them.
By all accounts, neither the government, operators, employers or customers were prepared for a change of that scale.
“It was the first market to eliminate the tip credit in 20 years,” said Mike Whatley, VP of state affairs and grassroots advocacy for the National Restaurant Association. Yet the process started with little education of customers, employees or operators about how the local dining-out world has changed.
It is, stakeholders agree, a mess. The surcharges, they say, have had such unintended consequences as percentage rents taking a quantum leap, when, in fact, a restaurant tenant’s traffic and demands on the premises haven’t changed. Sales taxes are also being levied, even though guests aren’t actually placing larger orders.
Customers don’t know whether the fees are in lieu of tips, or whether a tip is still expected. If so, is the gratuity calculated on the total tab, service fee included, or just the food and beverage charges? And what’s an appropriate amount, given they’re already paying anywhere from 3% to more than 10% as a service fee?
The situation has led to loud requests for more regulation in the District—with restaurateurs leading the chorus.
Regulators and lawmakers are trying to impose some order, but politics and the novelty of the issue have hamstrung the process. The District of Columbia’s attorney general issued guidelines intended to keep restaurants relying on a service fee from violating local consumer protection laws. He set out three requirements:
- The surcharges be flagged for customers before they order.
- The exact reason for the surcharge be clearly stated for the benefit of guests. “Paying servers higher wages” might be acceptable, but “covering a general increase in costs” is too vague.
- The proceeds be used solely for that purpose.
Legislation has also been introduced to define what a service charge is—a fundamental move that was somehow lost in the dash to implement the new pay rules—and to shield the revenues from service fees from being factored into percentage rents and sales taxes.
The proposal would also accelerate the time table for dropping the tip credit to zero, a cause being pushed behind the slogan, “Rip off the Band Aid!” Proponents say they’d prefer to face the worst and figure out how to live with the new conditions, instead of lurching through four complicated wage increases in the next four years.
“There are a couple of laws in this space, but if D.C. was to pass the legislation, it could be a model,” says Whatley. “When we meet with our state associations, the first question is always, ‘What’s happening in D.C.?’”
That’s in part because the Service Employees International Union (SEIU) and an affiliated group, One Fair Wage, have made other jurisdictions’ elimination of the tip credit a top goal.
Pennsylvania is currently considering a bill to gradually raise the state’s minimum wage and how much of a tipped employee’s pay has to come directly from employers rather than in the form of tips. The proposal, already passed by the state’s House of Representatives, would raise the pay floor for all workers to $15 an hour. Employer payments to tipped employees would rise to $9 an hour, from the current level of $2.83.
Among the undesirable potential side effects would be an increase in service fees, along with higher menu prices and faster replacements of human employees with advanced automation, the Pennsylvania Restaurant and Lodging Association has warned.
“Ohio and Arizona have both proposed initiatives to raise the minimum wage and eliminate the tip credit,” said Whatley. “To be honest, we’re all watching D.C. from an impact perspective. We’re looking at 2024 on the legislative side and the ballot initiative side, and there’s a fair amount of interest.”
According to One Fair Wage, proposals to end the tip credit have also been introduced in Massachusetts, Illinois and New York. The group has pledged to kill the employer concession in 25 states in total by 2026.
As that effort pushes more discussion of eliminating the tip credit, service charges will likely spread, according to the law firm Greenberg Traurig, the nation’s ninth largest.
“Surcharges are the new normal,” it noted in a presentation last summer. It warned that the rising prevalence will bring “more regulatory scrutiny of surcharges at the state and local level, in addition to more litigation activity.”
“Regulators are increasingly looking at this and might roll up their sleeves and say, ‘Let’s regulate this, too,’” Franklin Coley, a principal of the lobbying firm Align Public Strategies, said in a recent installment of the Working Lunch government-affairs podcast, which is carried on Restaurant Business. “I’m not saying don’t do it, I’m saying you need to be careful. You gotta be careful in the way you structure it.”
A consensus has formed that places like The Strudel Barn can help in fending off a backlash, be it from guests or regulators, by being as transparent as glass if it opts for a service charge.
“Our advice to operators is the more transparent you can be with customers, the better. That’s really important,” says the NRA’s Whatley. “It creates less outrage.”
Greenberg Traurig recommends that restaurants adding a service fee should be forthcoming with employees as well as guests. They should also check with local regulators to ensure they’ve met any disclosure requirements that have been set.
It notes that vague, complicated language in the disclosure statement can lead to litigation because of misinterpretation by customers and workers. It specifically recommends against using fuzzy terms like “happy kitchen fee” or “back of house fee” because too much is left up to the guest’s interpretation. Less language might be better, the firm says.
Whatley expresses confidence that confusion over service fees could abate as guests get accustomed to the surcharges. He also points out that the industry has gone through waves of the fees in the past and navigated its way through the confusion.
“If you looked back to after the [Affordable Care Act] passed, some restaurants put surcharges on their bills,” he said, referring to the landmark healthcare bill establishing what’s known as Obamacare. “It’s not a totally new issue.”