When Does a Service Charge Become a Tip in California?

On October 31, 2019, California’s First District Court of Appeal in Lauren O’Grady v. Merchant Exchange Productions, Inc. held that a "service charge" could be a "gratuity" under Labor Code Section 351, such that it would be required to be paid to non-managerial employees as a gratuity.

In light of O’Grady, employers should review their mandatory service charge policies and practices both to:

• Ensure clear communication to employees and customers; and
• Avoid conflating service charges with tips.

Distinction Between "Service Charges" and "Tips"

The California State Board of Equalization distinguishes between a "service charge" and a "gratuity" or "tip" in Publication 115. It groups "tips, gratuities, and services charges" together, and distinguishes them by whether each is optional v. mandatory.

Service Charges

A mandatory "service charge" or an "operations fee" – or whatever else an employer may call an extra fee added to a bill -- is a mandatory amount automatically included on the bill – i.e., the patron does not have the option to refuse payment of this amount. Large party automatic gratuities are also considered service charges.

The amount belongs to the employer, not the employees, and the employer can keep the service charge entirely, or share parts or all of the service charge with employees, including management/supervisors. Notably, some localities (e.g., Santa Monica, Oakland, and Berkeley) regulate service charges and specify they belong to the server.

When paid to employees, the service charge amount is treated as wages, so the California Labor Code and the FLSA apply. This means that an employer must do the following with service charges: pay employer taxes, unemployment insurance tax, workers’ compensation insurance, and calculate overtime based on the payment of the service charge as though it is a bonus (by calculating the regular rate for overtime with it).

• See our advisory on the regular rate of pay and overtime here.

Sales taxes also apply to service charges.

Because the amount is mandatory and customers may mistake it as a tip that is paid to the service staff, state consumer protection laws require employers to provide disclosures to patrons explaining what the service charge covers. The employer must disclose to customers where the money goes and, to avoid litigation, the employer must follow-through on that disclosure and ensure the money is spent as promised.

To avoid claims, such disclosures should be made in menus, on catering contracts, and on receipts and charge slips that the customer receives.

Tips (Gratuity)

Generally, a "gratuity" or a "tip," is a voluntary amount – i.e., it is entirely at the option of the patron to include this amount on the bill for the services rendered. Gratuities are generally not mandatory, and are not automatically added to the bill.

Labor Code Section 350 defines "gratuity" to "include[] any tip, gratuity, money, or part thereof that has been paid or given to or left for an employee by a patron of a business and above the actual amount due the business for services rendered or for goods, drinks, or articles sold or service to the patron."

Gratuities belong to the employee(s) to whom it is left (i.e., employees in the "chain of service"); the amount does not belong to the employer. See Labor Code Section 351 - "no employer. . . shall collect, take, or receive any gratuity or a part thereof that is paid, given to, or left for an employee by a patron, or deduct any amount from wages due an employee on account of a gratuity. . . . Every gratuity is hereby declared to be the sole property of the employee or employees to whom it was paid, given, or left for."

Generally, management or supervisors may not participate in the mandatory tip pool. Tip pools and mandatory tip-outs can be controlled by the employer as long as the employer does not take a "tip credit," and affected employees are informed about how the pool will work.

Tips are not treated as wages and are not subject to sales tax, unlike service charges. They are subject to social security and other taxes, like other wages.

O’Grady Background Facts and Arguments

Plaintiff Lauren O’Grady worked as server and bartender at Julia Morgan Ballroom in San Francisco, which is owned and operated by defendant Merchant Exchange Productions, Inc.

O’Grady’s class action complaint alleged that the restaurant had a practice of automatically imposing a 21 percent "service charge" to every food and beverage banquet bill, and that part of the service charge was kept by defendant, with the rest being distributed to "managers and other non-service employees."

She alleged that "when customers have paid these charges, it is reasonable for them to have believed they were gratuities to be paid to the service staff." Based on these facts, O’Grady alleged that defendant’s practices violated Labor Code Section 351 — which prohibits employers from taking any part of a gratuity "paid, given to, or left for an employee by a patron"— because the service charge constituted a gratuity, such that defendant had to distribute it to non-managerial banquet service employees.

Plaintiff alleged the violation was enforceable pursuant to California’s Unfair Competition Law (California Business & Professions Code Section 17200), and that the practice amounted to intentional interference with advantageous relations, breach of implied contract, and unjust enrichment by the employer.

The employer filed a general demurrer (essentially a motion to dismiss) as to each of O’Grady’s claims, asserting that, under California law, "a mandatory service charge which is automatically added to a customer’s bill and which a customer is required to pay, is not a gratuity …and thus need not be disseminated to employees..." 

The employer relied on two prior cases, Searle v. Wyndham International, Inc. and Garcia v. Four Points Sheraton LAX, for the position that a mandatory service charge can never be a gratuity as a matter of law.

The trial court agreed with the defendant, sustaining the employer’s demurrer and dismissing the complaint.

Court of Appeal's Decision

The issue presented for the Court of Appeal was whether a mandatory "service charge" could be a "gratuity" under Labor Code Section 351 such that it would be required to only go to non-managerial employees involved in the service.

Assuming O’Grady’s factual allegations as true, the Court of Appeal reversed the trial court, and held that a mandatory service could qualify as a gratuity as a matter of law. The court found that there existed no prohibition against what is called a service charge meeting the definition of a gratuity.

The court distinguished the facts in Searle or Garcia, and declined to treat either as controlling. The court found that neither case should be read as categorically establishing that what may be called a "service charge" by an employer can never be a gratuity.

Instead, the court found that the term "service charge" is amorphous and malleable, and takes meaning from the surrounding context, with the label itself hardly ever explaining what it is, or why it is being imposed. The court did not provide a hardline rule for when a service charge qualifies as a gratuity, but found that the purpose of Labor Code Section 351 would not be served by allowing employers to take money intended for employees simply by saying the customer has paid a "service charge."

Although the employee had the early motion to dismiss the case overturned based on the allegations alone, the result may be different at summary judgment or trial once the facts of the case develop.

Key Takeaways for Employers

O’Grady does not change the fact that all or a portion of a mandatory service charge may be kept by the employer, or that the employer can choose to pay it out to its employees, so long as the payment to employees is in the form of wages. The decision does not impact that service charges are always treated like bonuses under the FLSA and California Labor Code for purposes of overtime computation, and taxation by the IRS and CA FTB.

However, O’Grady highlights that employers must clearly communicate to customers and employees what happens to service charges so as to not mislead anyone. Employers should explicitly indicate what happens to service charges in all places in which the service charge is referenced – e.g., customer-facing materials like signs, menus, and receipts; private event or similar type of agreements; and in employee-facing documents, like a "service charge" policy either separate from or as a subpart of a valid tip pooling agreement.

If the service charge is not intended as a gratuity, the employer must explicitly indicate this.

Employers should immediately review their mandatory service charge policies and practices to ensure that service charges are appropriately identified, distributed, and paid.