If you run a restaurant, bar, or any business where employees regularly receive gratuities, the tipped wage credit is one of the most significant payroll rules you will deal with. It lets qualifying employers pay tipped employees a lower direct wage, with tips making up the difference to the federal minimum. Here is a plain-English breakdown of how it works, where it does not apply, and what you must do to stay compliant.
What the tipped wage credit is
The tipped wage credit is a provision of the Fair Labor Standards Act (FLSA) that allows employers to count a portion of a tipped employee’s tips toward the federal minimum wage obligation. In practice, it works like this.
- Federal minimum wage: $7.25/hour
- Minimum direct cash wage for tipped employees: $2.13/hour
- Maximum tip credit an employer can take: $5.12/hour ($7.25 minus $2.13)
The employer pays $2.13 in cash wages. The employee earns tips during the shift. If the tips, combined with the $2.13, equal or exceed $7.25/hour averaged over the workweek, the credit applies and no additional cash is owed.
If the tips fall short, the employer must top up the difference so the employee earns at least $7.25/hour for every hour worked. That top-up is not optional.
How the tip credit calculation works in practice
The calculation is done per employee, per workweek. Here is a simple example.
- Employee works 30 hours in a week at $2.13/hour direct wage.
- Employee earns $180 in tips over those 30 hours.
- Direct wages: 30 x $2.13 = $63.90
- Total earnings: $63.90 + $180 = $243.90
- Effective hourly rate: $243.90 / 30 = $8.13/hour
- Since $8.13 exceeds $7.25, no top-up is required this week.
Now consider a slow week. Same employee, same 30 hours, but only $60 in tips.
- Total earnings: $63.90 + $60 = $123.90
- Effective hourly rate: $123.90 / 30 = $4.13/hour
- Minimum required: 30 x $7.25 = $217.50
- Shortfall: $217.50 - $123.90 = $93.60 owed by the employer
That $93.60 must be paid. Carrying the shortfall forward to a better week is not permitted. Each workweek is evaluated on its own.
State tip credit rules (they vary a lot)
The federal tip credit is a floor, not a ceiling. States set their own rules, and many are more restrictive. The major categories:
States that do not allow tip credits
Several states require employers to pay the full state minimum wage in cash, regardless of how much an employee earns in tips. As of 2026, this includes California, Oregon, Washington, Minnesota, Alaska, Montana, and Nevada, among others. In these states, the tipped wage credit simply does not exist.
States with a higher minimum direct wage
Some states allow a tip credit but require a higher minimum direct wage than the federal $2.13. New York, for example, uses a tip credit rate tied to the state minimum wage rather than the federal floor. Always check current state Department of Labor guidance for the state where your employees work.
States that match the federal rules
A number of states follow federal FLSA rules exactly: $2.13 direct wage, $5.12 tip credit, $7.25 total minimum. If your state is in this category, the federal calculation applies.
What counts as a tip
Not everything a customer pays beyond the listed price qualifies as a tip for purposes of the credit. The FLSA defines a tip as money a customer voluntarily leaves for an employee as a personal gift. Key points:
- Voluntary cash tips: count in full.
- Credit card tips:count, but you may deduct the credit card processing fee from the tip before passing it on, as long as the employee’s net earnings still meet minimum wage.
- Mandatory service charges:these are not tips. A mandatory 18% added to every table is employer revenue, not a gratuity, unless you pass 100% of it to the employee and it is clearly voluntary from the customer’s perspective. The DOL looks at how it is presented on the menu and the receipt.
- Auto-gratuities for large parties: generally treated as mandatory service charges, not tips. Handle with care.
Tip pooling rules
The 2018 amendment to the FLSA changed tip pooling rules significantly. Here is where things stand.
- If you take the tip credit: you may only pool tips among employees who customarily and regularly receive tips (servers, bussers, bartenders). Kitchen staff and managers cannot participate in the pool.
- If you do not take the tip credit (you pay the full minimum wage in cash): you may include back-of-house employees in the tip pool. This opened the door to tip sharing with cooks and dishwashers at restaurants that pay the full minimum wage.
- Managers and supervisors cannot participate in tip pools under any circumstances if they have authority to hire, fire, or direct the work of employees.
What you must tell employees
Before taking a tip credit, the FLSA requires employers to notify each affected employee of several things:
- The amount of the direct cash wage you will pay (at least $2.13)
- The additional amount you are claiming as a tip credit (up to $5.12)
- That the tip credit cannot exceed the actual tips received
- That all tips received belong to the employee (except in a lawful tip pool)
- The terms of any tip pool arrangement
The notice must happen before the first workweek the credit is applied, not after. Many employers include this in the offer letter and employee handbook and then have new hires sign an acknowledgment. Skipping the notice forfeits the tip credit for any week in which you failed to provide it, even if the underlying math would have been valid.
How to track tipped wages accurately
Accurate tip credit compliance starts with accurate time records. You need to know, for each tipped employee, exactly how many hours they worked in each workweek. That means a time-clock system that records clock-in and clock-out times with no gaps.
From there, your payroll system does the math: gross tips divided by hours worked, compared against the minimum wage, with any shortfall added to the direct wage. Most payroll providers handle this automatically if you feed them accurate hours and reported tip totals.
If you are using a time-clock app that exports to ADP, Gusto, or QuickBooks, confirm that your export format includes hours by employee by workweek, not just totals for the pay period. That breakdown is what the tip credit calculation requires. See exporting payroll to ADP, Gusto, and QuickBooks for details on what those exports include.
If you are new to running payroll for tipped employees, review the most common first payroll mistakes before your first run. The tip credit is near the top of that list.