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Here’s a Tip About Service Charges

by D. Gregory Valenza | |

Readers who are concerned with tips and service charges may be interested in this post.  Everyone else, click the X. 

Way back when, I wrote this article in the San Francisco Daily Journal about tips and service charges.   Most of it’s still fine.  I believe the huge verdict referenced in the article was overturned on appeal. But one issue requires new attention.

In a nutshell, the Labor Code tightly controls “gratuities” or tips. Sections 350-352 define gratuity, and specify that gratuities belong entirely to the employees for whom the customer leaves them.  The employer has some control over how gratuities are shared among the employees entitled to them, e.g., via tip “pooling,” an equitable way of sharing tips among staff. However, employers have to be careful not to include in the pool “agents” or managers and supervisors. In addition, employers cannot include in the pool employees who have nothing to do with the service that generated the tip – such as those who aren’t working.  That said, case law allows lots tip-pool flexibility, such as sharing pooled tips among “back of the house” employees involved in a positive experience. There are further issues attendant to compliance with sections 350-352, but that’s not why we’re here today. 

Today, we’re here to talk about service charges.  It had been well understood that a “service charge”  is *not* a gratuity and, therefore, not subject to the Labor Code sections pertaining to gratuities discussed above.  Anyone who has worked in hospitality knows a service charge is a mandatory amount, imposed by the “house,” on the customer. The customer doesn’t set the amount.  The customer pays the sum directly to the company, regardless of the quality of the service.  Compare a tip: the customer decides the amount, and leaves it for the server. 

The Division of Labor Standards Enforcement apparently understood the difference between service charge and gratuity. The DLSE expressly said so in its Enforcement and Interpretations Manual.  At least two Court of Appeal could distinguish between a tip and a service charge as well.  The IRS and U.S. Department of Labor know the distinction too.  You see, there are big legal consequences that flow depending on whether a sum is a tip versus a service charge. 

Enter the Court of Appeal in O’Grady v. Merchants Exchange Productions, Inc.  The Court apparently had some difficulty accepting this bright line concept.  The Court decided that a “service charge” could constitute a “gratuity” under the Labor Code, even if it was mandatory, even if the employer set the amount, even if the customer paid it directly to the banquet company rather than the server, and even if the employer set the amount at 21 percent, not a normal amount for a tip.  Why?  Well, the Court apparently didn’t like the employer’s power to assign a label of “service charge” and remove the employees’ “rights” to gratuities, among other reasons. 

The Court acknowledged its holding was in conflict with a couple of earlier decisions.  However, it did not acknowledge the havoc its decision would cause if the IRS or DOL or DLSE decided that an “O’Grady“-gratuity turned out to be a service charge under the Tax Code or the Fair Labor Standards Act.  (The characterization of tip v. service charge affects IRS obligations, the DOL/DLSE regular rate of pay, etc.).  Moreover, as stated, for California wage and hour purposes, the employer can share a service charge with management — like a catering manager – but not a gratuity.  That’s what O’Grady is about.  Ms. O’Grady wants all 21 percent of the service charge Merchants Exchange charged the banquet customers, whether she provided good service or bad.    

Anyway, the O’Grady opinion issued. And when a Court of Appeal disagrees with sister courts, the California Supreme Court may step in to resolve the conflict. Merchants Exchange asked the Supreme Court to do just that.  Yours truly even submitted a letter in support of Merchants Exchange’s Petition for Review.  But the California Supreme Court declined to take the case (although two Justices voted to do so).  So, O’Grady remains on the books.  Courts may have to decide case by case whether a “service charge” is a tip or not. 

What does this all mean?  It means that restaurants, hotels, and banquet companies that impose mandatory service charges must be careful how they present the “service charge” to customers to avoid ambiguity.  For example, the Court of Appeal accepted O’Grady’s allegation that the customers may have been tricked into believing that all of the “service charge” would be paid to the service employees.  Even the term “service charge” vexed the Court of Appeal, so perhaps another term is necessary.  Employers will have to work with counsel and, presumably, their marketing departments, to develop the appropriate strategy. 

The case is O’Grady v. Merchants Exchange and the opinion is here. 

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