Thinking About Eliminating Tips? Consider These Consequences First

Fact: labor costs are skyrocketing for the restaurant industry. Cities like San Francisco and Chicago have passed laws to increase the minimum wage, and a new proposal from President Obama will make millions more workers in the U.S. eligible for overtime pay.

As a result, restaurants are starting to get creative about how they manage costs. Some have eliminated tipping from their businesses in favor of flat service charges or higher menu prices. For the most part, it’s too early to tell how successful these changes are — but it’s clear the traditional structures are shifting.

“Cost conditions for restaurants are becoming more and more concerning. I don’t think we’ve seen the level of creativity yet that we are likely to see, but I do think there will be shifts in pricing structure. There’s going to be a lot of pressure on margins.”

That’s Ed Levine, CEO of Vine Solutions, a company that offers full-service accounting and financial advisory services to restaurants, largely in California. He is also a restaurateur himself, as the principal partner at Left Bank brasseries in Larkspur, Menlo Park, and San Jose and LB Steak in San Jose.

Ed applauds restaurants’ efforts to experiment with different pricing models, but he cautions against implementing service charges or taking away tips before thinking through every implication the changes will have on your business. Here are eight consequences to be aware of.

Guests will pay more in sales tax

In some states, including California, guests must pay sales tax on a service charge, whereas they don’t pay tax on a tip. That means customers will pay the state of California sales tax (somewhere between 7.5% and 10%) on top of the 20% service charge implemented by the restaurant.

“To me, the customer is somewhat disadvantaged because at the margin they’re paying more money,” says Ed. And from a restaurateur’s perspective: “If you’re a service charge model you’re less price competitive than the tip model. Customers tend to pay a lot of attention to menu prices.”

Your hourly kitchen staff will benefit — maybe

Restaurateurs that collect service charges allocate a portion of that charge to improve wages in the back of the house, which is great for kitchen staff. But before you act, read the fine print: In municipalities, such as Oakland, California service charges are required to go to employees who are actively involved in the act of service. That prevents the money from going to the kitchen unless the kitchen is somehow involved in the act of service.

“I think the economic pressures are such that we’ve seen back of the house wages increase and I think we’re going to see them increase more,” says Ed. He believes the market will eventually solve the problem, because restaurants with competitive wages will attract the best cooks.

All service charges will go through payroll

When income is paid through service charges instead of tips, servers and bussers will be paid out every two weeks instead of taking home wages at the end of the night. Plus, 100% of tips will be reported. That’s a benefit for restaurateurs, who enjoy better cash flow and transparency, but not for those servers who are accustomed to underreporting tips and being paid daily.

Your servers may look for other options

On a similar note, many servers will prefer working for a tipping restaurant rather than one that collects service charges. With tips, they could be making 20% on the check average, tipping out 5% and taking home 15%; with service charges, cash gratuities will be negligible and the restaurateur is allocating a portion of the charge to the back of house. Servers may find that they take home more money with tips and move on to a restaurant that offers them, causing turnover.

On the flip side, Ed says very high-end restaurants may be able to get away with it and still retain staff. When check averages are high, restaurant owners can afford to pay servers well, and at an acclaimed restaurant they’re also gaining education and benefiting from the luster of the brand.

“If there’s a high enough guest check, there’s plenty of money to make everybody happy. But if the check average is a bit lower, then it’s a bit dog-eat-dog.”

Labor costs can escalate

If a restaurateur shifts from paying servers minimum wage to paying them $30 an hour, they also have to pay overtime on that $30 an hour. Additionally, they have payroll taxes and sick pay obligations on the higher wage. “All of those things greatly increase your cost structure,” says Ed.

The IRS uses the FICA tip credit to incentivize restaurateurs to encourage their service teams to report tips. At the end of the year, owners are given a percentage of all reported tips –but FICA tip credits are not given on service charges. Ed estimates that last year his FICA tip credit was around $32,000. “If I was in a service charge model, that would be $0,” he says.

“From my standpoint, I really have a hard time of seeing the advantages of service charges over tips in the current environment. Every constituency except for back of the house, hourly, is worse off than they were before. The beneficiary in a big way is the government. The state, they get additional sales tax, they get additional payroll taxes; and the feds, they get additional payroll taxes, they are no longer are giving a FICA tip credit. Until those things get sorted out, they seem like the big winner.”

You may need to get creative with your menu pricing

Ed owns two restaurants in San Jose, and three years ago the city announced it was increasing the minimum wage to $10 an hour. A knee-jerk solution would be to raise menu prices to combat the costs, but right across the street from him was the city of Santa Clara, where the minimum wage is $8.

“We really couldn’t raise our prices,” he says. “If we’re that much more expensive across the street, then we’re going to lose market share and we’re going to lose customers.”

Instead, Ed basically ate the extra costs, finding small ways to tweak his menu here and there. He says that while guests are very sensitive about printed menu prices, they tend not to be as knowledgeable about the price of a cup of coffee or a gin and tonic. “You may find opportunities to add 25 cents here and there to help make up some of it.”

Value and volume are critical for staying competitive

With all of these changes in play, what is the future of the restaurant industry? Ed believes that the price of restaurant meals will rise, but with the right business priorities restaurateurs can survive. “There’s still a strong argument to be made that if I can develop a very high-volume restaurant — lots and lots of guest counts — I can operate at a higher cost of goods than my competitor if I’m driving tremendous value,” he says.

By providing strong value, delivering beyond guests’ expectations (effectively underpricing relative to competitors) you’ll bring more people in the door. Everyone will see that you’re busy and, as a result, think the restaurant must be good.

“The best way to make money in the restaurant business is to grow your sales on the backs of increased guest counts. You are not better off having fewer people spend more money; you’re typically better off having more people potentially spend less money, because there’s a vibrancy, there’s greater word of mouth, more people are coming into your restaurant. If I can do more sales my labor cost is going to come in better than it would have otherwise.”

Model your business before you mess with it

If you’re shifting to a service charge model, don’t assume you’ll have the same customer numbers you had before. Some guests may reject it. Similarly, there are various expenses to factor in, such as additional workers’ comp, payroll taxes, losing the FICA tip credit, and the like.

“I always recommend that that stuff be modeled on a piece of paper before you put it into practice,” says Ed. “Plot it out, talk to your accountant or advisor, and really think it through before you just do it. And don’t do it just because the people down the street did it. By them doing it, you might have improved your competitive position because you didn’t do it.”