On July 4, 2025, President Trump signed the One Big Beautiful Bill Act (OBBBA), the legislation that created the new “no tax on tips” rule.
This new rule has raised questions across the restaurant industry about what it actually means and how to interpret it correctly.
In this article, we’ll explain the new law in clear terms so restaurant operators, managers, and tipped workers can understand how the rule works and what the federal government expects.
You will learn:
- Which tips qualify for a federal income tax deduction
- What doesn’t qualify and how it must be reported
- How to adjust payroll, reporting, and recordkeeping under the new rule
If you rely on tips or run a team that does, this breakdown will help you interpret the new tax on tips rules with confidence.
How the new “No Tax On Tips” rule works
The new rule introduced under the One Big Beautiful Bill Act updates how qualified tips are handled on tipped employees’ federal income taxes, but only under specific conditions.
What it doesn’t change is the day-to-day operations for operators—restaurants will still track, report, and run payroll for tip income the same way they always have.
Instead, the rule creates a way for eligible workers to reduce their taxable income when the tips received meet the federal definition of qualifying payments.
Let’s take a closer look at how this works.
Only specific tips qualify for the benefit
The rule applies strictly to qualified tips (more on that below) earned during the designated tax year window.
When tips meet the IRS definition of voluntary, direct, and correctly recorded, employees can use them to lower their taxable income and unlock the new tax break.
It’s not unlimited, though—the federal government sets an annual cap ($25,000) on how much can be deducted.
Reporting and payroll requirements stay the same
Even with the new tax deduction, operators still must follow the same reporting requirements for tip income. You’ll track, record, and report tips the exact same way you do now.
Nothing changes with payroll taxes, FICA, social security, or withholding. This rule affects the tax code, not your payroll workflow.
The deduction only works when tips are reported accurately
Employees must continue reporting all tips received, including cash tips. If the amount isn’t recorded correctly, it won’t count as a qualifying tip, and they can’t claim the deduction.
Clean reporting protects your team and keeps your records in line with IRS expectations.
What counts as a qualified tip under the law
Not all tips received are eligible for the new federal tax deduction. To count as a qualified tip under the law, the payment must meet three criteria defined by the IRS.
1. The guest must decide the amount
A payment counts as a qualifying tip only when the customer chooses the amount themselves. That means it has to be voluntary, optional, and free from any automatic percentages or preset charges.
If the guest can adjust it—up, down, or remove it entirely—it generally falls under tip income rather than wages.
2. The tip has to go directly to the employee
The IRS also requires that tips received—whether cash tips, card tips, or digital payments—are paid directly to the worker(s) who earned them. Tip sharing or tip pooling is allowed, as long as tip pooling laws are followed. Likewise, it’s fine if the payment is routed through payroll or an earned tip access solution. What matters is that it’s a true tip and not a built-in fee.
3. Qualified tips still need to be recorded accurately
Even with the new tax deduction, employees must continue reporting tips exactly as before. The amount must be recorded accurately so they can claim the deduction on their tax return.
Poor reporting can disqualify eligible amounts and cause headaches for both staff and employers during tax season.
What doesn’t qualify: service charges and mandatory fees
Let’s identify payments that might look like tips, but don’t meet the IRS definition of a qualified tip, and therefore, don’t qualify for the no tax on tips deduction.
Automatic gratuities and fixed fees are not considered tips
If a payment is added to a check without the guest’s control, it becomes a service charge, not tip income under the new deduction.
This includes:
- Automatic gratuities
- Large-party charges
- Banquet fees
- Bottle-service fees
- Event charges
- Preset percentages
Even if guests view these charges as tips, the IRS does not. Because the customer doesn’t control the amount, these payments are classified as service charges, not tips.
These payments must still be processed through payroll
These payments are considered service charges, not tip income, under IRS rules.
As such, they are treated as regular wages and are fully subject to income taxes, payroll taxes, and Social Security contributions. They are processed through payroll and included in W-2 Box 1 like any other earned income.
For employers, that means you must continue handling these charges as you would any standard wage: withhold taxes, include them in gross pay, and report them accordingly.
For employees, it's important to know that even though these payments may feel like tips, they do not qualify for the tips deduction and cannot be excluded from taxable income.
What operators, managers, and employees need to get right
Now that you understand which tips are eligible for the deduction, the next step is to ensure they are handled correctly. The no tax on tips rule only works as intended when restaurants and employees understand the distinctions and stay consistent in how payments are labeled and recorded.
Here are the three most important things for everyone to remember.
1. The voluntary vs. mandatory distinction determines everything
The single biggest factor in whether a payment qualifies for the tax break is whether the guest chose the amount. If the customer didn’t decide it, it’s a service charge—and that means no tax deduction and no special treatment.
Keeping this line clear helps employees understand which payments may lower their taxable income and keeps employers compliant during the tax year.
2. Employees must keep accurate records
Even with the new deduction, workers must continue documenting all tips received. The rule doesn’t replace existing reporting requirements—it simply adds a new way certain qualifying tips can reduce federal income taxes when an employee files their tax return.
3. Operators need clean labeling and clean workflows
Menus, receipts, and POS systems must clearly distinguish between tips and service charges. If something is misclassified, employees may lose out on eligible amounts, and managers end up with payroll corrections that take time to fix. Clear workflows make the new rule easier for everyone.
How restaurants should adjust their systems and training
To stay compliant with the new no tax on tips rule and help employees take full advantage of it, restaurants may need to update a few core systems and workflows.
- Review your use of service charges: Go through all automatic gratuities, event fees, or added charges to confirm they’re clearly labeled and not misclassified as tips. If they’re mandatory, they’re taxable income and must be processed as wages.
- Update your payroll and reporting systems: Make sure your setup can separate qualified tips from non-qualified payments. You’ll need to report qualified tips in W-2 Box 14, using the correct code, while non-qualified tips or service charges go in Box 1 as regular income.
- Train your team on accurate tip handling: Everyone—from servers to payroll staff—should understand the difference between a voluntary tip and a mandatory fee, and how each should be reported.
If your restaurant uses tip sharing or tip pooling, tip management software can help streamline distributions and create a clean digital record of how tips are allocated.
This makes it easier to send accurate data to your payroll provider and reduces the risk of reporting mistakes when tax season comes around.
No tax on tips frequently asked questions
Looking for fast answers to questions about the no tax on tips rule? Here are several answers to the most frequently asked questions.
What is the difference between a qualified tip and a service charge?
A qualified tip is a payment the guest chooses freely and can change at any time. A service charge is a preset or automatic fee the guest cannot adjust. Qualified tips may be eligible for a tax deduction. Service charges remain fully taxable and must run through payroll like wages.
Do employees still need to report tips if they’re not taxed?
Yes. Employees must still report all tips received, including cash tips, if they plan to claim the deduction. The IRS requires accurate reporting for every tax year, and unreported tip income can’t be used as qualified tips. Reporting is what protects the worker’s ability to use the tax break on their tax return.
Who is eligible for the qualified tip deduction?
Most tipped workers in occupations where tips are customarily and regularly received may qualify, assuming their reported tips meet IRS requirements. Eligibility also depends on income.
The deduction begins to phase out once a worker’s modified adjusted gross income exceeds $150,000 (single) or $300,000 (joint filers). The annual cap is $25,000 in qualified tips per tax year. Workers must keep accurate records to claim the deduction correctly.
How should restaurants classify automatic gratuities?
Automatic gratuities and preset fees must be treated as service charges. They are processed as wages with standard withholding tables applied.
These amounts do not reduce taxable income, do not qualify as qualified tips, and must run through payroll like any other earnings. Clear labeling helps both employees and employers avoid misclassification.
Does the new rule affect tip pooling or tip sharing?
Tip pooling and tip sharing are still allowed, but accuracy matters more under the new rule. The redistributed amounts must be tracked and reported as tips to remain eligible as qualified tips. Using tip management software can help ensure distributions are documented cleanly so employees have the correct information when filing their tax return and claiming the tip deduction.
