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Employee tips are normally included during payroll processing in order to properly calculate taxes. A tips earning will allow you to enter the employee’s reported tips so taxes are calculated on the correct gross wages, without increasing the employee’s net pay. The steps for setting up your payroll system to correctly pay tipped employees are as follows, and may vary depending on your payroll software.

How to Correctly Pay Tipped Employees With Payroll Software

Step A – Set Up Tips Earning Code

Having a separate earning code for tips allows you to enter the employee’s reported tips, so taxes are calculated on the correct gross wages without increasing the employee’s net pay. By doing this, when you look at earning reports you can see how much you paid them and how much they received in tips. Also, this information is needed to report correctly on the W-2 and is used when calculating the shortfall explained below.

There are three methods used to report tips. Depending on your payroll system, you’ll either have to set up an earning for tips, or an earning and a deduction. These earning codes are used to document the tips received by employees and deduct appropriate taxes.

1. Tips (No Allocation of Shortfall Required) – Usually used by small employers who are not required to allocate tips.

2. Indirect Tips – Tips not received directly from a customer. For example, a busboy or dishwasher receives them from a wait person. They do not appear in Box 8 of the W-2.

3. Direct Tips – Tips received directly from a customer, such as received by a wait person or bell person. These may be reported in Box 8 of the W-2.

If you select direct tips, enter the allocation rate. The standard allocation rate is 8% unless a lesser rate has been requested from the federal government. Specify the taxes that should be calculated.

Step B – Set up Matching Deduction (if necessary)

Depending on your payroll software, you may also have to set up a matching deduction so your system doesn’t pay employees the amount specified for the tip earning. In some payroll programs you don’t have to do this because it knows that if you are assigning it as a tips earning, it shouldn’t pay that amount. If you do need to set up a deduction, you will need to make sure that is exempt from taxes.

Step C – Assign Tips Earning (and deduction if required) to Employees

Once you have created the earning code, associate that earning code to the employees who will be reporting tips. Then you will be able to use that code the next time you run payroll.

Step D – Enter Tips on a Pay Run

Processing a pay run with tips is the same as any other pay run. Enter the pay run as usual. Enter the employees’ pay, including tips. Enter the total amount of tips reported in the rate column for the tips earning.

If using direct tips, enter the employee’s gross receipts for the pay period. It is not necessary to enter gross receipts for indirect or non-allocated types of tips.