Twenty states had increased the minimum wage as of January 1, 2015 and now New York is joining those ranks at the end of this year. While intended to advance the earnings of lower-wage workers, the recently approved increase from $5.00 to $7.50 an hour for tipped employees in New York, to be implemented with no tip-credit relief, could negatively impact restaurateurs and their patrons and even the tipped employees themselves. The real winners may only be the federal and state tax authorities.
The intent of the bill was to give servers, and others who work for tips, a fair wage increase, which they haven’t seen since 2011. But with the increase, restaurateurs are facing additional costs. Labor is the highest cost to a restaurant as a percentage of gross sales and the wage increase raises that cost 1-2% on average as seen in the chart below. In a business that makes money watching nickels, this cost could be too much to bear. Operators are seriously discussing strategies to help offset this new and very significant economic burden.
After sharing this piece with him, David Mancini, Managing Director of Le Bernardin wrote, “I wish our elected officials would read this article to understand the far reaching impact it has on all segments: guests, servers, restaurants, and tax authorities.”
Assessing the Numbers
The cost to employ a server in New York has risen by 50% based on the additional $2.50 an hour. If a FTE server works 1,800 hours per year, the cost to employ a waiter has increased by $4,500. Assuming that the current business model for most restaurants does not change, the increase in labor costs can be staggering.
The chart below compares the old labor cost versus the new cost after the minimum wage increase for New York restaurants of various sizes. Take a restaurant with $5,250,000 in revenue. Its labor cost just went up approximately $80,000 under the new law. “Rising rents and commodity costs, Obama Care, and now this. How can we make money?” said one of our clients, a leading New York restaurateur.
View the current Tipping Model: Effect of Minimum Wage Increase in New York
Is a New Business Model the Answer?
Restaurateurs are looking at new business models and strategies to offset these costs. The primary considerations are: raising prices, reducing labor hours, and reducing staff/terminating employees. Another model being discussed – one that has gained a lot of momentum – is the elimination of tipping all together. Under this scenario, servers would be paid a fixed hourly rate and a fee or service charge, is added to the check (similar to a tip of 15% or 20%). Those monies would be used to pay servers an hourly rate equivalent to what they are currently making when tips are included.
On the surface, it seems the strategy could work and everyone will share in the burden—guest, server, and restaurant. However, a deeper look in the numbers shows that there may be only one clear winner here if that happens, as shown in the series of charts below.
View the New Service Charge Model: No Tipping
A restaurant that included an 18% surcharge would be able to pay servers about $30 an hour with no added out-of-pocket costs associated with the new minimum wage. Guests may actually prefer this as they no longer need to figure out a tip or feel they need to evaluate a server with an economic reward of 15% for bad service and 20% for good service at the end of the meal.
“It works in Europe, but it will have big changes for the restaurant industry in the U.S.,” said Nick Mautone, a restaurant consultant with CohnReznick. “Beyond the economic issues, there would be significant intangible effects for guests, employees, the restaurant, and even the federal and state tax authorities.”
What isn’t clear is if a restaurant can even implement a surcharge. An old law on the New York City books says that it is illegal to add such a charge to a bill.
Some are working to change that law. If not a surcharge, than operators who eliminate tipping will have to implement a menu price increase.
Impact on Guests with Service Charge Model
The effect on guests is straightforward. They would no longer need to tip, but will be required to pay a percentage surcharge on top of the menu items. The net cost should be relatively the same as when tipping was left to the guest’s discretion. However, sales tax may need to be collected on the surcharge and that cost would likely be passed on to the guest. Moreover, it is likely that some patrons would prefer that restaurants just raise prices rather than implement a surcharge.
Impact on Servers
For the server, this model would represent a monumental change. Their income would be fixed and not subject to their individual performance as with the tipping model. They may no longer be incentivized to upsell or even go the extra mile to accommodate a guest. They may also take home less money as some restaurants may only pay them what they were currently making (tips /divided by hours). Many servers already make more per hour than the current minimum wage based on performance, length of service, etc. Things will get complicated. “What happens when a guest splurges and buys an expensive bottle of wine and there is an 18% surcharge on top of it?” asked one New York City server. “Do I get some of the money?”
Finally, servers would not have a variable pay check and some restaurants cash out tips at the end of the shift. That will no longer be the case. Instead, they would receive a weekly pay check like most people do with required withholdings and other pay deductions like health insurance. They may have the benefit of a higher hourly rate if they work overtime, but that would be at the discretion of the employer.
Impact on Restaurants
The effect on the restaurant is a minefield.
There could be upside. Consider restaurants currently paying a server $5.00 an hour, which will be increased to $7.50 on January 1st. Under a service-charge model, this cost could be eliminated as servers will get a new, higher flat hourly rate. The new monies collected from the guest represent revenue to the restaurant and they can set the hourly wage they are paying their servers. Better servers can receive higher hourly pay based on predefined metrics. A portion of the service charge can also be used to pay the flat salary to the server. They could then choose to retain some of the funds to cover other costs such as the back of the house staff.
Then, there is the downside. Depending on where a restaurant operates, the surcharge will probably be subject to sales tax. Who then pays the sales tax: the guest? the restaurant? It will surely be an issue on every sales tax audit. The overtime pay rate for servers would go up significantly. If a server is paid $30 an hour, the overtime rate would be $45 an hour. The new model could also expose the restaurant to more litigation from employees. Lastly, retaining quality servers will be an issue as some will leave to go to tip houses rather than opt for the fixed hourly pay.
Why the Tax Authorities Are Smiling
One area that is not often discussed is the tax effect. There is currently a significant tax credit available to restaurants based on the Social Security Taxes restaurants pay on tips. Restaurants that eliminate tipping will lose the benefit of the FICA TAX CREDIT. As the following chart shows, a restaurant grossing over $5 million would lose out on the credit estimated to be $78,000. Another lost savings is the ability to charge servers the credit card commission on tips. The same restaurant would incur an additional $23,000 in expenses.
View the Cost to Restaurants: No Tipping Model
While the intent of the new wage hike and tip credit was to increase pay to service staff, it may have the exact opposite effect. Operators will surely cut hours and staff to control labor costs. Price increases will also come into play either in the form of a surcharge or higher menu prices.
View the Tax Authority Benefit: No Tipping Model
If the New York restaurant community does away with tipping, servers will probably end up taking home less. Patrons may end up paying more. So, who wins in the end? Quite possibly, the only beneficiaries are the tax authorities. They will collect more in sales tax, receive more timely taxes paid by servers, and eliminate the FICA Tax Credit, which is estimated to be $12 billion across the industry.
The chart to the right details the potential scenarios for restaurants in light of the upcoming higher minimum wage and our take on who will/will not benefit.
The restaurant industry hasn’t made changes yet in response to the new minimum wage. But stay tuned. No matter what happens, restaurants will need to find an efficient, effective business model that works for them – one that helps them maintain revenue and profit margins in light of paying higher minimum wages to their service employees.
For more information, please contact Gary Levy, a CohnReznick partner and Hospitality Industry Practice Leader, at email@example.com or 646-254-7403.
For information on CohnReznick’s Hospitality Industry Practice, visit our website.
This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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