Service charges, VAT and the minimum wage

Tips, service charges and optional service charges

HMRC's guidance E24 defines a tip as "an uncalled for and spontaneous payment offered by a customer", and a service charge as "an amount added to the customer's bill before it is presented to the customer". A service charge is voluntary where it is made clear to the customer that the amount is purely discretionary and the customer does not have to pay it. Where the customer must pay, it is a mandatory service charge.

E24 says "HMRC will accept that a payment is a voluntary service charge if it is clearly presented to the customer as an entirely optional payment." The menu, the bill and what staff tell customers must all say the same thing. An amount a customer writes on an open card slip is likely to be a gratuity.

VAT on service charges

E24 section 4 says compulsory restaurant service charges "are part of the consideration for the underlying supply of the meals if customers are required to pay them. This means they are standard rated." Where customers "have a genuine option as to whether to pay the service charges", HMRC accepts that the charges are not consideration, even if they appear on the invoice, and they fall outside the scope of VAT.

The catering and hotel notices state the general rule more shortly: "If you make a service charge, it's standard-rated" (VAT Notice 709/1, section 2.3). Both notices say tips a customer gives freely, above the total charge, carry no VAT. What makes a service charge optional is the E24 test: whether the customer has a real choice and is told so.

A £100 bill with a 12.5% service charge

Compulsory service charge

£12.50 added to the bill as part of the price of the meal. VAT in the charge:

£2.08

Optional service charge

£12.50 the customer is free to refuse. Outside the scope of VAT. VAT in the charge:

£0.00

National Insurance and PAYE

E24 is direct about compulsory charges: "If you impose a mandatory service charge and the money is paid out to your employees, National Insurance contributions are always due on the payments. This is regardless of how the money is shared out between employees." PAYE applies too. Where mandatory service charges are paid out through a tronc, the employer is responsible for operating PAYE on them (E24 section 6).

A voluntary service charge is treated as a tip. Income tax is due through PAYE. National Insurance depends on who decides the shares: none is due where an independent troncmaster allocates them, and employer and employee National Insurance are due where the business allocates them.

A month with £9,000 of service charges

	Compulsory, paid through the payroll	Optional, shared by an independent troncmaster
Collected from customers	£9,000.00	£9,000.00
VAT paid to HMRC	£1,500.00	£0.00
Shared among staff	£7,500.00	£9,000.00
Employer National Insurance at 15%	£1,125.00	£0.00
Employee National Insurance at 8%	£600.00	£0.00

Employer National Insurance for 2026/27 is 15% of each employee's earnings above the £5,000 a year secondary threshold. An eligible employer can set the £10,500 Employment Allowance against its bill for the year, which covers National Insurance on service charges along with wages.

Over a year, £9,000 a month of compulsory service charges means £18,000 of VAT and £13,500 of employer National Insurance, before staff receive anything.

Service charges and tipping law

The Employment (Allocation of Tips) Act 2023 covers service charges as well as tips. The code of practice says it includes "both automatically added and other voluntary service charges". So every service charge the business collects is shared fairly among workers at that place of business and paid out by the end of the month after the customer paid (Employment Rights Act 1996, sections 27D and 27G).

The part of a customer's payment that is VAT does not count as a tip, gratuity or service charge (section 27C(7)). On a compulsory charge, the business pays the VAT to HMRC and passes on the rest. Other deductions are limited: the code says tips are passed on "without deductions, except in very limited scenarios, such as deduction of income tax".

The written tipping policy must say whether the business requires or encourages customers to pay tips, gratuities and service charges, and how they are allocated (section 27I(2)). Service charges go into the tipping record with card tips, kept for three years.

Sharing service charges between staff

The code of practice says sharing tips fairly "does not necessarily require employers to allocate the same proportion of tips to all workers". It asks employers to use "a clear and objective set of factors" and gives these as examples:

• the type of role, for example front of house or kitchen
• basic pay, and how workers are engaged
• hours worked during the period when the tips were received
• individual or team performance
• seniority or level of responsibility
• length of service
• what the customer intended

The factors used go in the tipping policy. Agency workers who help serve customers are considered along with employees. Employers must avoid discrimination in choosing and applying the factors, including indirect discrimination where one group of workers receives a smaller share. The code asks employers to consult workers so that the system is broadly agreed to be fair, and to review it as staff and the business change.

The minimum wage

E24 section 10 says that for pay reference periods starting on or after 1 October 2009, amounts paid to a worker "which represent tips, gratuities, service charges or cover charges paid by customers do not count towards National Minimum Wage pay". The government's minimum wage guidance adds that this applies "regardless of whether they are paid through your payroll or are given direct to workers by customers or a tronc master". The rule is in regulation 31(1)(e) of the National Minimum Wage Regulations 1999.

From April 2026 the National Living Wage for workers aged 21 and over is £12.71 an hour, and it rises to £13.21 in April 2027. Each worker's pay from the employer has to reach that rate for every pay reference period before any service charge share is added.

A server paid £12.00 an hour plus a service charge share

• Minimum wage pay for 160 hours at £12.00£1,920.00
• Service charge share of £3.00 an hourDoes not count
• Pay needed at £12.71 an hour£2,033.60
• Arrears owed to the worker£113.60
• Maximum penalty: 200% of the arrears£227.20
• Penalty if the notice is paid in full within 14 days£113.60

Where HMRC finds underpayment it issues a notice of underpayment. The arrears are worked out at the current minimum wage rate, so they grow when rates rise. The penalty can be up to 200% of the arrears, with a maximum of £20,000 per worker, and is halved if the notice is complied with in full within 14 days. Employers who break minimum wage law can also be named by the government, and failing to pay the minimum wage is a criminal offence.

Common mistakes and what HMRC or a tribunal does

• Calling a charge optional on the menu while staff tell customers they must pay it. HMRC looks at the literature and at what staff say.
• Charging no VAT on a compulsory service charge.
• Paying compulsory service charges to staff through a tronc with no National Insurance.
• Deducting card fees, breakages or till shortages from the service charge before sharing it.
• Counting service charge shares towards the minimum wage.
• Paying service charges out later than the end of the month after the customer paid.

VAT undercharged on service charges is assessed by HMRC, with a penalty of up to 30% of the extra tax where reasonable care was not taken. National Insurance that should have been paid is collected from the employer. A worker who is not paid service charges fairly or on time can bring a tribunal claim within twelve months, and the tribunal can order the employer to revise the allocation and pay compensation of up to £5,366.

Records and deadlines

• Copies of menus, bills, card terminal prompts and staff briefings that show how the service charge is presented, with the dates each version was used.
• Service charges collected each month, the VAT on compulsory charges, and the amount passed to staff.
• The tipping record, kept for three years from the date each charge was paid.
• Minimum wage records kept for at least 6 years, VAT records for at least 6 years, and PAYE records for 3 years from the end of the tax year.
• Service charges paid to staff by the end of the month after the customer paid.
• VAT return and payment one calendar month and 7 days after the end of each VAT period. PAYE paid by the 22nd of the next tax month.

How we help

We check the wording on your menus, bills and card terminals, set the right VAT code in the till, and run service charges through the payroll or an independent tronc. Every month we test each worker's pay against the minimum wage without the service charge. More on payroll, tips and tronc, and on accounts and VAT.