The tip credit is the amount of employee tips that restaurants may use to reduce the cash wages they must pay tipped employees. There are enough exceptions and special rules to delight the hearts of lawyers and glaze the eyes of everyone else. Here we will simplify things – some – in the interest of clarity and provide a few references later that go into greater detail.
At the end of the day, restaurant employees in the United States must make at least the minimum wage. The minimum wage to use is either the federal, state or local minimum wage, whichever is highest. This only makes sense. When the employee makes the highest amount then you are automatically in compliance with labor law in all the jurisdictions that apply to you. (Federal and state for most people.)
To simplify things we will only consider the case of what the feds require. Your state might be different. The Fair Labor Standards Act allows restaurants to pay tipped employees less than the minimum wage in cash. At the time of this writing the federal minimum wage is $7.25 per hour and the federal maximum tip credit is $5.12 per hour. On a good day this means you only need to pay a “customarily tipped” employee $2.13 per hour. ie $7.25 – $5.12 = $2.13. Now you might think “Hey this is great!” but there is a catch. The employee must make $5.12 per hour or more in tips for this to be true. If the employee makes less than that in tips you are required by law to make up the difference on their pay check.
In the end, the formula for hourly rate is really equal to:
Rate = MinimumWage – MaxTipCredit + MakeUpAmount
The MakeUpAmount will be zero if the employee makes enough in tips. If they don’t, there are significant fines unless you add it to their paychecks somehow. The best way is to make sure your payroll software does it automatically.