California tipped workers may now challenge “service charges” as deprivation of compensation

You have probably seen it on a restaurant bill: a notice that a percentage is added to your bill as a "service charge." But although a reasonable diner may assume this charge will be paid in full as a gratuity to their server, that is not always the case. Now, tipped workers may challenge this practice as deprivation of tipped compensation under California Labor Code Section 351, following the California Supreme Court's January 2020 refusal to review O'Grady v. Merchant Exchange Productions, Inc., 41 Cal. App. 5th 771 (2019).

O'Grady's named plaintiff, Laruen O'Grady, is a banquet server and bartender at a ballroom owned and operated by Merchant Exchange Productions. Merchant Exchange has a practice of adding a 21% service charge to its food and beverage banquet event bills. O'Grady alleged that these charges look like tips to customers who, according to the complaint, believe the service charge will go to servers. Unbeknownst to customers, Merchant Exchange distributes only a portion of each service charge to service employees, while the rest goes to employees who did not serve food or beverages at the event. O'Grady brought a class action for wrongfully withheld gratuities under Section 351 of the California Labor Code -- which prohibits employers from "collect[ing], tak[ing], or receiv[ing] any gratuity or a part thereof that is paid, given to, or left for an employee by a patron"--and three related causes of action in contract and tort. Merchant Exchange demurred, and the trial court dismissed the complaint, accepting the employer's argument that a service charge could never, as a matter of law, constitute a gratuity.

The 1st District Court of Appeal reversed. In holding that O'Grady had brought viable causes of action, the Court of Appeals analyzed the court's prior decisions in Searle v. Wyndham International, Inc., 102 Cal. App. 4th 1327 (2002), and Garcia v. Four Points Sheraton LAX, 188 Cal. App. 4th 364 (2010). Searle involved a customer challenge to a hotel's mandatory service charge practices, alleging that the service charges were in fact compelled gratuities paid to service employees. The Court of Appeal disagreed, concluding that the employer's decision to pay the entire 17% service charge to the service employee does not convert it into a gratuity, and in fact, the patron has "no legitimate interest in what the hotel does with the ... service charge." Id. at 1334. The Searle court spent little time with Section 351, only noting that because the challenged practice "cause[s] servers to receive more in the way of tips than would otherwise occur, it plainly does not violate the spirit or letter of Labor Code section 351." Id. at 1333-34.

In Garcia, hotel service workers sought to enforce a Los Angeles city ordinance directing hotels to pay mandatory service charges to service workers. In response, the defendant hotels sought to overturn the ordinance on several grounds, including, most importantly here, preemption by the California Labor Code. The trial court agreed that the ordinance conflicted with Section 350(e)'s definition of "gratuity" by converting the services charges into de facto gratuities. The Court of Appeal reversed the trial court's demurrers, holding in relevant part that the ordinance posed no conflict because the Labor Code covers gratuities, not service charges. Garcia, 188 Cal. App. 4th at 377.

Merchant Exchange argued that language in both Searle and Garcia established that charges designated by a service employer as service charges can never be gratuities. See Searle, 102 Cal. App. 4th at 1334-35 ("Because the service charge is mandatory and because the hotel is free to do with the charges as it pleases, the service charge is simply not a gratuity"); Garcia, 188 Cal. App. 4th at 377 ("A gratuity is not a service charge. ... [A] service charge by definition is not a gratuity."). But the O'Grady court distinguished both cases, including that "in neither case did the court take money from the employees." O'Grady, 41 Cal. App. 5th at 787. Garcia ultimately upheld the local ordinance at issue, rejecting the employers' state preemption argument and holding that the ordinance created for "the employees ... a property interest in the 'service charges' imposed by the hotels." Id. at 786. From this, the O'Grady court concluded that the California Legislature had not made clear that payments labeled as service charges could never be gratuities. Id. at 786.

As for Searle, the O'Grady court emphasized the difference between patrons believing service employees do not receive mandatory service charges when they actually do (Searle) and patrons believing service employees do receive mandatory service charges when they actually do not (O'Grady). If a patron intends a service charge to be the employer's property, the employer's decision to compensate its employees with that property is "none of the customer's business." Id. at 785. But if a patron intends a service charge to be the service employee's property, the protections of the California Labor Code kick in.

Merchant Exchange Productions had argued that distinguishing Searle on this basis would require an analysis of patrons' state of mind. Traditionally, tipping has been considered to be a voluntary transaction between a patron and a service employee, and the patron's state of mind is neither ascertainable nor relevant. Id. at 789 (collecting cases).

The O'Grady court rejected this reasoning, stating that "the customer's intent is not necessarily dispositive. Or even consulted." Id. at 789. The court recognized that "the traditional definition of gratuity may be changing," observing that "the notion of an involuntary gratuity has perhaps become more widespread and accepted than in the past," and citing common examples. Id. at 786 n.9, 789. Therefore, the court reasoned, O'Grady should have the opportunity to establish the existence of a hospitality industry custom to treat service charges as gratuities for tipped workers, as alleged in the complaint. O'Grady, 41 Cal. App. 5th at 789-90.

At the end of the opinion, the Court of Appeal highlighted a request for publication filed by the California Labor Workforce and Development Agency and the importance of the issues presented in the case. Id. at 793. The LWDA had cited the high volume of wage and hour violations, especially in the tipped worker context, and the Los Angeles City Council's consideration of the declining incomes of hotel workers due to the rise of mandatory service charges when enacting the ordinance at issue in Garcia. Id. at 793. The Court of Appeal included this brief discussion to highlight the widespread impact of service industry practices such as including mandatory service charges, noting, "Clearly, the Labor Commissioner does not believe this situation is confined to downtown Los Angeles." Id. at 793. Thus, the Court of Appeal closed its opinion by recognizing the wide-reaching implications of its decision and, impliedly, the certainty of future litigation and legislation concerning tipped employees' wages and conditions.

Following the California Supreme Court's refusal to review O'Grady, plaintiff-side employment attorneys who represent tipped workers should investigate potential defendant-employers' service charge practices and related customs in the industry. A potential client may not be aware that the service charge may be a gratuity to which they are entitled, especially because the Department of Industrial Relations' Division of Labor Standards Enforcement's "Frequently Asked Questions" page on gratuities has not been updated to reflect the O'Grady decision as of this writing. However, the DLSE recognizes in its revised Enforcement Policies and Interpretations Manual (2002, revised) that a service charge may be a gratuity in the wake of O'Grady. Id. at Section 19.3.5.

Likewise, attorneys should be sure to investigate other potential causes of action when a potential client complains of withheld service charges. Tipped workers experience disproportionately higher instances of wage and hour and other violations. For instance, although service industry employers are legally required to make up the difference between the tipped minimum wage and the minimum wage when an employee's tips fall short, this requirement is rarely enforced. In addition, tipped workers are likelier to experience discrimination, implicating the Fair Employment and Housing Act. Cal. Lab. Code Section 12940. Women make up around two-thirds of the tipped workforce, and they are far more likely than workers in most other occupations to experience instances of sexual harassment at the workplace -- one study found over 90% of Washington, D.C., restaurant workers experienced workplace sexual harassment. In addition, nearly 40% of tipped workers are people of color, who experience higher rates of racial harassment or discrimination. Attorneys seeking to represent tipped workers should be aware of these legal issues affecting the population and investigate accordingly.

Given that Section 351 challenges to service charges likely concern employment policies affecting multiple tipped workers, and that tipped workers are unlikely to be able to afford legal services, practitioners seeking to bring such actions may want to proceed as class actions, as in O'Grady, or under the Labor Code Private Attorneys General Act on behalf of the aggrieved employee and other current or former employees. Cal. Lab. Code Section 2698 et seq. Utilizing PAGA to enforce section 351 has the benefits of fee shifting and statutory penalties, plus such an action would not be subject to compelled arbitration even if the employees signed arbitration agreements, pursuant to Iskanian v. CLS Transportation Los Angeles, LLC, 59 Cal. 4th 348 (2014), 75% of the recovery would go to the LWDA, while the aggrieved employees would keep 25%. Cal. Lab. Code Section 2699(i). Notably, PAGA's provision allowing employers to cure some violations before suit (Cal. Lab. Code Section 2699.3(b)) does not apply to claims brought under Section 351. Cal. Lab. Code Section 2699.5.

The O'Grady decision affects a rapidly growing population; roughly 4.4 million workers rely on tipped income, and the number of tipped workers is growing at a faster rate than all occupations in general. As such, we can expect increased litigation to come regarding service charges under California Labor Code Section 351. 