Unlocking the FLSA Overtime Exemption: What Retail and Service Employers Need To Know in 2026

The U.S. Department of Labor’s Wage and Hour Division (DOL) recently issued Opinion Letter FLSA2026-4, shedding light on key aspects of the Fair Labor Standards Act (FLSA) Section 7(i) overtime exemption. This potentially powerful exemption can help qualifying retail and service employers manage overtime obligations for commissioned employees, provided specific requirements are met.

The opinion letter was spurred by a request from restaurant operators in a state where the minimum wage exceeds the federal minimum wage threshold. The operators classified their servers and server assistants as exempt from overtime through applying the FLSA’s Section 7(i) exemption. According to the operators, employees receive some portion of wages through service charges, as well as a small number of tips. The restaurants sought guidance on calculation of the regular rate, as well as application of the FLSA’s tip credit requirements. 

What Is Section 7(i)?

Section 7(i) of the FLSA allows retail and service employers to exempt certain employees from overtime if two main tests are satisfied:

1. The employee’s regular pay rate is more than 1.5 times the federal minimum wage.
2. More than 50% of the employee’s earnings (during a representative period of not less than one month) comes from commissions on goods or services. 

To be covered, a business must be a “retail or service establishment” with a “retail concept.” This means it primarily sells goods or services to the general public, serves the everyday needs of the community, operates at the end of the stream of distribution, supplies products and skills in small quantities, and does not take part in the manufacturing process.

Federal vs. State Minimum Wage: Which Applies?

One common area of confusion is whether to use the federal or a higher state minimum wage when applying the Section 7(i) exemption. DOL clarifies that the “regular rate” threshold for Section 7(i) is always calculated with reference to the federal minimum wage (which is currently $7.25 per hour), not any higher state or local minimum. Thus, for an employee to qualify under Section 7(i), their regular rate of pay (excluding overtime) must be more than 1.5 times the federal minimum wage each week the exemption is applied; that is, more than $10.88 ($7.25 x 1.5) per hour. While employers must always comply with the highest prevailing wage in their jurisdiction (federal, state, or local) for standard compensation, only the federal rate is relevant to determining if Section 7(i) applies.

When Do Tips Count as “Compensation” Under Section 7(i)(2)?

DOL reiterates that bona fide tips are not “commissions” for section 7(i) purposes.[1] However, service charges pegged to a percentage of the bill and remitted by the employer typically are commissions. The primarily commissioned test (whether more than 50% of the employee’s earnings comes from commissions) asks whether commissions exceed all other “compensation” for a representative period of not less than one month. 

As a general matter, “compensation” for section 7(i)(2) means amounts paid to or on behalf of an employee for employment. Tips are discretionary payments from customers and ordinarily are not “compensation” paid by or on behalf of the employer. However, to the extent an employer relies on tips to satisfy a wage obligation, such as by taking a federal, state, or local “tip credit,” those tips become part of the employee’s guaranteed earnings and count as “compensation” in the Section 7(i)(2) calculus. 

DOL illustrates the rule through an example of two servers. Meghan earns commissions from percentage-based service charges and also receives tips, but her employer does not apply any federal or state tip credit. As a result, none of Meghan’s tips count as “compensation” under Section 7(i)(2), so her commissions make up all of her compensation for the representative period, and she meets the primarily commissioned threshold. In contrast, Suzanne receives base wages, occasional service-charge commissions, and tips, and her employer takes a $2.00-per-hour state tip credit. The credited portion of Suzanne’s tips counts as “compensation,” and during the representative period, her commissions do not exceed her base wages plus credited tips, so she does not meet the primarily commissioned test. The key takeaway is that tips are considered “compensation” for Section 7(i)(2) only when an employer actually relies on them to meet wage obligations through a federal, state, or local tip credit. Otherwise, tips are not counted as compensation for this analysis.

Employer Takeaways: What Matters Now

Section 7(i)(1) uses a federal yardstick. Employers must ensure the employee’s regular rate exceeds 1.5 times the federal minimum wage for any week in which Section 7(i) is claimed. Higher state or local minimum wages may independently apply and must be satisfied, but they do not alter the Section 7(i)(1) threshold. 

For the Section 7(i)(2) primarily commissioned test, an employee’s commissions must be more than all other types of pay over at least one month. Service charges usually count as commissions, but tips do not. However, if an employer uses a federal, state, or local tip credit to meet wage requirements, the credited part of the tips is treated as “compensation” and must be included with base wages when checking if commissions make up more than half of the employee’s total pay. 

Finally, the Section 7(i) analysis is employee- and period-specific. Employers should designate and substantiate representative periods in their records and regularly audit whether each employee’s compensation structure continues to meet both the minimum pay standard and the primarily commissioned requirement. 

Practical Tips for Employers

• Monitor the federal 1.5x threshold weekly. Ensure each covered employee’s regular rate exceeds 1.5 times the federal minimum wage in every week you claim the exemption.
• Classify commissions and tips correctly. Treat percentage-based service charges as commissions and exclude tips unless they are used for a tip credit.
• Designate periods and document. Set a representative period of at least one month and keep records showing commissions exceeded 50% of compensation.

Endnote

[1] DOL acknowledges the U.S. Court of Appeals for the Fourth Circuit’s decision in Wai Man Tom v. Hosp. Ventures, 980 F.3d 1027, 1039 (4th Cir. 2020), which treated all tips as “compensation” under Section 7(i), and cautions employers within the Fourth Circuit's geographic territory not to rely on this opinion to the extent it conflicts with that precedent.