Finance & Accounting Labour Compliance

Gratuity: Definition, Eligibility, Calculation, and Exemption – A Complete Overview

Payment of Gratuity is governed by the provisions of the “Payment of Gratuity Act, 1972”. Gratuity is a monetary benefit given to the employee apart from the regular monthly salary paid by the employer.

Employers for whom Gratuity is mandatory to be paid to the Employees

As per the Gratuity Act, 1972, following employers having more than ten employees at any day during the preceding financial year are required to pay gratuity on a mandatory basis:

• Mines
• Oil fields
• Factories
• Shops & establishment

Calculation of gratuity and tax paid thereon varies as per the different rules for government employees, employees covered under the Gratuity Act^[1] and employees who are not covered under this Act.

What are the Eligibility Criteria for Gratuity Payment?

Gratuity Eligibility shall be payable to an employee after the termination of his employment.

• On his superannuation
• On his retirement or resignation
• On his death or disablement due to accident or disease.

Calculation of Gratuity

The employer deposits the eligibility of Gratuity fund with an insurer who in return invests the same into some ventures to get a fixed return. Usually, the amount is invested in fixed income or debt funds to avoid the risk of market volatility.

eligibility is calculated based on factors such as the total number of completed years of service and the last salary drawn.

Salary as per the Gratuity Act means Basic Salary plus dearness allowances. Gratuity is paid by the employer to its employees who have completed at least 5 years of service. Also, part of the year is treated as 1 complete year, for instance, if an employee completes 7 years and 7 months of service, it is rounded off to 8 complete years.

For calculation of Gratuity eligibility, a month is assumed to be of 26 complete days. So, for calculating the 15 days salary, we have to multiply the year of service with 15/26 multiplied by the last salary is drawn.

In case of the death of an employee, the requirement of 5 years of service is not applicable, and the amount accrued is to be paid to the legal heirs or nominee of employees. Gratuity shall be paid within 30 days of the last working day.

For Example:

Last salary drawn: INR 50000

Employment Tenure: 11 years 7 months

Gratuity payable: 50000*12*15/26 = INR 3, 46,154 /-

The formula for the calculation of Gratuity:

The last salary is drawn (Basic + Dearness Allowance)*Number of years of completed service* 15/26

Exemption of Gratuity from Taxation

Taxation on gratuity is exempted up to a certain limit as specified under Section 10(10) of the Income Tax Act, 1961.

• Employees covered under the Gratuity Act, 1972:

Every employer of factories, mines, oil fields, etc. who has at least 10 employees on any day during the preceding year is covered under the Gratuity Act. Though once covered under the act, provisions of the act remain applicable even if the number of employees falls below 10. 

Least of the following is exempted from the tax:

Gratuity calculated as per Gratuity Act, 1972. The formula for calculating the gratuity is:

The last salary is drawn (Basic + Dearness Allowance)* Number of years of completed service* 15/26

Or

INR 20 Lakhs (as amended)

Or

Gratuity received

For Example:

The salary is drawn: INR 1,00,000

Gratuity received: 11,00,000

Period of Employment: 19 years 6 months.

Gratuity as per act:  100000*20*15/26 = 11,53,846

Maximum Exemption allowed: 20,00,000

Gratuity actually received: 1,00,000

Exempted Gratuity: 11,00,000 ( Least of the three)

Taxable Gratuity:                        NIL

• Employees not covered under the Gratuity Act, 1972

Certain employers who are not covered under the Gratuity Act make the payment of gratuity to its employees voluntarily. Gratuity payable to the employee is calculated based on a half-month salary for every completed year.

Least of the following is exempted from the tax:

Last 10 months salary drawn (Basic + Dearness Allowance)* Number of years of completed service* 1/2

or

INR 10 Lakhs (amended limit of exemption is for employees covered under Gratuity Act)

or

Gratuity received

For Example:

The salary is drawn: INR 1,00,000

Gratuity received: 11,00,000

Period of Employment: 19 years 6 months.

Gratuity as per act:  100000*20*1/2       10,00,000       

Maximum Exemption allowed:              10,00,000

Gratuity actually received:                    11,00,000

Exempted Gratuity: 10,00,000 ( Least of the three)

Taxable Gratuity: 1,00,000

• Government employees

This paid by the Government employers to its employees is fully exempted from taxation.

Amendment and its Impact

Ministry of Finance has enhanced the limit of maximum exemption from INR 10 Lakhs to INR 20 Lakhs for gratuity taxation as per section 10(10)(iii) of Income Tax Act,1961. The ceiling of gratuity has been amended from time to time by the Indian Government as per the overall economic situation and employer’s capacity to pay.  This decision of increase in the tax-free amount of gratuity has left the employees happy as they get to save a lot on the amount of tax that was earlier supposed to be paid by them.