A complete guide to understanding Gratuity

Gratuity, also known as the ‘golden handshake,’ is an important job benefit that employers in India are legally bound to provide for their employees. As of 2024, this benefit remains a key source of financial security for millions of salaried Indians.

It is a valued element in any employee’s package and is designed to provide financial cushioning in cases of retirement or loss of job to reward long-term service.

Gratuity Act, 1972

The Gratuity Act of 1972 is the central legislation regulating gratuity in India. This statute defines the eligibility criteria, how gratuity is calculated, and other related details.

Key Provisions of Gratuity Act, 1972

Gratuity meaning is an amount that’s payable to an employee on completion of the minimum eligible criteria as follows:

Minimum Continuous Service Period: The employee should have served the employer continuously for a minimum of five years. Breaks in service, such as periods of unemployment or leave without pay, can count against eligibility.
Type of Employment: The Act applies mainly to employees in public-sector organisations, government-owned companies, and private-sector establishments with 10 or more employees. Some states have extended the coverage to establishments with fewer employees.

Payment of Gratuity

The employer must pay the gratuity within 30 days of the employee’s retirement, resignation, or termination. If the payment is delayed, the employer is liable to pay interest on the amount.

Tax Implication of Gratuity

Some part of the gratuity is totally exempted from income tax. The formula for arriving at the limit of the tax-exempt gratuity is as under:

Maximum Tax-Exempt Gratuity = (Number of Years of Employment x Previous Salary x 15) / 26

The maximum tax-exempt limit, however, is capped at ₹20 lakhs. Any amount that exceeds the above limit is subject to taxation according to the individual concerned’s income tax slab.

Let’s break down the formula with an example:

Suppose you have worked for a company for 10 years, and your previous salary was Rs. 20,000 per month.

Number of Years of Employment: 10
Previous Salary: Rs. 20,000

Using the formula, the maximum tax-exempt gratuity would be:

(10 x 20,000 x 15) / 26 = Rs. 1,15,385

However, there’s a cap:

The maximum tax-exempt limit is capped at Rs. 20 lakhs.

So, even if your calculated tax-exempt gratuity exceeds Rs. 20 lakhs, the maximum exempt amount will still be Rs. 20 lakhs.

Amendment to the Act

By increasing the maximum limit of tax-exempt gratuity from Rs. 10 lakh to Rs. 20 lakh, the government aimed to provide greater financial security to employees and recognize their long-term contribution to their organizations.

Key reasons for the amendment:

Rising Cost of Living: The cost of living has increased significantly over the years, making the previous cap of Rs. 10 lakh insufficient to meet the financial needs of employees upon retirement or other eligible circumstances.
Inflationary Pressures: Over time, inflation erodes the purchasing power of money. The amendment aimed to protect the real value of the gratuity amount by increasing the cap.
Changing Employment Landscape: The nature of employment has evolved. More people work in the organized sector and expect better social security benefits.
Employee Welfare: The amendment was a step towards enhancing the overall welfare of employees by providing them with a more substantial financial cushion upon retirement or other eligible events.

The Gratuity Act has been amended over the years to update itself with the changes in economic conditions and employment practices. Some of the significant amendments are as follows:

Tax-Free Limit Increased: The tax-free limit for gratuities has been increased many times to provide employees with more financial security.
Expansion of Coverage: The Act has been expanded to cover a greater number of employees, including some specific sectors such as the IT industry.
Eligibility Criteria: The eligibility has been amended in detail for employees belonging to some sector or employment contracts.

Therefore, if employees know well the major provisions of Gratuity Act, they would also realise how they are eligible to claim gratuity and will better plan their financial future accordingly. Consultation with legal and tax professionals is also desirable to know more specific matters in regard to claims for gratuity and tax implications.

Eligibility for Gratuity

Gratuity is only granted to an employee who satisfies the following:

Five-Year Benchmark: The employee should have served continuously for five years under the employment of the employer. Continuous service implies that a break in service in the nature of unemployment or leave without pay shall also have an impact on eligibility.
Minimum Period of Continuous Service: Five years of service should not be interrupted. If some breaks occur, then there is a possibility that the gratuity amount will get affected.

Termination of Service

Gratuity would be payable on the termination of service for any of the following reasons:

Retirement: When the employee attains the age of retirement as specified under the retirement scheme of the Employer or as provided under the Retirement Scheme applicable to him.
Resignation: When the employee resigns from the service.
Retrenchment: Where the employer terminates employment with the employee due to closure of business, redundancy, or economic reasons.

Note: The necessary requirements and calculations may differ slightly based on the nature of employment-public or private sector or government owned companies-and the relevant state-specific labour laws.

Calculation of Gratuity

The gratuity amount is determined based on the following formula:

Gratuity = (Previous salary) x (Employment tenure) x (15/26)

Previous salary: This refers to the last basic salary the employee receives.
Employment tenure: This refers to the total number of years of continuous service with the employer.

Example:

If an employee’s previous salary is Rs. 50,000 per month and they have completed 10 years of continuous service, the gratuity amount would be:

Gratuity = (50,000) x (10) x (15/26) = Rs. 2,88,462

Factors Affecting the Gratuity Amount

The following factors may influence the final amount of gratuity:

Previous Salary: This is the last salary of the employee, which comprises basic salary, dearness allowance, and commission. The higher the last drawn salary, the higher will be the gratuity amount.
Number of Years of Continuous Service: The more time the employee spends with the organisation, the greater the amount of gratuity. Any kind of break in service, be it unemployment or leave without pay, will affect this calculation.
Gratuity Scheme of the Employer: Some employers may have their own gratuity schemes, which would provide more generous benefits than those of the statutory formula. In such cases, the eligibility conditions and calculation may vary from the one above.
Bonus and Leave Encashment: All these components can also be included in the last drawn salaries in order to hike the amount to which a worker is eligible at the end. Their inclusion may sometimes vary according to the agreement under that job contract and prevalent labour legislation.
Reason for Termination: Gratuity eligibility and calculation also depend on the reason for termination of employment. The full gratuity is payable in cases of retirement or resignation. However, if the reason for termination is misconduct or gross negligence, the employer may withhold or reduce the gratuity.

Notwithstanding the above, the determinants of gratuity will depend on the nature of employment, the labour laws applicable to a specific case, and the employment contract. In this regard, the best practice is to consult an HR professional or legal expert in order to ensure accurate gratuity calculation and timely payment.

Tax Implications of Gratuity

The Indian Income Tax Act offers tax exemption on part of an employee’s gratuity. This exemption is to help employees when they retire or get terminated from their jobs.

Tax Exempt Limit

The tax-exempt limit for gratuity is computed as follows:

Maximum Tax-Exempt Gratuity = (Years of Service x Last Drawn Salary x 15) / 26

However, it is capped at ₹20 lakhs. This implies that even if the calculated amount of gratuity exceeds ₹20 lakhs, the first ₹20 lakhs shall be exempted from tax.

Calculation of Tax

That amount of gratuity above the limit of exemption in tax shall be liable for tax according to the slabs of income tax prevailing for that particular person.

This taxable amount will form a part of that particular person’s total income earned during the financial year.

Illustration:

If an employee receives a gratuity of ₹25 lakhs, the first ₹20 lakhs will be exempted from tax. The remaining ₹5 lakhs will be added to the individual’s taxable income and taxed according to the individual’s income tax slab.

It should be noted that the gratuity tax implications may change with individual circumstances and changes in tax laws. Therefore, it is recommended that you consult a tax professional for proper advice.

Impact of 2018 Tax Reforms on Gratuity

Some significant tax reforms, which are of great concern, resulted in gratuity becoming taxable. The most noticeable change is in the exempt limit.

Increased Tax Exemption:

Earlier, the maximum amount exempted from tax was ₹10 lakhs only.
Now: The same has been increased to a considerable amount of ₹20 lakhs.

This increase in the tax-exempt limit brings considerable relief to employees, as a greater share of their gratuity is exempt from income tax. This can result in a much higher amount of post-retirement security.

Other Tax Implications:

Though this increased tax-exempt limit is an encouraging development, there are other tax implications that have to be taken into consideration:

Taxable Income beyond the Tax-Exempt Limit: The amount exceeding the tax-exempt limit is taxable.
Impact of Other Sources of Income: The taxable portion of the gratuity is added to other sources of income, such as rental property or investments, to calculate the total tax liability.

Key Takeaway Points

Based on these key takeaways, the employee can accordingly design his financial future and get a good return on gratuity:

Eligibility: An employee who has completed five years of continuous service with the employer can claim gratuity.
Calculation: Gratuity is computed as a percentage of the years of service, the last salary drawn, and a formula established by law.
Taxability: The gratuity is partly exempt, and the rest is taxable.
Gratuity Scheme of the Employer: Many employers have gratuity schemes, which might be better than the statutory formula.
Consult HR or Legal Experts: It is always best to consult with HR professionals or legal experts for proper information and guidance on calculating and claiming gratuity.
Financial Planning: When planning for the long term, it is a good idea to factor in the amount of gratuity expected.

Keep in touch with changes happening in labour laws and tax laws that might affect your gratuity benefits.

Conclusion

Gratuity is one of the significant retirement benefits that can boost your finances when you need it most. Understanding eligibility criteria, calculation, and tax implications can help you optimise this benefit and prepare for the future.

Take advantage of this knowledge: Utilise financial planning resources, like Power Up Money, to devise a personalised plan that maximises your gratuity and places you on the road to retirement financial wellness.

Frequently Asked Questions (FAQs)

1. What is gratuity?

Gratuity is a retirement benefit that employers are legally obligated to pay to their employees upon retirement, resignation, or retrenchment. It is a lump sum payment that recognises and rewards long-term service.

2. Who is eligible for gratuity?

An employee is eligible for gratuity if he has completed five years of continuous service with the employer.

3. Is gratuity taxable?

Part of the gratuity is tax-free, and the rest is taxable. The current limit for tax-free gratuity is ₹20 lakhs.

4. What are the factors that determine the amount of gratuity?

The gratuity amount depends on factors such as years of service, the last salary paid, and the employer’s gratuity scheme.

5. What happens if an employee resigns before five years of service?

If an employee resigns before completing five years of continuous service, he/she is not entitled to gratuity.

Disclaimer: This information is supplied solely for informational reasons. Any mistakes, omissions, or results resulting from the use of this information are not PowerUp’s responsibility.