Gratuity is a financial benefit given by employers to employees in India, rewarding years of service and loyalty to the organization. The Payment of Gratuity Act, 1972, serves as the primary legislation governing gratuity payments, applicable to both private and public sector employees. Gratuity calculation depends on factors such as salary, tenure of service, and gratuity eligibility conditions. While gratuity provides financial security, it also carries tax implications that employees must navigate. This article outlines the tax rules essential for gratuity calculation and the nuanced considerations when claiming gratuity.
Eligibility for Gratuity
Before delving into the tax rules, understanding gratuity eligibility is crucial. An employee qualifies for gratuity under the Payment of Gratuity Act, 1972, if they:
- Have completed at least five years of continuous service with the same employer (exceptions exist for certain specific cases such as death or disability).
- Are retiring, resigning, or being dismissed after fulfilling tenure requirements.
- Have worked in an establishment with 10 or more employees.
Components of Gratuity Calculation
Gratuity is calculated using a formula defined under the Act:
– Gratuity Amount = (Last drawn salary × 15 × Years of service) ÷ 26
– Last drawn salary: Includes basic pay and dearness allowance (DA).
– Years of service: Only completed years are considered.
For example, suppose an employee retires after 20 years of service, with a last drawn monthly salary of ₹50,000 (Basic + DA):
– Gratuity = (₹50,000 × 15 × 20) ÷ 26 = ₹5,76,923
This formula applies to organizations covered by the Payment of Gratuity Act. For others, gratuity calculations may differ based on employment contracts and company policies.
Tax Rules Under Gratuity Calculation
The tax liability on gratuity depends largely on whether the employee is:
- Covered under the Payment of Gratuity Act.
- Not covered under the Payment of Gratuity Act.
- A government employee.
Let’s explore the taxation nuances for each category.
1. Gratuity for Employees Covered Under the Act
Gratuity received by employees covered under the Payment of Gratuity Act is partially tax-exempt under Section 10(10) of the Income Tax Act. The tax exemption is limited to the least of the following amounts:
- Actual gratuity received.
- ₹20 lakh (the maximum tax-free gratuity limit set by the government).
- Gratuity calculated using the formula:
– (Last drawn salary × 15 × Years of service) ÷ 26
For example:
– Last drawn salary (Basic + DA): ₹60,000
– Years of service: 25
– Formula-based gratuity: (₹60,000 × 15 × 25) ÷ 26 = ₹8,65,385
– The employee received a gratuity payment of ₹10 lakh.
The tax-free portion of gratuity will be the least of:
- Actual gratuity received: ₹10 lakh
- ₹20 lakh (government limit)
- Formula-based gratuity: ₹8,65,385
Tax-exempt gratuity = ₹8,65,385
The balance amount ₹10 lakh – ₹8,65,385 = ₹1,34,615 is taxable.
2. Gratuity for Employees Not Covered Under the Act
For employees not covered under the Payment of Gratuity Act, different taxation rules apply. The tax exemption under Section 10(10) is still available, but it is calculated as the least of:
- Actual gratuity received.
- ₹20 lakh (maximum tax-free gratuity limit).
- Half the eligible monthly salary × Completed years of service.
The formula here is:
– Gratuity = (Last drawn salary × ½ × Completed years of service)
For instance:
– Last drawn salary: ₹50,000
– Years of service: 15
– Half the eligible salary × years of service:
– (₹50,000 × ½ × 15) = ₹3,75,000
– The employee received ₹4 lakh as gratuity.
The tax-free gratuity will be the least of:
- Actual gratuity: ₹4 lakh
- ₹20 lakh limit
- Formula-based gratuity: ₹3,75,000
Tax-exempt gratuity = ₹3,75,000
Taxable portion = ₹4 lakh – ₹3,75,000 = ₹25,000
3. Gratuity for Government Employees
Gratuity received by central, state, and local government employees is completely tax-free. No portion of their gratuity is subject to taxation, irrespective of the payment amount.
Tax Deduction at Source (TDS) on Gratuity
If gratuity is taxable, the employer is required to deduct Tax Deducted at Source (TDS). Taxable gratuity is added to the employee’s total income for the financial year, and tax is calculated based on the applicable slab rate. For individuals earning more than ₹10 lakh annually, gratuity payments exceeding tax-free limits may attract 30% tax liability under current tax laws.
Employees can avoid higher taxes through exemptions under Section 10(10), wherever applicable, by proper documentation and filing their tax returns correctly.
Tax Filing Process for Gratuity
When claiming gratuity exemptions, employees need to keep the following documents handy:
- Form 16: Shows the TDS deducted on gratuity and other earnings.
- Gratuity receipt: Official evidence of gratuity paid by the employer.
- Salary slips: Proof of last drawn salary details (Basic + DA).
- Employment contract: Sometimes required if gratuity calculation deviates from the Act provisions.
Ensure that gratuity exemptions are included under Section 10(10) while filing income tax returns to avoid challenges in tax assessments.
Gratuity Payments for Death or Disability
If an employee becomes eligible for gratuity due to death or permanent disability, the gratuity payment is completely exempt from tax, irrespective of the amount paid.
For example:
– An employee’s legal heir receives ₹25 lakh as gratuity following the employee’s death or disability.
– Exemption under Section 10(10) applies, and the entire gratuity amount of ₹25 lakh is tax-free.
Limit on Tax-Exempt Gratuity
The gratuity tax exemption cap was revised to ₹20 lakh in 2019 (prior limit: ₹10 lakh). Employers paying gratuity amounts beyond ₹20 lakh may structure the excess payments under non-taxable allowances (e.g., leave encashment or retirement benefits), as permissible within tax rules.
Important Disclaimer
Gratuity calculations and related tax exemptions vary depending on employment contracts, the tax regime adopted by the employee (old or new), and legal provisions. Employees should clarify tax liabilities with their employer and seek financial advice where needed. The employee must gauge all the pros and cons before making financial decisions or trading in the Indian financial market, as the tax rules could affect long-term financial planning.
Summary
Gratuity is an employer-provided benefit governed by the Payment of Gratuity Act, 1972. If any employee wants to claim gratuity, employees should consider factors such as salary, tenure, gratuity eligibility, and tax rules applicable under Section 10(10) of the Income Tax Act. Tax-exempt gratuity caps vary based on employee categories, with government employees receiving complete tax exemptions and private sector employees eligible for exemptions up to ₹20 lakh.
Key formulas for gratuity calculation include:
- (Last drawn salary × 15 × Years of service) ÷ 26 for employees covered under the Act.
- Last drawn salary × ½ × Completed years of service for employees not covered.
Tax exemptions depend on amounts received, applicable tax caps, and employment status. Employees should retain proper documentation and ensure tax rules are adhered to during gratuity claims. Financial planning must carefully account for taxable gratuity amounts exceeding exemption limits. All decisions should be made after considering legal disclaimers and obtaining professional advice.