Understanding Gratuity: How Do Employers Justify Liability with Salary Increments?

Hi, I have a query regarding gratuity application. We are an organization of 25 and have been in existence since 2005. We are implementing the gratuity benefit for our employees and are trying to calculate the percentage of basic salary that should be considered monthly for gratuity.

During the process, I realized that if an employee completes 5 years and has a yearly increment of at least 15-20% on their salary, how is the employer's liability justified when considering the standard 4.81% of gratuity typically followed by companies? Additionally, the gratuity payment after 5 years will be based on the last drawn basic salary.

Could you please clarify this for me?

Thank you,
Raj

Hi, thanks for the same. But my query is not how to conclude on the gratuity figure. I am quoting an example for your understanding: Assuming I have an employee with a CTC of Rs. 10,000/- in the year 2008 and an increment of Rs. 5,000 is made to the salary every year. Basic salary is calculated as 40% of CTC. So, the employee's salary and Basic salary each year till 2012 are as follows:

2008 - Rs. 10,000 - Rs. 4,000
2009 - Rs. 15,000 - Rs. 6,000
2010 - Rs. 20,000 - Rs. 8,000
2011 - Rs. 25,000 - Rs. 10,000
2012 - Rs. 30,000 - Rs. 12,000

Now, gratuity would be contributed by the company or kept aside on a month-to-month basis as per the basic mentioned above each year. But when we end up paying the employee at the end of 5 years, we take the calculation as LAST DRAWN MONTHLY BASIC SALARY / 26 * 15 days * 5 years considering the 4.8% of basic as the monthly contribution towards gratuity. How is the company going to compensate for the incremental aspect of the employee's gratuity calculation?

Regards,
Raj

Understanding Gratuity Provision in Accounting

There is an accounting procedure for gratuity provision in the books of accounts. If you consult your Finance Head or an insurance expert, they will explain. Basically, the following facts are taken into consideration:

• Attrition percentage
• Percentage increase in salary over the years
• Projected interest

There are a few more figures they consider, and I am not a finance expert to explain all. But 4.8 percent is more than sufficient to cover gratuity provision. Assuming that the increase is 12% every year, and assuming that gratuity provision on the existing basis every year should fetch 12% interest, then you are very close to the gratuity amount on the last drawn basic. There still may be some gap which will be set off by attrition.

Regards,
T. Sivasankaran.

Dear Mr. Raj,

Calculation of Gratuity Liability as a Percentage

The figure of 4.81% is arrived at as follows:

Let Rs. 100 be the wages of the employee (Basic + DA). Therefore, one day's wage is Rs. 100/26 = 3.84. Therefore, 15 days' wages are 3.84 x 15 = 57.69. This is for one year of continuous service or for 12 months. Therefore, the monthly liability is arrived at by dividing 57.69 by 12, and the answer is equal to 4.807 or 4.81.

As the gratuity liability per month for a wage of Rs. 100 is 4.81, when expressed as a percentage, the liability is stated as 4.81%.

Purpose and Management of Gratuity Fund

This is a figure for the purpose of accounting and is shown as a monthly liability of the employer towards gratuity in respect of all the employees. It might be kept aside as the "Gratuity Fund" in the books of account or might be kept aside as a separate fund or might be given to a gratuity trust formed by the employer with the approval of the Government. If any employee leaves the company before completing five years of continuous service, then the employer need not pay gratuity. Such amounts would keep on adding to the "Gratuity Fund." In the case of those who leave the company after five years, the liability of the employer would be met from the fund. If the funds are not sufficient, then the employer has to make good the difference. The 4.81 percent is used more to assess the liability of the employer under the head "gratuity" than for anything else.

With regards,

Thank you for your explanation. It's quite detailed. On the same note, I have just one more query. Assuming that 4.8% of the basic salary is the gratuity contribution accounted for on a monthly basis, would it be possible for the employer to increase the percentage to, for example, 5% or higher for added security?

Regards,
Raj

I think this is more of a tax-related issue. I do not believe that providing funds exceeding what is accepted in accounting norms will be treated as expenses.

T. Sivasankaran

Gratuity Liability Assessment

Assessing the monthly gratuity liability at 4.81% is for the purpose of providing a gratuity fund or a reserve for meeting the obligations for the payment of gratuity. This amount will be shown as having been credited to the gratuity fund of the company/establishment and in the books of accounts probably would be shown as "provision for gratuity." This provision for gratuity remains with the company, and this provision when made every month/quarterly/half-yearly/annually does not flow out of the company's funds. Therefore, if you make a provision for gratuity liability at more than 4.81%, there is no legal bar for that action.

On the other hand, when the company makes a payment of gratuity to its employees, there is an outflow of cash, and this becomes an expenditure to be shown in the income-expenditure statement and will be reflected in the profit or loss made by the company. If the employee is covered by the provisions of the Payment of Gratuity Act, the maximum amount of gratuity payable is Rupees ten lakhs, and this amount could be claimed by the company as a valid and legal expenditure and deducted from the income, and on this Rupees ten lakhs, the company need not pay tax. On the other hand, if the company pays more than Rupees ten lakhs to an employee covered by the provisions of the Payment of Gratuity Act, then for the amount paid in excess of Rupees ten lakhs, the company may have to pay tax.

There are instances where companies make payment of gratuity to their employees covered by the PG Act at a rate higher than that prescribed under the Payment of Gratuity Act. Also, there are other instances of employees who are not covered by the provisions of the Payment of Gratuity Act being paid gratuity at the same rates as prescribed under the PG Act or at a higher rate. In such cases, what are the liabilities of the companies under the tax laws, an expert in taxation will be able to give a correct picture.

Regards

Thanks for the clarification, Mr. Harikrishnan and Mr. Sivasankaran! Is the term "if you make a provision for gratuity liability at more than 4.81% there is no legal bar for that action" used again with context to the tax benefits or Gratuity Act? Just trying to understand if it is illegal?

Dear Mr. Raj,

Understanding Gratuity Provisions and Legal Requirements

No law requires an employer to make a provision for gratuity in their finances/accounts. The only obligation is to pay gratuity at the appropriate time when the payment falls due. Companies make a provision for gratuity just to have a reserve fund to meet the contingencies arising when gratuity becomes payable. Some companies opt for a group gratuity scheme offered by insurance companies. Again, there is no law that requires an employee to join a group gratuity scheme. However, in the case of insurance, the situation is different. Please read Section 4A of the Payment of Gratuity Act. This section requires an employer to take out insurance, insuring their liability to pay gratuity under the Payment of Gratuity Act. In other words, the employer's liability to pay gratuity is insured by the insurance company.

Section 4A Implementation Status

Again, please read the opening line of Section 4A(1), which reads as "With effect from such date as may be notified by the appropriate Government...etc." This means that Section 4A comes into effect only from the date notified by the Government. As far as my knowledge goes, the Central Government has not made any notification under Section 4A. Neither has the Government of Tamil Nadu made any notification under Section 4A. I am not aware of the situation in other states. Therefore, in effect, Section 4A has not come into operation. Therefore, the conclusions are:

1. No law prescribes the creation and maintenance of a gratuity fund by the employer.
2. The provision for gratuity is at the sole discretion of the employer. The rate at which the provision has to be made is also at the discretion of the employer.
3. Section 4A of the Payment of Gratuity Act, which requires an employer to insure their liability to pay gratuity under the Payment of Gratuity Act, has not yet been notified and therefore is not in force now, though it forms part of the Payment of Gratuity Act.

With regards,

Gratuity Payment Without Provision

If a company has not made provision for the payment of gratuity, is the payment of gratuity still allowed? Please provide relevant case laws (latest).