What is Gratuity?
Gratuity is a benefit received by an employee for services rendered to an organization. For companies covered under the Gratuity Act, this benefit is paid when an employee completes five or more years of service with the employer. An employee receives gratuity when they resign, retire, or are laid off. In the case of death or disablement, there is no minimum eligibility period.
How Gratuity is Calculated
The gratuity amount depends on the tenure of service and the last drawn salary. It is calculated according to this formula: Last drawn salary (basic salary plus dearness allowance) X number of completed years of service X 15/26. According to this formula, a time period of over six months or more is considered as one year. This means if you have completed five years and seven months of service, the number of years would be considered as six years for the calculation of gratuity benefits. On the other hand, if the service period is five years and five months, for gratuity calculation, it will be considered five years. An employer can, however, give a higher gratuity than the amount under the prescribed formula.
Maximum Amount
For government employees, Rs. 20 lakh is the maximum amount that can be paid as gratuity. The Seventh Pay Commission had recommended an increase in the gratuity ceiling to Rs. 20 lakh from the earlier level of Rs. 10 lakh.
Income Tax Treatment of Gratuity
For government employees, the entire amount of gratuity received on retirement or death is currently exempted from income tax. In the case of non-government employees, income tax rules on gratuity are applicable depending on whether employees are covered under the Payment of Gratuity Act, 1972, or not. For non-government employees covered under the Gratuity Act, the income tax exemption on any gratuity received is the least of the following:
- The maximum amount specified by the government, which is currently Rs. 10 lakh
- Last drawn salary X 15/26 X years of service
- Actual gratuity received
For example, the last drawn salary (basic plus DA) of Mr. Ashish is Rs. 60,000 (per month), and he has worked for 25 years. The gratuity according to the formula is Rs. 8.65 lakh, but suppose he has actually received a gratuity of Rs. 12 lakh. So for income tax calculation, Rs. 8.65 lakh will be considered for exemption. Mr. Ashish will pay tax on Rs. 3.35 lakh (Rs. 12 lakh - 8.65 lakh).