Income Tax Exemption on Gratuity: Rules, Limits and Calculation

In Summary

Gratuity received at retirement, resignation or another qualifying employment termination may be fully or partially exempt from income tax in India. The applicable exemption depends on the employee’s category and the rules governing the payment. For many non-government employees, the maximum exemption is Rs. 20 lakh, subject to the applicable calculation and conditions. Qualifying government employees may receive full exemption under the relevant service rules.

Key points to remember:

• Tax treatment: Gratuity is generally treated as salary income, but eligible payments may qualify for an exemption or deduction under the applicable tax framework.
• Employees covered by gratuity legislation: The exemption is generally the least of the actual gratuity received, the prescribed ceiling and the amount calculated using the statutory salary-and-service formula.
• Employees not covered by gratuity legislation: A separate calculation based on half a month’s average salary for each completed year of service applies, subject to the relevant ceiling.
• Tax law changes: The Income-tax Act, 2025 came into force on 1 April 2026. Payments relating to earlier tax periods may fall under the Income-tax Act, 1961.
• Eligibility and tax exemption are different: Being eligible to receive gratuity does not automatically make the entire amount tax-free.

Gratuity can be fully exempt, partially exempt or taxable, depending on the circumstances of the payment and the applicable law.

The tax treatment generally falls into these categories:

• Qualifying government employees: Gratuity received under applicable government pension or service rules is generally fully exempt, subject to the relevant provisions.
• Employees covered by gratuity legislation: The eligible amount is exempt up to the applicable limit and calculation.
• Employees not covered by gratuity legislation: A separate exemption formula applies, subject to the prescribed limit.
• Gratuity received during employment: A payment described as gratuity but received while employment continues may be taxable, depending on the circumstances and applicable provisions.

The exemption limit is not necessarily the same as the amount an employee is legally entitled to receive. Any amount that does not qualify for exemption may be included in taxable income.

The calculation depends on whether the employee is covered by the applicable gratuity legislation.

1. Employees covered by gratuity legislation

For employees covered by the statutory gratuity framework, the exemption is generally the least of:

• The actual gratuity received.
• The prescribed maximum exemption limit, generally Rs. 20 lakh for the relevant non-government employee category.
• The amount calculated using the prescribed salary and years-of-service formula.

For the conventional statutory calculation, the formula is:

Gratuity calculation = Last drawn eligible salary × 15/26 × eligible years of service

Here, eligible salary generally includes basic salary and dearness allowance (DA), where applicable. The statutory method for counting years of service must also be followed; under the traditional Payment of Gratuity Act calculation, a part of a year exceeding six months is counted as a full year.

The actual entitlement and calculation should be checked against the applicable labour law, particularly where the employment period crosses a change in legislation.

Example of gratuity tax exemption for an employee covered by gratuity legislation

Suppose an employee has a last drawn eligible monthly salary of Rs. 1,00,000 and 20 eligible years of service. The employee receives gratuity of Rs. 18 lakh.

The example illustrates the conventional formula and assumes that the employee falls within the category to which the stated ceiling and calculation apply. The final tax treatment depends on the applicable law and individual circumstances.

2. Employees not covered by gratuity legislation

For employees who are not covered by the statutory gratuity framework, the exemption is generally the least of:

• The actual gratuity received.
• The prescribed maximum exemption limit.
• Half a month’s average eligible salary for each completed year of service.

The conventional formula is:

Exemption calculation = ½ × Average monthly eligible salary for the last 10 months × Completed years of service

Average eligible salary generally includes basic salary and DA to the extent it forms part of retirement benefits, along with any other components specified by the applicable rules.

Example of gratuity tax exemption for an employee not covered by gratuity legislation

Suppose an employee receives gratuity of Rs. 11 lakh after 25 completed years of service. The employee’s average eligible monthly salary for the last 10 months is Rs. 90,000.

This example assumes the employee qualifies for the stated calculation and ceiling. The actual exemption should be determined using the applicable rules.

The tax regime selected by an individual does not, by itself, determine whether a qualifying gratuity payment is exempt. The applicable gratuity provisions, employee category, payment circumstances and prescribed limits are the relevant factors.

The claim that gratuity is exempt only up to Rs. 5 lakh under the new tax regime is not a correct general statement of the gratuity exemption rules.

For a payment received during Tax Year 2026–27, refer to the Income-tax Act, 2025 and the applicable rules. For earlier periods, the relevant provisions of the Income-tax Act, 1961 may apply.

If a portion of the gratuity is taxable, the amount will be considered in determining the employee’s tax liability under the applicable rules.

If the gratuity received exceeds the amount eligible for exemption, the excess may be taxable.

For example, if an employee receives Rs. 25 lakh but qualifies for an exemption of Rs. 20 lakh, the remaining Rs. 5 lakh may be taxable, assuming the applicable rules and formula permit an exemption of Rs. 20 lakh and no other adjustment applies.

However, the prescribed ceiling is only one part of the calculation. If the salary-and-service formula produces a lower exemption, the exempt amount may be lower than Rs. 20 lakh. Conversely, the rules for qualifying government employees may provide a different treatment.

Employees should therefore calculate the eligible exemption rather than subtracting the ceiling from the gratuity amount automatically.

The reporting process depends on the tax year and the applicable income-tax legislation.

In general, an employee should:

1. Obtain the gratuity payment statement from the employer.
2. Identify the portion that qualifies for exemption under the applicable rules.
3. Determine whether any portion is taxable.
4. Report the payment and exemption in the relevant fields of the income tax return.
5. Retain supporting documents, including the employer’s calculation and relevant service details.

For Tax Year 2026–27, use the return and forms prescribed under the Income-tax Act, 2025. For earlier tax periods, follow the applicable return requirements under the previous framework.

Where a taxable gratuity payment relates to past service and increases the tax burden in the year of receipt, relief may be available under the applicable provisions. Under the Income-tax Act, 2025, Section 157 provides for relief in specified cases, with Form 39 used for the relevant claim. Eligibility and filing requirements should be confirmed before claiming relief.

Gratuity can provide an important financial benefit when employment ends, but the amount exempt from income tax depends on the employee’s category, eligible service, gratuity received and applicable tax rules. While many non-government employees are subject to a maximum exemption limit of Rs. 20 lakh, the actual exempt amount may be lower depending on the prescribed calculation. With the Income-tax Act, 2025 applying from 1 April 2026, it is important to check the rules relevant to the tax year in which the gratuity is received. Reviewing the employer’s calculation and seeking professional advice where necessary can help clarify the taxable amount.