Income Tax Exemption on Gratuity

Gratuity is a payment offered by the employer to an employee as a recognition of dedicated service to the company. The Payment of Gratuity Act of 1972 governs gratuity payments in India. The employee is eligible to receive gratuity after completing 5 years of service with a company.

Gratuity is a financial component that is part of the benefits package and can also serve as a retirement benefit. It is considered a part of an employee’s salary and is taxable under the Income Tax Act of 1961. However, there are certain conditions under which income tax exemption on gratuity is granted. Gratuity is now tax-exempt up to Rs. 20 lakh from the previous ceiling of Rs. 10 lakh.

Key objectives

• Definition & Eligibility: Gratuity rewards employees for long service, typically after five years.
• Tax Treatment: Partially tax-free under Section 10(10); ceiling increased to Rs. 20 lakh.
• Eligibility Conditions: Applicable after five years, or earlier in death/disability; firms must have 10+ employees.
• Exemption Calculation: Least of salary × years × 15/26, Rs. 20 lakh, or actual gratuity.
• Amendment Impact: Higher exemption benefits salaried employees; government employees fully exempt upon retirement.

When an employee is granted gratuity for their long service, the amount is completely taxable as income under the Income Tax Act. Meanwhile, if gratuity is granted to an employee upon retirement, resignation, death, or other certain cases, tax exemption is provided under section 10(10) of the ITA.

The amount received as a gratuity by an employee is treated as income under the head 'Income from Salary.’ However, in case of the death of an employee, the gratuity is paid to their nominee or legal heir. In this case, the amount is treated as their income under the head 'Income from Other Sources’.

An employee is granted gratuity when the following conditions are met:

1. Employee-employer relationship

To be eligible for gratuity, the employee must work under a contract of employment with the employer. This includes both fixed-term and permanent employees.

2. Completion of service

The employee must have completed at least five years of continuous service with the employer. This duration of service is calculated from the date of joining to the date of retirement, resignation, or termination of employment.

3. Retirement or superannuation

Gratuity is often paid at the time of an employee's resignation, retirement, or voluntary separation upon the completion of five years of service. In the case of an employee's disablement or death due to an illness or accident, gratuity can be granted even before completing five years of service.

4. Termination due to disability or death

If the employment is terminated due to disability or death before completing five years of service, the gratuity amount is payable regardless of the minimum service requirement.

5. Minimum employee count

The Payment of Gratuity Act of 1972 applies to establishments with ten or more employees on any day of the preceding 12 months.

Every employee – working in a mine, factory, oil field, port, plantation, railways, shops, and establishments or educational institution with an employee strength of 10 or more on any day in the preceding 12 months – is entitled to gratuity.

Calculation of Gratuity exempted from tax

The least of the following is exempt from tax:

1. Last salary (Basic + DA) * Number of years of employment * 15/26
2. Rs. 20 lakh (increased from Rs. 10 lakh as per the amendment)
3. Gratuity actually received

Examples of calculation of gratuity exempted from tax

Key points:

• Gratuity is calculated based on 15 days of salary for each completed year of service or part thereof, using the formula 15/26.
• The number of years in service is rounded off to the nearest full year.

Employers are not legally prohibited from providing gratuity to their employees, even if their organisation does not fall under the Payment of Gratuity Act. The gratuity amount is typically calculated based on half a month’s salary for each completed year of service.

Tax Exemption calculation for gratuity

The following amounts are exempt from tax, whichever is the least:

• Half of the average salary (basic + DA) for the last 10 months multiplied by the number of years worked.
• Rs. 20 lakh, an increase from the previous limit of Rs. 10 lakh.
• The actual gratuity received.

For example, let’s consider Raju, who has worked for 25 years and 2 months, earning an average salary of Rs. 90,000 for the last 10 months. He received a gratuity of Rs. 11 lakhs.

Points to Note:

• The average salary for the last 10 months is used in the calculation.
• The total number of years worked is rounded off to the nearest full year for the purpose of calculating gratuity.

Impact of the amendment

The recent amendment's effects are clearly illustrated through the example provided. By raising the ceiling to the maximum tax exemption limit, the amendment reduces the amount of gratuity that is taxable. This change particularly favors those with higher salaries in the immediate term. Moreover, for those with many years until retirement, this amendment will prove beneficial to a broader range of employees over time.

Income tax exemption granted to employees working in the private sector depends on whether they are covered under the Payment of Gratuity Act or not.

1. Exemptions received by government employees

According to the Act, the gratuity received by government employees upon their retirement, termination, or superannuation is exempt from tax. This applies to State and Central Government employees, employees from the defence sector, and employees working in any local authority.

2. Exemptions received by private sector employees

Exemptions for private sector employees are decided on whether they come under the Payment of Gratuity Act of 1972. Differential tax treatment is provided based on this criterion.

A. When private sector employees are covered under the Act

The income tax exemption on gratuity received is the least of the following three:

• Latest salary (basic + dearness allowance) * number of years of employment * 15/26;
  • Rs. 20 lakh (which has been hiked from Rs. 10 lakh as per the amendment);
  • Gratuity actually received

B. When private sector employees are not covered under the Act

The income tax exemption on gratuity received is the least of the following:

• Last 10 month’s average salary (basic + dearness allowance) * number of years of employment * 1/2;
  • Rs. 20 lakh (which has been hiked from Rs. 10 lakh as per the amendment);
  • Gratuity actually received

Also read: What is tax evasion

Gratuity, as the name implies, is a form of ‘financial gratitude’ offered by employers to their employees after they complete at least five years of service. It is part of their benefits package and can be used as a retirement benefit. Furthermore, gratuity is partially tax-free under Section 10 (10). Under exceptional circumstances, such as termination of employment due to employee misconduct, an employer can withhold gratuity payment, either partially or entirely.