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Gratuity, Its Meaning, Gratuity Calculation and Gratuity Act

Updated on: 23 May, 2024 05:22 PM

As discussed in our previous blog, Gratuity is one of the incomes which are partially tax-free. In general terms, gratuity is a sum of money paid by an employer to its employee at the end of the period of his/her employment as a tip for contributing to the company and is one of the many retirement benefits offered by an employer to an employee upon leaving a job. While the whole amount of gratuity is not exempted for all employees, a part of the income is exempted u/s 10(10) for every employee. We will discuss the provisions of gratuity in detail here as per the Payment of Gratuity Act, 1972 as well as the Income Tax Act, 1961:

Who is entitled to Gratuity?

If you are an employee (except apprentice) working in a factory, mine, oilfield, port, railways, plantation, shop, establishment, or educational institution that has 10 or more employees on any day in the preceding 12 months, then you are entitled to gratuity. However, gratuity is entitled to even if the number of employees goes below 10 after the Act becomes applicable to your employer once.

Payment Timeline and Forfeiture of Gratuity

Payment Timeline of Gratuity

The gratuity payment process follows these three key steps:

  1. Initiation: The employee initiates the process by submitting a written application to the employer requesting gratuity payment.
  2. Calculation and Acknowledgement: Upon receiving the application, the employer calculates the gratuity amount and sends a formal acknowledgment to the employee and the controlling authority. This acknowledgment details the specific gratuity amount payable.
  3. Disbursal: The employer has a legal obligation to disburse the gratuity amount within 30 days of sending the acknowledgment.

Forfeiture of Gratuity

bAn employer can withhold gratuity payment, partially or entirely, even after an employee completes five years of service. However, this applies only in cases of termination due to employee misconduct.

How does Gratuity Payment Work?

An employer may at his own discretion offer a gratuity amount to its employees out of his own funds or may approach a life insurer in order to purchase a group gratuity plan. In such a case, he has to pay annual contributions as decided by the insurer. Generally, the gratuity amount is totally paid by the employer; however, in case the employee wishes to make contributions to his gratuity fund, he is free to do so. The gratuity will be then paid by the insurer based on the terms and conditions of the group gratuity scheme.

When is Gratuity payable?

After completing five years of continuous service with the same company, you will be eligible to receive the gratuity benefit. It is payable:

  • On Superannuation (or) Retirement.
  • On your Resignation (or) Termination (the gratuity can be rejected in case the termination is on account of misconduct of employee)
  • On death or Disablement due to accident or disease. (the sum of gratuity will be paid to the nominee or legal heir, in this case, continuous service of five years is not applicable in this case)

Tax and Gratuity

How is the amount of exemption on Gratuity Calculated?

There are three categories of employees for the calculation of exemption of Gratuity:

Any gratuity received by an employee of the Central Government, State Government, or local authority

Gratuity is wholly exempt from tax.

Any gratuity received by a non-government employee covered by the Payment of Gratuity Act, 1972 is exempt to the extent of lower of the following:

15/26 x last salary is drawn x number of years in employment (i.e. 15 days salary x years of service).

Maximum amount specified, i.e., Rs. 20,00,000/- [earlier it was Rs. 10 lakh]
Gratuity actually received.

For the purpose of the last drawn salary, only the basic salary and dearness allowance are taken into consideration. For the calculation of years of service, the number of years is rounded off to the nearest full year i.e., 6 months rounding off. For instance, if you have worked for 11 years and 7 months in an organisation, your service period will be taken to be 12 years. But if your service tenure is 11 years and 5 months, then for the purpose of this calculation your tenure will be taken as 11 years only. Further, in the case of seasonal employment, gratuity shall be calculated by replacing 15 days in (a) above by 7 days.

Suppose, Mr Baid worked for a company covered under the Gratuity Act for a period of 14 years and 11 months. He received an income of Rs. 5,000 per month initially and reached Rs. 20,000 per month by retirement. Further, he received an amount of Rs. 5,00,000/- as gratuity from his employer. The amount of exemption available to him shall be lower of the following:

  • 15/26 x last salary drawn x number of years in employment = 15/26 x 20000 x 15 i.e Rs. 1,73,077/-
  • 20,00,000 (maximum amount specified)
  • Actual gratuity received i.e. Rs. 5,00,000/-

Thus, Mr Baid is entitled to an exemption of Rs. 1,73,077/- as gratuity under income tax and the balance shall be taxable.

Any gratuity received by a non-government employee not covered by the Payment of Gratuity Act, 1972 is exempt to the extent of lower of the following:

  • Half month's average salary for each completed year of service, i.e., [Average monthly salary] Completed years of service.
  • 10,00,000/-
  • Gratuity actually received.

For the purpose of calculation of average salary, the basic salary, dearness allowance and commission is taken into consideration for the last 10 months preceding the month of retirement. Further, unlike above, your service period will not be rounded off to the nearest full year in this case but instead will be rounded off to completed years only. For instance, if you have a total service period of 21 years and 11 months, only 21 years will be considered for the calculation of completed years of service.

Let's say, Mr Baid's employer is not covered under the Gratuity Act, and his average monthly salary for 10 months immediately preceding the month of retirement is Rs. 30,000. In this case, the amount of exemption available to him shall be lower of the following:

  • Average monthly salary Completed years of service = 30000 x x 14 i.e. Rs. 2,10,000/-
  • 10,00,000/-
  • Gratuity actually received i.e. Rs. 5,00,000/-

Thus, Mr Baid is entitled to an exemption of Rs. 2,10,000/- as gratuity under income tax and the balance shall be taxable.

Note: If gratuity is received from more than one employer either in the same year or in different years, the limit of Rs. 10,00,000/- cannot be exceeded for the total amount received from both employers.

Gratuity received: Taxable under which head of income?

Gratuity received by you on your retirement (or) during your service period is taxable under the head Income from Salary. If the gratuity amount becomes due and paid to the legal heir/nominee before the death of the employee, then it is taxable under the head "Income from Other Sources."

Now you know what is gratuity and how you can calculate it, however, if you still need help calculating gratuity and tax implications on gratuity, our tax experts can help you do it. Since the e filing of income tax return has already been started for the financial year 2023-24, don’t wait for the last date to file ITR. Book eCA Today!

CA Abhishek Soni
CA Abhishek Soni

Abhishek Soni is a Chartered Accountant by profession & entrepreneur by passion. He is the co-founder & CEO of Tax2win is amongst the top 25 emerging startups of Asia and authorized ERI by the Income Tax Department. In the past, he worked in EY and comes with wide industry experience from telecom, retail to manufacturing to entertainment where he has handled various national and international assignments.