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What is Income Tax Exemption on Gratuity?

Updated on: 06 Feb, 2023 04:54 PM

Gratuity is a payment of a lump sum amount made by an employer to his employees in recognition of their services towards the organization. Earlier it was not mandatory to pay gratuity to employees. It was paid voluntarily as a token of appreciation. However, with the introduction of the Payment of Gratuity Act, 1972, certain companies are mandatorily required to discharge their obligation of payment of gratuity amount if the employee renders five years of continuous service. Gratuity is not required to be paid as a part of monthly salary but shall be paid on the occurrence of either of the following events:

  • On superannuation (an employee is said to be on superannuation when he attains the age of retirement)
  • On retirement or his resignation
  • On his death or disablement due to disease or accident (5 years of continuous service is not mandatory where service termination was due to the employee’s death or disability).

Will the amount of gratuity received by an employee be treated as salary? Will it be offered to tax in the same manner as salary? Read on to find the answers to all your questions on gratuity.

Taxability of gratuity

If any employee receives gratuity during his service, then it is fully taxable as income in his hands under the Income Tax Act, 1961 (‘the Act’). However, if gratuity is received in case of death, retirement or resignation and certain other cases, then tax exemption is provided under section 10(10) of the Act.
Any amount received as a gratuity by an employee shall be treated as income of such person under the head 'Salaries’. However, in case of the death of such an employee, the gratuity shall be paid to his nominee or his legal heir as the case may be. Such an amount shall be treated as their income under the head 'income from other sources'.
Note: Every employee is compulsorily required to prescribe the name/s of their nominee after completing a year of service as per the Payment of Gratuity Act, 1972.


Income tax exemption on gratuity

The tax exemption on gratuity income provided under section 10(10) of the Act is available up to the following limits:

  • Retirement gratuity received by members of the Defence Service under the Pension Code Regulations, is entirely exempt from tax.
  • Employees of Central and State Government/local authority or Members of Civil Services: Any death cum retirement gratuity is entirely exempt from tax under section 10(10)(i).
  • Other employees:
    1. Private sector employees covered by the Payment of Gratuity Act, 1972:
      The Payment of Gratuity Act, 1972 prescribes gratuity for employees of certain organizations. The employees of the following organizations are entitled to gratuity:
      - Factory, plantation, mine, oilfield, port and railway company
      - Shops, establishments or educational institutions having ten or more employees on any day during the preceding twelve months
      Any death and retirement gratuity is exempt from tax to the extent of least of the following:
      (a) Rs. 20 lakhs (hiked from Rs. 10 Lakh as per the amendment)
      (b) Actual gratuity amount received
      (c) Total salary amount should be a sum of 15 days of services for every completed year or part thereof i.e. 15/26.
      Note: Once the Act becomes applicable to an organization, gratuity shall continue to be applicable for it even if the employees' count falls below ten.
      **Salary for this section means basic salary and dearness allowance (if it is given in the terms of employment for retirement benefits that form part of salary)
    2. Private sector employees not covered by the Payment of Gratuity Act, 1972:
      The Payment of Gratuity Act, 1972 mandates certain organisations to make gratuity payments. However, other organisations are free to make a voluntary payment of gratuity to their employees. There are no restrictions on making such payments of gratuity.
      Tax exemption limit for such employees is the least of the following:
      A. Rs.10 lakhs
      b. Actual gratuity amount received
      c. The formula: 1/2x(last 10 months average salary)/10 x number of years of employment
  • Calculation as per Gratuity Calculator
    The gratuity calculator is used to compute the gratuity amount using the below provided formula:-
    Gratuity Formula: (15 * your most recent wage * your length of service) / 26.
    You can know more about gratuity calculator here.

Illustrations

Mr A retired on 28.7.2020 after completing 25 years 6 months of service and received a gratuity of INR 15,00,000. During retirement, his salary was:

  • - Basic Salary: INR 40,000 p.m.
  • - Dearness Allowance: INR 15,000 p.m. (of which 60% is for retirement benefits)
  • - Commission: 1% of turnover (in the last 12 months turnover was INR 1,20,00,000)
  • - Bonus: INR 30,000 p.a.

Computation of his taxable gratuity assuming:

  1. He is private sector employee and covered by the Payment of Gratuity Act 1972.
    Particulars Amount (in INR)
    Gratuity received at the time of retirement 15,00,000
    Less: Exemption under section 10(10)(ii)
    Least of the following:
    1. i) Statutory limit= INR 20,00,000
    2. ii) Gratuity received= INR 15,00,000
    3. iii) As per formula:
    (salary last drawn x number of years of employment x15/26)
    (40,000+9000) x 26 x15/26= INR 7,35,000
    7,35,000
    Taxable Gratuity 7,65,000
  2. He is private sector employee and not covered by the Payment of Gratuity Act 1972.
    Particulars Amount (in INR)
    Gratuity received at the time of retirement 15,00,000
    Less: Exemption under section 10(10)(iii)
    Least of the following:
    i) Statutory limit= INR 20,00,000
    ii) Gratuity received= INR 15,00,000
    iii) As per formula:
    1/2x(last 10 months salary)/10 x years of employment.
    1/2x ([(40,000x10)+(15,000x60% x10)+(1% x1,20,00,000 x 10/12)])/10x 25= INR 7,37,500
    INR 7,37,500
    Taxable Gratuity 7,65,000
  3. He is a Government employee.
    Particulars Amount (in INR)
    Gratuity received at the time of retirement 15,00,000
    Less: Exemption under section 10(10)(i) [fully exempt] 15,00,000
    Taxable Gratuity Nil

Conclusion

The below chart summarises the taxability and related exemptions for gratuity amount received by an employee.

chart summarises

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.in. 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.

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