What is gratuity? What is the taxation on it?

When you join a company, it is imperative to understand the eligibility criteria for gratuity. It is necessary to know what your monetary benefits are, how to calculate them, and what the tax implications on your gratuity payment are.

Gratuity is a monetary benefit a company pays to an employee towards the end of the tenure after five years or more in service as a token of gratitude. The Payment of Gratuity Act, 1972 governs the provisions of gratuity. According to the Act, all employees who work in factories, oil fields, plantations, mines, ports, shops and establishments, and educational institutions with ten or more employees on any day of the preceding 12 months may receive gratuity.

The law is applicable to employees who have completed at least five years of service in an organisation with ten or more persons. Gratuity is one of the several components that form the gross salary of an employee.

An establishment may either pay the gratuity amount to its employee from its own account or provide its employee with gratuity life insurance by making annual payments to a life insurance company. Later, the life insurance company pays the gratuity amount to the employee.

Life insurance term plans act as valuable tax-saving options for employees in the long run. ULIPS and other term plans help employees in planning their retirement age.

The entire gratuity amount is paid solely by the company without any contribution by the employee.

Eligibility criteria for gratuity payment

According to the Payment of Gratuity Act, 1972, gratuity is payable to an employee

· upon their employment termination after continuous service of at least five years or

· on their superannuation (an employee eligible for a retirement fund) or

· on their retirement or resignation or

· on their sudden demise or disablement due to accident or disease.

In case of termination of employment due to misconduct, the employer reserves the right to forfeit the gratuity payment of the employee despite the completion of 5 years of service.

Also, the gratuity payment of the deceased employee is given either to the beneficiary mentioned in the gratuity life insurance plan or to family members in the absence of such a plan. 

How to calculate the gratuity amount?

There are many online income tax calculators available that assist in calculating the gratuity amount. However, a standard mathematical equation that companies use to calculate the gratuity amount is as follows.

Gratuity Amount = 15 x Y x S +DA /26

Y – stands for years of employment

S – stands for last basic salary drawn every month

For instance, Gautam is a clerk of a bank and has worked with the company for 10 years and has drawn Rs. 30,000 as basic salary + dearness allowance (DA). Then as per the mathematical calculation mentioned, his gratuity amounts to:

Gratuity Amount= 15 x 10 x 30000/26 = 1,73,077

Any gratuity payment that exceeds the existing ceiling limit of 20 lakhs is taxable (increased from the earlier 10 lakhs ceiling, as per the latest amendment).

For employees not covered under the Payment of Gratuity Act, 1972, companies usually calculate their half month’s salary for each year of service.

This means the mathematical calculation for these employees will be:

Gratuity Amount = 15 x Y x S +DA /30

Taxation rules on gratuity payment

There are different types of ITR (Income Tax Returns) applicable on gratuity payments. The taxes levied on gratuity payment depend upon the type of employee receiving the amount.

Whether working for local municipal authority, state, or central government, any government employee gets tax exemption on his entire gratuity payment.

For employees of private companies who may or may not be covered under the Payment of Gratuity Act, 1972, tax exemption is applicable in the following cases:

· The statutory limit of Rs. 20 lakhs

· Last drawn salary x 15/26 x No. of completed years in service

· Actual gratuity received

If the gratuity amount exceeds the limit mentioned above, it is taxable.

While filing for ITR, enter the gratuity amount on the ITR-1 form as income after deducting the exempted amount. Similarly, the same exempted amount must be entered in the ‘Exempt Income’ section for verification.

In case of a deceased employee, the gratuity amount is either paid to the beneficiary or the employee’s dependent. The person filing ITR should put the amount under the heading: Income From Other Sources.

A hike in the gratuity maximum limit seems more beneficial for those who earn a higher income and for those who have a long time to retire.

Advance tax applies to those employees who work for organisations in India that do not follow the Indian taxation structure. For instance, foreign bodies such as foreign consulates or other national companies do not deduct Indian taxes from employees’ incomes. In this case, employees need to discharge their taxes as advance taxin specific installments. (for example, 15% of total tax by 15 June, 45% of total tax by 15 September, 75% of total tax by 15 December, and 100% of total tax by 15 March).

Advance tax is calculated based on individual income received. Any delay in payments leads to interest implications.