Gratuity: Calculation, Formula and Tax

Gratuity is paid to employees by their employer at the time of retirement/resignation if they have worked with them for at least five years. The gratuity is also paid in case of death or disablement due to accident or disease.

The rules of Gratuity is covered by Payment of Gratuity Act 1972. In this post we would tell you how gratuity is calculated and how its taxed?

Is Gratuity payable by all employers?

The Payment of Gratuity Act has divided non-government organizations into two categories:

  1. Organizations covered under the Gratuity Act
  2. Organizations not covered under the Gratuity Act

An organization is said to be covered by Payment of Gratuity Act in case it employees more than 10 employees even for a day in last 12 months. And once the organization comes under the gratuity act, it always remains so even if the count of employees falls below 10.

Also Read: Leave Encashment: Calculation & Taxation

How is Gratuity Calculated?

In case of employees covered by Gratuity Act, the amount of gratuity paid depends on two factors:

  1. Period of continuous employment with the employer
  2. Amount of last drawn salary (basic salary + Dearness Allowance only)

For Organizations covered under the Gratuity Act:

The gratuity is calculated using the following formulas:

Gratuity Amount = [(Last Salary * 15)/26] * Years of Service

In case the last drawn salary (basic salary + Dearness Allowance only) is Rs 1,20,000 and the numbers of years with the employer is 35 years, the gratuity would be

Gratuity = [(1,20,000 * 15)/26] * 35 = Rs 24,23,077

For Organizations NOT covered under the Gratuity Act:

For organizations not covered under the gratuity act can also make gratuity payouts to their employees but its voluntary.

The gratuity is calculated using the following formulas:

Gratuity Amount = [(Last Salary * 15)/30] * Years of Service

In case the last drawn salary (basic salary + Dearness Allowance only) is Rs 1,20,000 and the numbers of years with the employer is 35 years, the gratuity would be

Gratuity = [(1,20,000 * 15)/30] * 35 = Rs 21,00,000

The difference between Organizations NOT covered under the Gratuity Act Vs those are covered is for calculation of half-monthly salary, gratuity covered organization take 26 days as month (4 being Sundays) while those not covered take full 30 days as month.

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Gratuity Calculation: Important Points

For calculation of employment tenure, the year is rounded off. So, in case employee has worked for 10 years and 4 months the gratuity would be paid for 10 years. However, if he has worked for 10 years 8 months the gratuity would be paid for 11 months.

The other thing to note is the above calculation gives the minimum amount that employer needs to pay if covered under the Payment of Gratuity Act. They can willingly pay more, however the extra part may be taxable as explained below.

Tax on Gratuity

The tax rules on gratuity are different for government employees’ vs others.

Tax on Gratuity for Government Employees

For government employees, the entire gratuity paid is tax exempt.

Tax on Gratuity for Non-Government Employees (covered by Gratuity Act)

For all other employees covered by gratuity act, the tax exemption on gratuity is minimum of following 3:

  1. Rs 20 Lakh (effective from March 29, 2018 – before this the limit was 10 lakh)
  2. Eligible Gratuity as calculated using above formula
  3. Actual Gratuity received

If we take above case, the tax would be computed as follows:

Minimum of following would be tax free:

  1. Rs 20 Lakh
  2. Eligible Gratuity as calculated using above formula = Rs 24,23,077
  3. Actual Gratuity received = Rs 24,23,077

Tax Free Gratuity = Rs 20,00,000   ||  Taxable Gratuity = Rs 4,23,077

Tax on Gratuity for Non-Government Employees (NOT covered by Gratuity Act)

For employees not covered by gratuity act, the tax exemption on gratuity is minimum of following 3:

  1. Rs 20 Lakh (effective from March 29, 2018 – before this the limit was 10 lakh)
  2. Eligible Gratuity as calculated using above formula (NOT covered by Gratuity Act)
  3. Actual Gratuity received

If we take above case, the tax would be computed as follows:

Minimum of following would be tax free:

  1. Rs 20 Lakh
  2. Eligible Gratuity as calculated using above formula = Rs 21,00,000
  3. Actual Gratuity received = Rs 21,00,000

Tax Free Gratuity = Rs 20,00,000  ||  Taxable Gratuity = Rs 1,00,000

Also Read: How to Calculate Income Tax for Senior Citizen with Salary, Pension & Interest Income?

Forfeiture of Gratuity

According to Payment of Gratuity Act of 1972, employer can forfeit gratuity for an employee under only one condition – if the employee has been terminated due to disorderly conduct wherein, he/she tries to physically harm individuals during his/her employment.

Gratuity FAQs

Gratuity - Formula and Calculation

Gratuity – Formula and Calculation

Is gratuity payable if service tenure is in between 4 to 5 years?

What if the employee resigns at 4 years and 6 months? Would it be rounded off to 5 years and he would be eligible to receive gratuity?

The employee would not receive gratuity in case he resigns from his job before 5 years. However, a judgement from Madras High Court says that employee would be eligible if he has served the company for more than 4 years 240 days.

Is 5-year service rule applicable for all cases?

In case the employee dies while he was on the rolls of the employer, the legal heirs are eligible to receive gratuity irrespective of the working tenure. Also, in case employee has become disabled due to an accident or a disease, the employer is mandated to pay him/her gratuity irrespective of the tenure of service.

Are contractors eligible for Gratuity?

Contractors are not eligible for gratuity.

Also Read: Should you Choose to be Employee or Independent Consultant from Taxation Perspective?

To Conclude

The post answers some of the common questions related to payment of gratuity, how it is calculated, formula used and how gratuity is taxed? We hope this helps to clear gratuity benefits. In case you have any question or experience related to gratuity, do share it in the comments below.

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