Everything You Should Know About Gratuity and its Tax Implications

Gratuity is a voluntary payment made by an employer in appreciation of the services rendered by an employee. For organisations covered under the Payment of Gratuity Act, 1972 (“Gratuity Act”), it is mandatory to pay gratuity to employees subject to the fulfilment of conditions. For other organisations, payment of gratuity is a matter of organisational policy. 

Gratuity is generally paid as part of salary at the end of the employment term of an employee, provided the term is a minimum period of 5 years. The gratuity amount is exempt from tax to the extent of the limit prescribed in Section 10(10) of the Income-tax Act, 1961. An employer generally pays gratuity from its own funds or by purchasing a group gratuity plan from an insurance provider.

In this article, we will discuss the eligibility conditions for receiving a gratuity, the concept of gratuity in income tax, and the extent to which a tax exemption is available.

Understanding Gratuity 

Prior to 1972, there was no law mandating employers to pay gratuity to their employees. However, with the introduction of the Gratuity Act, it became mandatory for a factory, plantation, mine, oilfield, port, or railway company, and for an owner of a shop, educational institution, or corporation having more than 10 employees, to pay gratuity to its employees.

What is gratuity?

The word gratuity is derived from the Latin word gratus which means pleasing or thankful. As the origin of the word suggests, gratuity is a lump sum amount given by an employer to its employees, paid not as part of the regular monthly salary but in recognition of their services to the employer.

The Gratuity Act mandates certain organisations to pay gratuity to their employees subject to the fulfilment of certain conditions.

When is gratuity given?

The Gratuity Act mandates the following organisations to make gratuity payments:

  • Every factory, mine, oilfield, plantation, port, and railway company; and
  • Every shop or establishment in which 10 or more persons are employed, or were employed on any day of the previous 12 months.

A shop or establishment to which the Gratuity Act has become applicable once is required to continue to make gratuity payments even if the number of persons employed falls below 10 subsequently. Employers not mandated under the Gratuity Act can voluntarily offer gratuity to their employees. 

Gratuity is usually paid at the time of retirement or at the time of changing jobs, provided the employee has rendered continuous service for at least 5 years.

Eligibility criteria for receiving gratuity 

For employees covered under the Gratuity Act, gratuity is payable on superannuation, retirement, or resignation if the employee has rendered continuous service for at least 5 years. Gratuity is also payable on death or disablement of the employee due to accident or disease, even if the employee has not rendered 5 years of continuous service.  The Gratuity Act entitles an employee to receive 15 days of salary as gratuity in for every completed year of service.

For other employees, payment of gratuity is not dependent on the fulfilment of statutory conditions but rather on the organisational policy.

It should be noted that interns or temporary workers are not eligible for gratuity. Also, in the determination of 5 years, a continuous and active period of 240 days is considered to be one full year. For example, if a person has worked for 4 years and 240 days, he/she will be eligible for gratuity benefits. In the case of establishments which work less than 6 days a week, continuous and active service of 4 years and 190 days will be considered as 5 years, thus making the person eligible for gratuity benefits. 

Is Gratuity Taxed? 

If gratuity is received during employment, it is fully taxable irrespective of whether the recipient is a government employee or a non-government employee. However, the tax treatment of gratuity received on account of retirement, resignation, death, illness, or superannuation is different for various classes of employees. Here, three classifications can be made – (i) Government employees and defence personnel, (ii) Employees covered under the Gratuity Act; and (iii) Other employees – those who are not covered under the Gratuity Act.

Government Employees and Defence Personnel

Retirement gratuity received by members of the defence service is fully exempt from tax. Similarly, retirement and/or death gratuity received by employees of Central or State Government, local authorities or Members of Civil Services is also fully exempt from tax. 

Employees covered under the Gratuity Act

Gratuity received by employees covered under the Gratuity Act is exempt from tax to the extent of least of the following:

  1. 15 days salary (Basic + DA) each completed year of service or part of the year in excess of 6 months;
  2. Rs. 20,00,000 (hiked from Rs.10,00,000); or
  3. Amount of gratuity actually received.

Employees not covered under the Gratuity Act

Gratuity received by employees not covered under the Gratuity Act is exempt from tax to the extent of least of the following:

  1. Half month’s salary (Basic + DA) for each completed year of service, on the basis of the average salary for the last 10 months;
  2. Rs. 20,00,000 (hiked from Rs.10,00,000); or 
  3. Amount of gratuity actually received. 

FAQs

Is gratuity fully exempted from tax?

Any gratuity received by government employees, as well as retirement gratuity received by members of the Defence Service, is fully exempt from tax.

For other employees, a gratuity would be fully exempt if the amount of gratuity received is the lowest out of the three amounts mentioned above.

What is the maximum exemption limit of gratuity?

The maximum exemption limit differs for employees that are covered under the Gratuity Act and for other employees that are not covered under the Gratuity Act. The maximum exemption limit is the least of the three amounts mentioned above.

How can I show my gratuity in income tax?

Gratuity is taxed under the head “Salaries” as per the Income-tax Act, 1961. In case the ITR-1 form is applicable, the taxable amount of gratuity should be disclosed in Schedule Salary and the amount of gratuity exempt from tax should be disclosed in Schedule Exempt Income.

What is the impact of the new labour codes on gratuity?

Under the four new labour codes, the Code on Social Security requires organisations to pay a minimum of 50% of the salary as basic pay. As gratuity is calculated as a percentage of basic pay, higher basic pay may lead to a higher gratuity payment.

Animesh Gupta is a Chartered Accountant by profession and a NISM certified Mutual Fund Expert. He has over 4+ years of experience working in the Financial Services Industry. In his role at Wintwealth, he is part of the Credit and Risk team and evaluates the risk of the bonds available on Wintwealth's platform.

Was this article helpful?
YesNo

Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The article may also contain information which are the personal views/opinions of the authors. The information contained in this article is for general, educational and awareness purposes only and is not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision, whether related to investment or otherwise, taken on the basis of this article.

Leave a Comment