Gratuity in India: Everything You Need to Know

What is Gratuity?

It is a onetime payment from an employer to their employees for their services to their company. It is like a thank you gift from the employer for staying with the company and working hard for so many years.

Mostly employees get their gratuity at retirement. But one doesn't need to wait until retirement to get it. If something unfortunate happens, like the death or a disability caused by an accident or illness to an employee, gratuity can be paid earlier, too.

Employees need to complete at least 5 years of continuous service with a company to be eligible for gratuity. The only exceptions are death or disability, where this 5-year rule does not apply. And according to the new labour law rules, gratuity service year eligibility is reduced to 1 year for fixed-term employees, and contract workers are also eligible for gratuity similar to fixed-term employees; they are eligible after their 1 year of service.

The law divides the companies in two parts –

1. Companies covered under the Payment of Gratuity Act, 1972

2. Companies that not covered under this Act

A company falls under the Act if it has employed at least 10 people on any single day in the last 12 months. once a company falls under the Act, it stays under the Act forever, even if the number of employees drops below 10 later.

How is gratuity calculated?

1. If our company is covered under the act –

The formula is

(15*Last drawn salary*Years of service) / 26

Here, the last drawn salary is equal to our basic pay + dearness allowance + any sales commission we earn.

Example: Suppose Jaydeep’s last drawn basic salary is 60,000 per month, and he has worked at his company for 20 years and 7 months.

Since he has worked more than 6 months in his last year, this extra period is rounded up to a full year. So, his tenure is counted as 21 years, not 20.

Gratuity = (15*60,000*21) / 26 = 7.26 lakh

If Jaydeep had worked for 20 years and 5 months, then his tenure would have been counted as only 20 years, and the gratuity amount would have been lower.

2. If our company is not covered under the act –

Employers can still choose to pay gratuity even if their company is small. The formula changes a little bit -

(15*Last drawn salary*Years of service) / 30

Here we will count only completed years in the last drawn salary.

For example, if Jaydeep's company was not covered under the Act, his 20 years and 7 months of service would be counted as 20 years.

Gratuity = (15*60,000*21) / 30 = 6 lakh

Gratuity for Central Government Employees –

The formula for central government is different –

One-fourth of (basic pay + dearness allowance) for every completed 6-month period of service.

Even if someone has served for 33 years or more, the maximum retirement gratuity will be 16.5 times the basic pay plus dearness allowance, with the overall ceiling of 20 lakhs. Retirement gratuity for central government employees is governed by the Central Civil Services (Pension) Rules.

What happens if an employee passes away?

The gratuity is paid to the family of the employee, and it depends on the length of qualifying service.

In all cases, the maximum amount payable is capped at 20 lakhs.

Is Gratuity Taxable?

This is one of the most common questions people ask. Here's the simple explanation –

• For government employees, gratuity is fully tax-free.

• For private-sector employees, it depends on whether their company is covered under the Act or not.

If covered under the Act

Your gratuity is tax-free up to the lowest of these three amounts:

1. 1.20 lakhs

2. 2. Last drawn salary*number of years of service*15/26

3. 3. The actual gratuity amount an employee received

Anything above this lowest figure becomes taxable.

If not covered under the Act

Gratuity is tax-free up to the lowest of these three amounts –

1. 1.20 lakhs

2. 2. Average salary ½ number of years of service

3. 3. The actual gratuity amount one received

The knowledge of gratuity helps every employee to plan for his financial security in the long run. If you work in the private sector or for the government, understanding your eligibility, how it’s calculated and how it’s taxed will help you make informed decisions about your retirement.

We will be covering other retirement and accumulation products like EPF, NPS, PPF, superannuation, etc. in our subsequent articles.