Tax treatment of Gratuity under the Income Tax Act, 1961

Gratuity:- Gratuity’ is a retirement benefit. Gratuity Act, 1972 act envisages in providing retirement benefit to the workman who have rendered long and unblemished service to the employer. Gratuity is a reward for long and meritorious service. Earlier, it was not compulsory for an employer to reward his employee at the time of his retirement or resignation. But in 1972 the government passed the Payment of Gratuity Act that made it mandatory for all employers with more than 10 employees to
pay gratuity.

Applicability of the Act: The act provides for the payment of gratuity to workers employed in every factory, mine, oil field, plantation, port, railways, shop & Establishments or educational institution employing 10 or more persons on any day of the proceeding 12 months.

A shop or establishment to which the Act has become applicable shall continue to be governed by the Act even if the numbers of persons employed falls below 10 at any subsequent stage.

Here employees are defined as those hired on the company’s payroll. Trainees and interns are not eligible for this compensation.

Eligibility criteria

Gratuity shall be payable to an “employee” on the termination of his employment after he has rendered continuous service for not less than five years.

• On his superannuation.
• On his retirement or resignation.
• On his death or disablement due to accident or disease.

Note: However, the condition of five years of continuous service is not necessary if service is terminated due to death or disablement.

To whom is Gratuity Payable?

Gratuity is normally payable to the employee himself, however in the case of death of the employee it shall be paid to his nominee & nomination has been made to his heirs. Incase the nominee is a minor; share of the minor shall be deposited with the controlling authority who shall invest the same for benefit of the minor, until he/she attains majority.

Maximum amount payable under the Gratuity Act:-

Maximum gratuity payable is Rs 10 lakhs  for Government & Non Government  employees. [Section 4(3)] [Of course, employer can pay more. Employee has also right to get more if obtainable under an award or contract with employer, as made clear in section 4(5)].

Nomination facility: - Yes, by filling Form “F” at the time of new joinee formality, each employee is required to nominate one or more member of his family, as defined in the Act, who will receive the gratuity in the event of the death of the employee.

Forfeiture of Gratuity:- The gratuity of an employee whose service have been terminated for any Act of willful omission or negligence causing any damage or loss to or destruction of property belonging to the employer, gratuity shall be forfeited to the extent of the damage or loss caused. The right of forfeiture is limited to the extent of damage.

The gratuity payable to an employee shall be wholly forfeited:

1. If the services of such employee have been terminated for his riotous or disorderly conduct or any other act of violence on his part, or
2. If the service of such employee have been terminated for any act which constitutes an offense involving moral turpitude, provided that such offense is committed by him in the course of his employment.

Applicability to contract Employee:- Yes, the only criterion is to serve at least 5 years of service at a stretch.

Calculating gratuity

a)     In respect of Employees covered Under the Payment of Gratuity Act, 1972:

As per the Act, the gratuity amount is 15 days’ wage multiplied by the number of years put in by you. Here wage refers to basic salary plus dearness allowance. Take the monthly salary drawn by you last (basic + dearness allowance) at the time of resignation or retirement. Divide this by 26. This gives you your daily salary. Multiply this amount by 15 days, and further by the number of years of service you have put in.

If you have put in 10 years and seven months in an organisation, your service period will be taken to be 11 years. But if your service tenure is 10 years and five months, then for the purpose of this calculation your tenure will be taken to be 10 years only.

Take an example. Suppose that your average monthly salary is Rs 26,000. Your daily salary will be Rs 1,000. Multiply this by 15 and then by 10. The gratuity you are entitled to after 10 years of service will be Rs 1.5 lakh.

Formula :- Gratuity shall be calculated as per the below formula:

Gratuity = Last drawn salary x 15/26 x No. of years of service

Your last drawn salary will comprise your basic + DA. For computation of gratuity, your service period will be rounded off to the nearest full year.

b)     In respect of Employees not  covered Under the Payment of Gratuity Act, 1972:

For non-government employees, who are not covered under this Act, the manner of calculating gratuity is different. First, the average salary is calculated: for this the average of last ten months’ salary is taken (this will include the basic plus dearness allowance plus commission as a percentage of turnover achieved by the employee). Divide this average salary by 30 (ignore fractions). Now, multiply this amount by 15 and further with the number of years of service put in. Dividing the daily salary by 30 instead of 26 does put those not covered by the Gratuity Act at a disadvantage.

Formula :- Gratuity shall be calculated as per the below formula

Gratuity = Last drawn salary x ½ x No. of years of service

Your last drawn salary will comprise your basic + DA+ commission on sales on turnover basis. For computation of gratuity, your service period will not be rounded off to the nearest full year. While calculating completed years, any fraction of the year will be ignored. For instance, if the employee has a total service of 20 years, 10 months and 25 days, only 20 years will be factored into the calculation.

Tax treatment of gratuity :- For the purpose of exemption of gratuity under sec.10 (10) the employees are divided under three categories:

1. Any death cum retirement gratuity received by Central and State Govt. employees, Defense employees and employees in Local authority shall be exempt.
2. Any gratuity received by persons covered under the Payment of Gratuity Act, 1972shall be exempt subject to following limits:-
   • For every completed year of service or part thereof, gratuity shall be paid at the rate of fifteen days wages based on the rate of wages last drawn by the concerned employee.
   • The amount of gratuity as calculated above shall not exceed Rs. 10,00,000/-
3. In case of any other employee, gratuity received shall be exempt, subject to the following exemptions
   • Exemption shall be limited to half month salary (based on last 10 months average) for each completed year of service or Rs. 10 Lakhs whichever is less.
   • Where the gratuity was received in any one or more earlier previous years also and any exemption was allowed for the same, then the exemption to be allowed during the year gets reduced to the extent of exemption already allowed, the overall limit being Rs. 10 Lakhs.

As per Board’s letter F.No. 194/6/73-IT(A-1) Dated 19.06.73 exemption in respect of gratuity is permissible even in cases of termination of employment due to resignation. The taxable portion of gratuity will qualify for relief u/s 89(1).

Gratuity payment to a widow or other legal heirs of any employee who dies in active service shall be exempt from income tax subject to provisions mentioned above Circular No. 573 dated 21.08.90).

The ceiling of Rs. 10  lakh applies to the aggregate of gratuity received from one or more employers in the same or different years.

Taxable under what head:- Gratuity received by an employee on his retirement is taxable under the head “Salary” and gratuity received by the legal heir is taxable under the head” Income from Other Sources”.

Frequently Asked Question:-

QUESTION: I am a pensioner from Orissa State Government. I retired in 2007 receiving an amount of Rs. 3,00,000 as gratuity. But I received a further amount of Rs. 1.20 lakhs in December 2002 consequent on revision of pay. At the time of my retirement the exemption limit was Rs. 3.50 lakh. Am I eligible for the higher exemption limit under Sec. 10(10) available at the time of receipt. The higher limit of Rs. 10  lakhs is raised by Gratuity Amendment Bill 2010.

ANSWER: Every time the limit has been raised, such limit has only referred to the retirement on or after the date on which it was raised. Hence the limit on the date of retirement time would alone have to be considered, so  exemption with reference to the enhanced limit will not apply to the reader’s case. It is stated that the reader is a government pensioner. There is no ceiling for Central or State pensioners. If the reader is a retiree from the civil service of a State or held a civil post under a State or had even been an employee of a local authority, the gratuity amount, that is received, is totally exempt vide Sec. 10(10)(i) of the Income-tax Act irrespective of the date of retirement or the notification.