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Breaking Down Gratuity in India – Meaning and Calculation

There are varying components that constitute an individual’s gross salary with gratuity being one of them. Gratuity is a benefit that is owed to an employee by the employer under Payment of Gratuity Act issued in 1972.

Understanding the term Gratuity and what it stands for:

The term Gratuity refers to the sum of money paid by an employer to his employee as a token of gratitude for the services imparted by the employee in the company. This payment is a benefit plan and a part of retirement benefit that an employer offers the employee while leaving the job for any of the reasons - retirement, voluntary retirement, or to work at a new company.

Gratuity, as explained under Section 10 of Income Tax Act, is only payable to the employees who have worked in a company for a period of five years or more. This payment can also be compared to an employer giving a tip to the employee for a job well done. Gratuity is influenced by culture and therefore different countries have different gratuities.

The Process in which Gratuity Payment Works:

The employer may give the gratuity to the employee from either his own pocket or may take up a gratuity plan with an insurance company. In case if the insurance is acquired, the annual contribution is made towards the insurance plan by the employer. The employee too is free to contribute towards this gratuity amount if he/she wants to. The gratuity sum paid by the insurance company will depend upon the clauses mentioned in the group insurance scheme.

Payment of Gratuity Act, 1972

The Payment of Gratuity Act was passed by Parliament of India on August 21st, 1972 and came into action on 16th September 1972. The act applies to India as a whole and it caters to the employees engaged in companies, plantation, industries, mines, ports, factories, oil fields and railway companies.

Apart from these given companies, any other organizations are eligible under this act only if the company employs more than 10 employees:

  • Under the Act of Section 1 (3-A), if the number of employees in an organization is reduced below 10, the company will continue to process under the previous act, irrespective of the number of employees.
  • Section 1 (2) applies to the whole India, apart from the port and plantation employees in the State of Jammu and Kashmir who do not come under this act.
  • Section 2 (e) applies to individuals who hold civil posts under the Central Government or State Government.

Criteria to be Eligible to Claim Gratuity Payment

Listed below are the criteria for an employee to claim gratuity payment:

  • If he/she is retiring.
  • If he/she is eligible for superannuation.
  • If he/she is voluntarily retiring after working for a period of five years for one employer.
  • If he/she suffers disability due to an accident or illness or has passed away.

Calculating Gratuity Amount using the Formula

The various components required to calculate the gratuity amount, depending upon the number of years served in the company and the salary last drawn are as follows:

Here,

N = number of years an employee served in the company.

B = last drawn salary + DA (Dearness Allowances)

Gratuity will be = N X B X 15/26

For example,

If Rohit is an employee who has worked for an oil company XY for 16 years and had Rupees 35,000 as his last drawn basic salary plus DA amount.

Then,

Rohit’s payable Gratuity Amount = 16 X 35,000 X 15/26 = Rupees 3,23,076.9230.

An employer can even decide to pay an amount higher than the general gratuity value as gratuity is nothing but gratitude for service rendered by an employee. As per the Payment of Gratuity Act, the gratuity amount cannot be higher than Rupees 10 Lacs. Any value above Rupees 10 Lacs is considered as exgratia, which is a voluntary payment and not enforced by law.

Process of Taxation in relation to Gratuity

The gratuity received by an employee is considered taxable when accounted under the ‘income through salary’. It also depends on the employee receiving the gratuity.

On this basis two cases arise for tax calculation on gratuity:

  • A salaried individual who receives Gratuity Amount from an employer who is legally bound by Payment of Gratuity Act: An employ who obtains his/her gratuity from an employer that comes under the jurisdiction of the Payment of Gratuity Act can have tax exempted on his/her income to an extent that it does not include the 15 days of salary, as per the last drawn amount of the individual.
  • Any other salaried individual getting Gratuity Amount from an employer who is under Law of Payment of Gratuity Act: In a case such as this, the following three amounts can be excused from the tax:
    1. Rupees 10,00,000.
    2. Gratuity amount received by the employee.
    3. 15 days of salary for every year of service.

Forfeiture of Gratuity

The Payment of Gratuity Act of 1972 has the provision that allows an employer the right to relinquish the payable gratuity either partially or fully, even if the employee has worked in the company for more than five years. This situation is only prevalent when the individual’s employment is terminated due to dishonorable conduct or under circumstances where he/she has tried to inflict physical harm to anyone during the term of employment.

The Steps involving Gratuity payment are as follows:

  • Initiation – An authorized person or individual employee must send an application regarding his/her gratuity payment that is owed to the employer for the services rendered in the company.
  • Calculation and Acknowledgement – As soon as the application is received it is processed. This means the payable amount of the employee is calculated and an acknowledgment is issued to the same individual by the governing authority with the amount specified.
  • Disbursal – After the employer has sent the acknowledgment, he/she has a period of 30 days within which the payment of the gratuity owed to the employee must be made.

Gratuity Act for the year 2017-18

As per the current Gratuity Act, employees are required to work at a company for a minimum of five years to be eligible to claim the benefits of gratuity.

The letter circulated by the Indian government on February 15th, 2017 proposed an amendment with regards to Payment of Gratuity Act. This appendix deals with increasing the maximum amount that can be exempted from the tax, which is Rupees 10 Lac to 20 Lacs as per Section 4 (3) of the Act.

Important things to note about Gratuity

The key points with regards to payment of gratuity to an employee by an employer are listed as follows:

  • If any employee receives a gratuity payment of more than Rupees 10,00,000 from his/her employer, the amount is subjected to taxation as per the policy mentioned under Taxation on gratuity section.
  • If an employee has been terminated from his current position in the company due to misconduct, the employer reserves the right to forfeit the gratuity payment on such account.
  • The nominee or heir of the employee can claim the gratuity amount in case the employee has passed away. This amount gained is taxable as per the income earned from other sources.