Gratuity Calculation in India: Rules, Formula, and Tax Treatment

Gratuity is a lump sum payment made by an employer to an employee as a token of appreciation for long-term service. In India, it's governed by the Payment of Gratuity Act, 1972, and is typically paid upon retirement, resignation, death, or disability, provided certain service conditions are met. Understanding its calculation, eligibility, and tax implications is crucial for both employers and employees.

What is gratuity and who is eligible for it?

Gratuity is a statutory benefit paid to an employee by an employer under the Payment of Gratuity Act, 1972, for rendering continuous service for a specific period. Generally, an employee becomes eligible for gratuity after completing at least five years of continuous service with the same employer. This payment is a part of the employee's compensation package and is intended to provide a financial cushion upon the cessation of employment.

The Payment of Gratuity Act, 1972, applies to:

• Every factory, mine, oilfield, plantation, port, and railway company.
• Every shop or establishment in which ten or more persons are employed, or were employed, on any day of the preceding twelve months.
• Such other establishments or class of establishments in which ten or more employees are employed, or were employed, on any day of the preceding twelve months, as the Central Government may, by notification, specify in this behalf.

How is the 5-year continuous service condition applied?

The 5-year continuous service condition is a primary eligibility criterion for gratuity, meaning an employee must have completed at least four years and 240 days (or 190 days in certain seasonal establishments) to be considered as having completed five years of continuous service. This rule is particularly important for employees who resign or are terminated before completing full five calendar years. The Act defines "continuous service" broadly to include periods of absence due to sickness, accident, leave, lockout, strike not being illegal, or cessation of work not due to any fault of the employee.

However, this five-year condition is waived in cases of death or disablement of the employee. In such unfortunate circumstances, the gratuity becomes payable to the nominee or legal heir, or to the employee directly, irrespective of the length of service.

What is the formula for calculating gratuity?

The formula for calculating gratuity depends on whether the employer is covered under the Payment of Gratuity Act, 1972, or not.

For employees covered under the Payment of Gratuity Act, 1972:

The gratuity is calculated using the formula: (Last Drawn Salary × 15/26 × Number of Completed Years of Service)

Let's break down the components:

• Last Drawn Salary: This includes basic pay and dearness allowance. For employees receiving commission, if it's a fixed percentage of turnover achieved by the employee, it's also included.
• 15/26: This represents 15 days' salary for each year of service, assuming a month has 26 working days.
• Number of Completed Years of Service: Any service period exceeding six months in the last year is rounded up to a full year. For example, if an employee has served for 10 years and 7 months, it will be considered as 11 years. If they served for 10 years and 5 months, it will be considered as 10 years.

For employees not covered under the Payment of Gratuity Act, 1972:

Employers not covered by the Act may still pay gratuity under their own policies or employment contracts. While there's no statutory formula, it's generally calculated as: (Half Month's Salary × Number of Completed Years of Service)

Here, "Half Month's Salary" is usually based on the average of the last 10 months' basic salary plus dearness allowance. The rounding-up rule for service years (exceeding six months) does not apply here; only completed years are considered.

How is gratuity treated for tax purposes?

Gratuity received by an employee is subject to income tax, but certain exemptions are available under Section 10(10) of the Income Tax Act, 1961. The extent of exemption depends on whether the employee is a government employee or a non-government employee, and if the latter, whether their employer is covered under the Payment of Gratuity Act, 1972.

Here's a comparison of the tax treatment:

| Category of Employee | Tax Exemption Rule (Least of the following) | | Government Employee | Fully exempt under Sec. 10(10)(i) | | Non-Government Employee (Covered by Act) | 1. Actual gratuity received <br> 2. ₹20,00,000 (Statutory limit, Sec. 10(10)(ii)) <br> 3. (Last Drawn Salary × 15/26 × Number of Completed Years of Service) | | Non-Government Employee (Not Covered by Act) | 1. Actual gratuity received <br> 2. ₹20,00,000 (Statutory limit, Sec. 10(10)(iii)) <br> 3. Half month's average salary for each completed year of service (based on average salary for 10 months immediately preceding the month in which the event occurs). | | Non-Government Employee (Covered by Act, but death/disability) | 1. Actual gratuity received <br> 2. ₹20,00,000 (Statutory limit, Sec. 10(10)(ii)) <br> 3. (Last Drawn Salary × 15/26 × Number of Completed Years of Service) - No minimum service period applies. | | Non-Government Employee (Not Covered by Act, but death/disability) | 1. Actual gratuity received <br> 2. ₹20,00,000 (Statutory limit, Sec. 10(10)(iii)) <br> 3. Half month's average salary for each completed year of service (based on average salary for 10 months immediately preceding the month in which the event occurs). - No minimum service period applies. |

Important Note: The maximum tax-exempt gratuity limit of ₹20,00,000 is an aggregate limit for all gratuities received from one or more employers during an employee's lifetime. If an employee receives gratuity from multiple employers, the total exemption cannot exceed this limit.

How SP & SC helps

Navigating the complexities of labour laws, including gratuity calculations and compliance, can be challenging for businesses. SP & SC Legal and Taxation Services offers comprehensive labour compliance services to ensure your business adheres to all statutory requirements, avoiding penalties and fostering a positive work environment. Learn more at /services/compliance/labour-compliance.

Frequently asked questions

Is gratuity mandatory for all employers?

The Payment of Gratuity Act, 1972, makes gratuity mandatory for establishments employing 10 or more persons. If an employer falls under the purview of this Act, they are legally obligated to pay gratuity to eligible employees. Even if not covered by the Act, many employers choose to offer gratuity as a part of their employee benefits package.

Can an employer refuse to pay gratuity?

An employer cannot refuse to pay gratuity if the employee meets the eligibility criteria under the Payment of Gratuity Act, 1972. However, under Section 4(6) of the Act, an employer can forfeit the gratuity of an employee whose services have been terminated for certain acts, such as riotous or disorderly conduct, or any other act of violence on the part of the employee, or for any act which constitutes an offence involving moral turpitude, provided such offence is committed by him in the course of his employment. The forfeiture can be partial or full depending on the damage or loss caused to the employer.

Is gratuity paid on resignation?

Yes, gratuity is payable on resignation, provided the employee has completed at least five years of continuous service with the employer. The calculation remains the same as for retirement.

What happens to gratuity in case of an employee's death or disability?

In case of an employee's death or disablement, the gratuity becomes payable to the nominee or legal heirs, or to the employee directly, irrespective of the length of service. The five-year continuous service condition is waived in these circumstances.

Is gratuity calculated on gross salary?

No, gratuity is not calculated on gross salary. For employees covered under the Payment of Gratuity Act, 1972, it is calculated on "last drawn salary," which typically includes basic pay and dearness allowance. For those not covered by the Act, it's usually based on the average of the last 10 months' basic salary plus dearness allowance.

Can an employee receive gratuity multiple times from the same employer?

Gratuity is generally a one-time payment made upon the cessation of employment. An employee typically receives gratuity when they leave an organisation after fulfilling the service conditions. If an employee rejoins the same employer, their previous service period and gratuity would be settled, and a new period of service would begin for future gratuity eligibility.