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November 27, 2020

Know all about Tax exemption when you receive gratuity

by CA Shivam Jaiswal in Income Tax

Know all about Tax exemption when you receive gratuity

Gratuity is a monetary benefit given by the employer to his employee at the time of retirement. It is a defined benefit plan where no contributions are made by the employee.  Gratuity payments in India are governed by the rules and requirements set out in the Payment of Gratuity Act, 1972. Gratuity is calculated on the basis of last drawn salary and years of service.

When is an individual eligible to receive gratuity? 

An individual is eligible to receive the gratuity once he/she has completed five years of service with an employer. However, it can be paid before the completion of five years at the death of an employee or if he has become disabled due to an accident or disease.

How is Gratuity Calculated?

The formula for computing gratuity is based on the 15 days of last drawn salary for each completed year of service or part of thereof in excess of six months. 

The formula is as follows: (15 * last drawn salary * tenure of working) divided by 26 

Last drawn salary means basic salary, dearness allowance and commission received on sales. 

For instance, A’s last drawn basic pay is Rs. 50,000 per month and he has worked with XYZ Ltd for 15 years and 7 months. In this case, using the formula above, gratuity will be calculated as: 

(15 X 50,000 X 16)/26 = Rs. 4.62 lakh 

In the above case, we have taken 16 years as tenure of service because A has worked for more than 6 months in year. If he worked for 15 years and 5 months, then 15 years of service would have been taken into account while calculating the gratuity amount.

Who receives gratuity on an employee’s death?

  • The deceased employee’s nominee shall receive the gratuity if the employee dies.
  • The condition of minimum tenure of completion of five years of service does not apply here.
  • If the nominee is a minor, the gratuity sum would be deposited with the controlling authority who shall invest the money for the benefit of the minor until the minor attains majority.

What is the exemption available on gratuity?

Gratuity received by a government employee is fully exempt. This extends to employees of both State and Central Government employees, employees from the defence sector and those working in any local authority.

For a non-government employee, the Income-tax Act, 1961 exempts gratuity from tax up to a certain limit. Tax-free gratuity amount is the lowest of three things:

  • the eligible gratuity,
  • actual gratuity received and
  • Rs. 20 lakh, which is the upper tax-free limit set by the government.

Suppose your employer paid you Rs. 12 lakh as gratuity. So, if your last drawn salary was Rs. 50,000 (basic and dearness allowance) and the employment tenure was 12 years, you will be eligible for a gratuity of {(50,000/26) x 15}x12 or Rs. 3,46,154.

Here, the lowest of:

  • The eligible gratuity amount (Rs. 3,46,154),
  • Actual gratuity received (Rs. 12 lakh) and
  • Rs. 20 lakh, the upper tax-free limit set by the government will be tax-exempt.

Here the lowest amount is Rs. 3,46,154, which will be exempt from tax, and the remaining Rs. 8,53,846 will be taxable as per your applicable income-tax slab rate.

The ceiling of gratuity amount under the Payment of Gratuity Act, 1972, has been raised from time to time keeping in view overall economic condition and employers’ capacity to pay and the salary of employees, which have been increased in private sector and in PSUs. The latest enhancement of tax exemption limit on gratuity follows a government notification issued on March 29, 2018, under which the ceiling was increased from Rs 10 lakh to 20 lakh effective March 29, 2018.

The government of India introduced gratuity under Payment of Gratuity Act, 1972. It is a financial incentive given to an employee for being in service and for his loyalty towards the company. It acts like a benefit that acts as post retirement plan. Likewise, gratuity should be paid because it is important as a form of social security provided by employer to the employees in monetary terms for the total service employees have worked with employers.

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