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Gratuity is a lump sum amount that employers pay their employees as a sign of gratitude for the services provided.

The gratuity rules are mandated under the Payment of Gratuity Act, 1972. The act was passed by the Parliament on 21st August 1972 and came into force on 16th September the same year.

All central and state government departments, defense, and local governing bodies are covered under this act. Private organisations can come under its purview subject to fulfillment of certain conditions.

What is the Rule of Gratuity?

Rules pertaining to the applicability of gratuity are mentioned below –

1. Gratuity is payable if an organisation employs 10 or more individuals – 

Organisations with a workforce of 10 employees on a single day in the preceding 12 months are liable to pay gratuity. If the number of employees of the same organisation reduces to under 10, it will still have to pay the gratuity, as per regulations of the Act.

2. Employees have to complete 5 years of service to be eligible – 

To be eligible, an employee has to render his/her services for 5 continuous years. However, this condition is not taken into consideration in situations of demise or disablement of an employee.

For the calculation of the 5 years, a single year is assessed as 240 working days for employees working in organisations that do not involve work underground. For those working in mines and other such fields, a year is assessed as 190 days.

For instance, if Mr. A has worked for 4 years and 7 months in an organisation, it will be counted as 5 years. Contrarily, if he has worked for 4 years and 1 month, it will be taken as 4 years.

The 5 years of continuous service also include interruptions caused by strike, lockout, accident, leaves, layoff, absence from duty without leave, and termination of service not on the part of an employee.

3. Gratuity can be paid not only upon retirement – 

As per the gratuity rules, an employee will be eligible to avail gratuity upon –

  • Retirement.
  • Resignation.
  • Demise.
  • Disablement due to an accident or a disease.
  • VRS.
  • Termination.
  • Lay off due to retrenchment.

4. Calculation of gratuity is based on the last drawn salary and years of service –

Gratuity is calculated based on an individual’s last drawn salary and years of service. The formula for calculation differs from the applicability of the Payment of Gratuity Act, 1972.

a. Gratuity calculation for employees covered under the act

As mentioned before, organisations with 10 employees in a single day in the preceding 12 months are covered under this act.

For calculation of gratuity of employees in such organisations, the formula is –

Gratuity = (15 x last drawn salary x number of completed years of service) / 26

Here,

  • The last drawn salary includes basic and dearness allowance (DA). Any other component of income will not be included in the salary.
  • Completed years of service include any year where an employee has served for more than 6 months.

For instance, if Mr. B works for an organisation for 12 years and 8 months, his completed years of service will be taken as 13 years as per the gratuity rules. However, if he had worked for 12 years and 3 months, it would be considered as 12 years.

Now, let us assume that Mr. B’s last drawn salary was Rs.77,000. If he worked for 13 years, his gratuity will be –

(15 x 77,000 x 13) / 26 = Rs.5,77,500.

b. Gratuity calculation for employees not covered under the act 

For calculation of gratuity of employees not covered under the act, the formula is –

(15 x average salary for the last 10 months x number of years employed) x 30

Here,

  • Salary includes basic, DA, and commissions. Any other component of salary is not to be included.
  • The number of years employed is only considered based on the completion of each year of service.

For instance, if Mr. C has been employed at an organisation for 15 years and 8 months, his number of years employed will be considered as 15 years.

Now, let’s assume that Mr. C’s average salary for the last 10 months was Rs.92,350. Then, his gratuity will be –

(15 x 92,350 x 15) /30 = Rs.6,92,625. 

5. Gratuity can be forfeited for several reasons – 

As per the gratuity rules, employers can forfeit to pay a gratuity of the employee who has been terminated for the following reasons –

  • Committing an offence involving moral turpitude.
  • Riotous or disorderly conduct or any other violent act.

6. Employers cannot refuse to pay gratuity even during bankruptcy – 

An organisation is liable to pay gratuity to its employees even if it declares bankruptcy. No court decree or order can restrict an employer against it.

7. Gratuity up to the tune of Rs.20 Lakh is exempt from taxation –

A gratuity of up to Rs.20 Lakh paid by organisations covered under the Payment of Gratuity Act, 1972, other than central and state government departments, defence, and local governing bodies, is exempt from tax as per the gratuity rules 2020. Earlier, this threshold was set to Rs.10 Lakh.

8. Income tax applicability differs for different employees – 

Organisation typeGratuity tax implications 
 

Covered under the act

 

Not applicable up to least of the following:

  • Rs. 20 Lakh.
  • Actual gratuity received.
  • 15 x last drawn salary x number of completed years of service) / 26
Not covered under the actNot applicable up to least of the following:

  • Actual gratuity received.
  • Rs. 10 Lakh.
  • 15 x average salary for the last 10 months x number of years employed) x 30
Central/state government, defence, and local government authoritiesNot applicable

9. The Rs.20 Lakh threshold for tax exemption is for cumulative gratuity received – 

For instance, Mr. D received a gratuity of Rs.17 Lakh after leaving an organisation. After that, he joined another company that paid him a gratuity of Rs.5 Lakh. The cumulative gratuity he received was Rs .23 Lakh. 

Hence, Mr. D will be liable to pay income tax on Rs. 3 Lakh (Rs. 23 Lakh – Rs. 20 Lakh).

10. Gratuity paid to the widow or legal heir of an employee will be exempt of tax –

Upon an employee’s demise, the gratuity that is paid to his widow or legal heir will be exempt from tax. Any ex-gratia payment made to an employee or his legal heir on account of an injury caused will also be tax-free.

It is crucial for individuals to be aware of these new gratuity rules to ensure that they can maximise their benefits from this aspect attached to their employment terms.

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