All you need to know about Gratuity & Its Tax Implications

A guide to Gratuity & Its Tax Implications:

gratuity & its tax implicationsGratuity is a part of the salary paid by an employer to his employee for the continuous service of five or more years(minimum 240 days a year). It is one of the retirement benefits received by an employee from his employer upon leaving his job. In other words, It can be referred as a reward paid by the employer for the long and meritorious service of the employee.

As per the Payment of Gratuity Act, 1972 it is mandatory for an employer to pay gratuity if on any day of the preceding twelve months there are/were 10 or more than 10 employees employed in his organisation.

Payment of Gratuity

As per the Section 4(1) of the Payment of Gratuity Act, 1972 gratuity is payable to an employee at the termination of his/her employment once he/she have completed continuous service for not less than five years:

• On his/her superannuation or
• On his/her retirement/resignation or
• On his/her death or disability due to accident or disease

Exception to five-year service tenure

• Completion of five years of service is not necessary in the event of death or disablement due to an accident or disease and in such event, gratuity is payable to the nominee listed by the employee.
• If there is no nomination, then the benefit amount is paid to the employee’s legal heir.
• If the nominee or the legal heir is a minor, the money is deposited with the controlling authority who shall deposit the money for the benefit of the minor in a bank or other financial institution until the minor attains majority.

Note: Under the Section 4(4) of the act, the benefit amount paid to an employee, who is employed after his/her disablement on reduced wages is calculated considering the wages received by him/her prior to the disablement and the reduced wages received by him/her after the disablement.

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Entities covered under Payment of Gratuity Act

As per Act no. 39, Section 1(3) of the Payment of Gratuity Act, 1972 the below entities are entitled to pay gratuity to its employees:

• Every factory, plantation, mine, port, oilfield and railway company.
• Every shop or establishment covered under the meaning of the law for the time being in force related to such shops and establishments in a state where on any day of the preceding twelve months, there are/were 10 or more than 10 employees employed.
• Such other establishments or class of establishments, where 10 or more than 10 employees are/were employed, on any day of the immediately preceding twelve months, as the Central Government may, by notification, specify in this behalf.

Calculation of Gratuity amount

The amount is calculated based on the service tenure and the last drawn monthly salary. Further, the benefit is paid to three different categories of employees:

1. Government employees.
2. Non-Government employees: Covered by the Payment of Gratuity Act, 1972.
3. Non-Government employees: Not covered by the Payment of Gratuity Act, 1972.

Tax Exemption on Gratuity amount

1. For the Government employees [Section 10(10)(i)]:

Any gratuity amount received on retirement or death have been exempted from tax under Section 10(10)(i). The threshold limit for the amount payable as a gratuity to the Government employees has been raised to Rs. 20 lakhs from the previous limit of Rs. 10 lakhs with effect from Jan 01, 2016 as per the recommendation in the seventh pay commission.

On the other hand, for the Non-Government employees, amount exempted from tax is calculated based on whether the employee is covered under the Payment of Gratuity Act, 1972 or not.

2. For Non-Government employees covered under the Payment of Gratuity Act, 1972 [Section 10(10)(ii)]:

The formula for gratuity calculation in this case is:

Gratuity = {Number of years of service * Last drawn monthly salary (Basic + DA)} * (15/26)

The exemption allowed on the gratuity amount is on the least of the following:

• Actual Gratuity received.
• Maximum amount as designated by the Central Government i.e. Rs. 10 lakhs.
• 15 days salary (Basic + DA) based on the rate of salary last drawn by the concerned employee for every “Completed year of service or part thereof” in excess of six months.

Notes:

• “Completed year of service or part thereof” implies that the full-time service of more than six months is considered as 1 full year of service. So, if you have completed five years and seven months in the service, then the tenure for the calculation will be considered as six years.
• On the other hand, if the term is less than six months, then it will not be considered. For instance, if you have worked for five years and four months, then only five years tenure will be taken into consideration for the calculation.
• The 15 days salary is calculated by dividing the monthly rate of salary last drawn by the employee by 26 and multiplying the quotient by 15.
• Seven days are considered instead of 15 days for calculation, for an employee who is employed in a seasonal establishment.
• In case of a piece rated employee, daily salary will be calculated based on the average salary earned by the employee in the previous three months immediately preceding his/her termination from the employment. Also, the overtime pay received by the employee will not be considered for the calculation.

3. For Non-Government employees not covered under the Payment of Gratuity Act, 1972 [Section 10(10)(iii)]:

The formula for gratuity calculation in this case is:

Gratuity = {Number of years of service * average monthly salary in the last 10 months of employment (Basic + DA) } * (1/2)

The exemption on the gratuity amount allowed is on the least of the following:

• Actual Gratuity received.
• Maximum amount as designated by the Central Government i.e. Rs. 10 lakhs.
• Half month’s average salary (based on the last 10 month’s average salary) for each “Completed year of service”.

Notes:

• Half month’s average salary is calculated based on the average salary received by the employee in the previous 10 months immediately preceding his/her retirement.
• “Completed year of service” here refers to the full time of service for more than one complete year. So for instance, if you have worked for 10 years and 11 months, the number of years in service will be considered as 10 years only and not 11 years.
• The maximum amount, an employer, can pay as gratuity is Rs. 10 lakhs as per the act. However, if the employer wants to pay any higher amount than this, then the employer have to pay the remaining amount in the form of performance bonus or ex-Gratia.

Also read: A Guide to understanding your Salary and its Tax Implications

Let me take you through an example for better understanding of the above rule for tax exemption in case of Non-Government employees:

Suppose Mr. Ram has worked for 20 years and 9 months. His last drawn monthly salary (Basic + DA) is Rs. 50,000 and he has received a gratuity of Rs. 15,00,000 (Assuming, his salary has not changed in the last 1 year).

1. Mr. Ram is covered by the Payment of Gratuity Act, 1972:

Gratuity- Section 10(10)(ii)

Calculation of 15 days wages (Basic + DA) for every “Completed year of service or part thereof” in excess of six months:

• Duration of Service = 25 months and 9 months i.e. 26 years
• 15 day’s wages = 50,000 * (15/26) = Rs. 28,846
• The total amount of salary will be = Rs. 28,846 * 26 = Rs. 7,49,996

From the table above, eligible amount for tax exemption will be Rs. 7,49,996 being least among the all. Thus, the taxable amount will be Rs. 7,50,004 (Rs. 15,00,000-Rs. 7,49,996).

2. Mr. Ram is not covered by the Payment of Gratuity Act, 1972:

Gratuity- Section 10(10)(iii)

Calculation of Half month’s average salary for each completed year of service:

• Duration of Service= 25 years 9 months i.e. 25 years
• Half month’s salary will be = 50,000/2 = Rs. 25,000
• The total amount of salary will be = Rs. 25,000 * 25 = Rs. 6,25,000

From the above table, eligible amount for tax exemption will be Rs. 6,25,000 being least among the all. Thus, the taxable amount will be Rs. 8,75,000 (Rs. 15,00,000-Rs. 6,25,000).

Note:

Benefit amount received by an employee on the retirement or during the service is taxable under the head “Income from Salary”.

Benefit amount received by the nominee or the legal heir in case of death of the employee is not taxable. However, if the gratuity amount becomes due or is paid before the death of the employee, it is taxable under the head “Income from other sources” and they have to disclose the gratuity amount while filing ITR.

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Forfeiture of Gratuity payment

• As per the provision under Section 4(6)(a) of the Payment of Gratuity Act, 1972 the gratuity of an employee whose service has been terminated as a result of any act, willful omission, or due to any negligence, resulting in the damage or loss of any property belonging to the employer, shall be forfeited to the extent of the loss or damage caused.

• Also, as defined in Section 4(6)(b) of the Payment of Gratuity Act, 1972 the gratuity payable to an employee may be partly or fully forfeited if:

a). Service of the employee has been terminated as a result of a disruptive behaviour or any act of violence on his part.
b). Service of the employee has been terminated due to any act that constitutes any offence involving moral turpitude, provided the employee has committed such offence during his/her service of employment.

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