Gratuity Exemption

Gratuity Exemption: Overview

What is Gratuity?

There are several tools and services available in the present times to save money and put something away for retirement. However, there are only a few of these tools/services are provided by the employer and gratuity is one of the most popular ones in this regard. Gratuity is in many ways, your organization’s way of thanking you for the services that you have provided to them in the long term. The amount comes in handy during retirement and acts as a bonus for the employee.

In lot of cases, gratuity is included in the cost to company (CTC) that an individual receives from his/her employer. A small portion of the monthly salary is put into the gratuity bucket, which can only be paid out under certain key circumstances. The Payment of Gratuity Act, 1972 governs the rules and regulations that employers need to follow for receipt of the company’s gratuity benefit.       

An individual is entitled to gratuity if they attain the age of retirement, retire or resign from their job after extended years of service or in case of death/disability occurring due to an accident or any disease. An employee can avail gratuity only if they have served for a minimum of five years in the company. However, in the case of death or disability due to accident, the five-year clause is not mandatory.

An individual working in any establishment or organization (example: factories, shops, educational institutions, mines, plantation, railway etc.) is entitled for gratuity if in the last twelve months, the company’s total employee strength exceeds 10 individuals. Once gratuity is applicable for an employer, even if the workforce strength reduces to less than 10 at a later date, the gratuity clause would still hold true.

Tax Exemption Rules

As an employee, it is very important to understand the taxation rules of gratuity so that you can make the most out of it. Gratuity, a bulk deposit, can come in handy and help generate savings for the long term, if planned properly. There are three primary categories of employers who provide their employees with gratuity benefits and the tax exempt on gratuity differs from one to the other.

State or Central Government

For all state government and central government employees, the gratuity amount received either on retirement or death is completely exempt from tax. The benefits are also extended to local government based offices and also army personnel. If you are an employee from any of these sectors, you need not worry about taxation on gratuity.

For Employers governed by Payment of Gratuity Act

For employees who are part of any organization which is covered under the Payment of Gratuity Act, 1972, the gratuity is calculated as follows –

The total number of years in service is multiplied by 15 days salary for the last drawn salary. Any number of days in service, in excess of six months is considered as a complete year for the calculation of the gratuity amount. And the last drawn salary considered for gratuity purposes includes only the basic salary and DA components of the salary.

The gratuity amount that is exempt from the income tax is the lowest among of any of the following:

- Gratuity calculated as per 15 days of last drawn salary.
- Rs. 10 lakhs (as per the maximum cap set by the government)
- Actual gratuity amount received by the employee.

The following example illustrates this calculation:

Rohan has been working for an organization for 11 years and 3 months and his friend Kaushik has been working in another organization for 7 years and 7 months. For ease of calculation, the duration of one's service is always rounded off to the nearest year. Thus, the years of service for Rohan is 11 years and that of Kaushik is 8 years (as he worked for more than 6 months for that year).

The last drawn salaries are Rs. 25,000 and Rs. 20,000 for Rohan and Kaushik respectively. As per calculations, the last drawn salary is to be divided by 26 days and multiplied by 15 to get the gratuity amount for one year. The same is then multiplied by the number of years in service.

Thus, Rohan's gratuity for one year turns out to be Rs. 14,423 and Kaushik's Rs. 11,538. When both Rohan and Kaushik decided to part ways with their organizations, they received gratuity amounts of Rs. 3 lakhs and Rs. 2.50 lakhs espectively from their organizations.

For Rohan, the three values stand at:

  • Rs. 158,653 (15 days of last drawn salary X total years of service)
  • Rs. 10,00,000 (Maximum allowed limit)
  • Rs. 3,00,000 (Gratuity received)

As we can see, the Rs. 158,653 value is the lowest among the three values and it stands exempt from tax. Rohan now has to pay taxes on the remaining amount from his gratuity received, which is Rs. 141,347 INR based on the slab that he is part of.

For Kaushik, the three values stand at:

  • Rs. 92,304 (15 days of last drawn salary X total years of service)
  • Rs. 10,00,000 (Maximum allowed limit)
  • Rs. 2,50,000 (Gratuity received)

From the above we can see that 15 days of last drawn salary value multiplied by the number of years of service is the lowest amongst the three and thus this is the amount that is exempt from taxes. Kaushik now has to pay taxes on the remainder amount (2,50,000 – 92,304) = Rs. 157,696.

For Employers who do not fall under Payment of Gratuity Act

For employees, whose organisations are not covered under the Payment of Gratuity Act, 1972, the gratuity calculations are a little different. For gratuity, half of the average salary received for the preceding 10 months is considered. For someone who has served his organization for 9 years and 10 months, the term for calculation of gratuity would be considered as 9 years only. Thus, the amount of gratuity that is exempt from taxes is the lowest among the following:

  • Half of average monthly salary for 10 months times number of years of service
  • Rs. 10 lakhs
  • Actual gratuity received by the employee.

The following example will help you understand how much of your gratuity is exempt from taxes.
Sohini decides to retire from her job after 26 years and 9 months and receives a gratuity amount of Rs. 7 lakhs from her organization. Considering her average salary for the previous 10 months is Rs. 40000, then the three brackets would be as follows:

  • Rs. 20000 * 26 = Rs. 520,000 (15 over here represents half of the month)
  • Rs. 10 lakhs (Maximum allowed gratuity)
  • Rs. 7 lakhs (Amount Sohini actually received)

We can clearly see that Rs. 5.2 lakhs is the lowest among these and thus it will be the amount that is exempt from taxes. Now Sohini has to pay taxes on the remaining Rs. 1.8 lakhs based on her applicable tax slab. The additional amount of Rs.1.8 lakhs is considered as “Income from salaries” for the purposes of taxation.

Withdrawal Limit Extension

The Labor Ministry and representatives from the state and central government employees and employers recently took a decision to increase the withdrawal limit for gratuity. The new limit for gratuity withdrawal was bumped up to Rs. 20 lakhs. Along with it, the tax-free limit for gratuity withdrawal has also been increased to Rs. 20 lakhs. The earlier limit was set at Rs. 10 lakhs, meaning one would withdraw gratuity of up to Rs. 10 lakhs without paying any taxes (subject to clauses mentioned earlier). The same has now been revised to Rs. 20 lakhs.

Let us consider the example of Ritika who earns a salary of Rs. 80,000 per month and is retiring from after a service of 25 years with her current organisation. On her retirement, she receives a gratuity of Rs. 13 lakhs from her employer. As described earlier, the amount exempt from taxes is one among the following:

  • (80000/26)*15*25 = Rs. 11,53,846
  • Rs. 10 lakhs is the maximum cap set.
  • Rs. 13 lakhs – Total gratuity received.

In this case, Ritika can claim up to Rs. 10 lakhs without paying any taxes and she has to pay taxes on the remaining Rs. 3 lakhs she received as gratuity. This remaining Rs. 3 lakhs is usually paid out by employers as a bonus or ex-gratia amount.

But once the new exemption laws kick in, the scenario changes a bit. Instead of paying taxes on the entire Rs. 3 lakhs, she would have to pay taxes only on the balance amount Rs. 146,154 (13,00,000 – 11,53,846).

If Ritika was working for organization that is not covered under Payment of Gratuity Act, the calculations would look like the following.

  • 40000 * 25 = Rs. 10 lakhs (half of previous 10 months average salary multiplied by term)
  • Rs. 10 lakhs – maximum cap set.
  • Rs. 13 lakhs – Total gratuity received.

As per the new exemption laws, Ritika can claim up to Rs. 10 lakh gratuity as tax free and pay taxes only on the additional Rs. 3 lakhs as applicable.

The extended withdrawal limit would mean that people benefit from higher amount of tax exemption on their applicable gratuity amount. The new laws would be valid for state government and central government employees. It would also stand good for employers who are covered under the Payment of the Gratuity Act as well as employers who are not covered under the same.

Employer has the right to cancel gratuity amount if an employee is terminated due a few specified reasons. In case of death of an employee, the legal heirs stand to receive the gratuity amount. The calculation of taxes on gratuity amount would still be valid for the receiver. The amount would be categorized as “income from other sources”. The new law, as it stands at this point, would benefit the employees who have performed long years of service in the past.

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