What is Gratuity | How to Calculate Gratuity Amount?

Gratuity is a sum of money that a company pays to an employee for services rendered in the company. It is one of the many benefits paid to the employee upon leaving his/her job for various reasons. It is paid only to those employees who complete 5 or more years with the company. It is an important form of social security benefit payable under the Payment of Gratuity Act passed in the year 1972.

Eligibility for Gratuity Payment

An employee is eligible for gratuity under the Gratuity Act if he/she has completed 5 or more years with the company, except in case an employee expires or suffers disability due to accident or illness. The company needs to have at least 10 employees so that they can pay gratuity to eligible employees.

Gratuity is paid when

1. An employee is eligible for superannuation

2. An employee retires

3. An employee resigns

4. An employee expires or suffers disability due to accident or illness (if an employee expires, it will be paid to the employee’s nominee)

The Payment of Gratuity Act, 1972

This Act was passed by the Indian Parliament on 21 August 1972 and came in force on 16 September 1972. It covers employees engaged in factories, mines, oilfields, plantations, ports, railway companies, shops and other establishments which have more than ten employees. The gratuity amount is fully paid by the employer without any contribution from the employee’s salary. All types of government jobs come under this Act.

How does Gratuity Payment Work?

An employer may offer a gratuity to his/her employees from his/her own funds or may purchase a group gratuity plan from an insurance provider. The employer has to pay annual contributions to the insurance provider for this gratuity plan. The employee is also free to make contributions to his/her fund. The gratuity paid by the insurance provider is based on the terms of the group insurance scheme.

How Gratuity is calculated?

The gratuity amount depends upon the length of service and last drawn salary. It is paid for 15 days of every completed year of service. If you have worked for more than six months in a year, it would be treated as one completed year. It means if you have worked 8 years and 6 months, it would be considered as 9 years for calculations. On another hand, if you have worked 8 years and 5 months, it would be considered as 8 years for calculations. Below is the formula for calculation of gratuity amount

Gratuity = [Last Drawn Salary X 15 Days X No. of Years of service] / 26

Last Drawn Salary = Basic salary + Dearness Allowance.

Income Tax Exemption on Gratuity payment

For the purpose of calculation of Income Tax Exemption on gratuity, employees may be divided into 3 categories.

1. Government employees

2. Non-government employees covered under the Payment of Gratuity Act, 1972

3. Non-government employees not covered under the Payment of Gratuity Act, 1972

In the case of Government Employee

The entire amount of gratuity received by an employee of the central government, state government or local authority, on retirement or death is fully exempt from tax.

In case of an employee where the employer is covered by the Payment of Gratuity Act, 1972

The least of the three below is exempt from tax:

1. The amount actually received

2. Rs 20,00,000

3. 15 days salary for every completed year of service or part thereof in excess of 6 months.

In case of an employee where the employer is not covered by the Payment of Gratuity Act, 1972

The least of the three below is exempt from tax:

1. The amount actually received

2. Rs 10,00,000

3. Half month’s average salary (average salary of the 10 months immediately before the month in which the person retires) for every completed year of service (no part thereof).

Notable Points

1. The employer has the right to reject payment of Gratuity to the employee if the employee’s services have been terminated due to any misconduct.

2. If an employee expires, gratuity amount will be paid to the employee’s nominee or the legal heir of the employee.

3. The employer has a time period of 30 days to pay the gratuity amount to the individual from the date it is billed.

4. Rs. 20 lakhs is the maximum amount that can be paid as a gratuity to government employees.

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