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A Comprehensive Guide on How to Calculate Gratuity

28 Jul 2023

Introduction

Gratuity is a monetary benefit that an employer pays an employee for the services rendered to the organisation. It is a form of gratitude from the employer to the employee for their loyalty and contribution. The Payment of Gratuity Act 1972 outlines the gratuity provisions, setting forth guidelines for eligibility, calculation, and taxation of this benefit.

Whether you are an employer looking to comply with labour laws or an employee planning for a secure future, this guide will equip you with knowledge of gratuity calculations.

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Gratuity Eligibility Criteria

According to the Act, employees who have completed at least five years of continuous service with an organisation are eligible for gratuity. The term 'employee' covers any person employed on wages, whether in a managerial, administrative, or technical capacity. 'Continuous service' means uninterrupted service, except for absence due to sickness, accident, leave, lay-off, strike, or lock-out.

However, there are some exceptions to the five-year rule. An employee can also claim gratuity before completing five years of service if:

  • They retire from service.
  • He or she resigns due to permanent disability caused by an accident or disease.
  • He or she dies while in service (in this case, the gratuity is payable to the nominee or legal heir).

The Payment of Gratuity Act applies to every establishment where ten or more persons are employed on any day of the last 12 months. It also applies to factories, mines, shops, oilfields, plantations, ports, railways, and other establishments notified by the Central Government.

How to Calculate Gratuity?

The formula for calculating gratuity depends on whether the employer falls under the provisions of the Payment of Gratuity Act. 

If the employer falls under the Act, then the gratuity amount is calculated as follows:

Gratuity = (15 x Last drawn salary x Number of years of service) / 26

In this formula:

  • Last drawn salary = Basic salary + Dearness allowance
  • Number of years of service = Completed years of service rounded off to the nearest integer
  • 26 = Number of working days in a month as per the Act

For example, if you have worked with an organisation for 10 years and 7 months, and your last drawn basic salary plus dearness allowance was Rs. 50,000, then your gratuity amount will be:

Gratuity = (15 x 50,000 x 11) / 26 = Rs. 3,17,307

Note: As per the Act, the maximum gratuity payable to an employee is Rs. 20 lakhs. Any amount exceeding this limit will be treated as ex-gratia and taxed accordingly.

If the employer does not fall under the Act, then the gratuity amount is calculated as follows:

Gratuity = (15 x Last drawn salary x Number of years of service) / 30

In this formula:

  • Last drawn salary = Basic salary + Dearness allowance
  • Number of years of service = Completed years of service without rounding off
  • 15 = Half-month's salary as per the employer's policy
  • 30 = Number of days in a month as per the employer's policy

For example, if you have worked with an organisation for 10 years and 7 months, and your last drawn basic salary plus dearness allowance was Rs. 50,000, then your gratuity amount will be:

Gratuity = (15 x 50,000 x 10.58) / 30 = Rs. 2,64,500

Note: There is no upper limit on the gratuity payable to an employee if the employer does not fall under the Act.

How is Gratuity Taxed?

The tax treatment of gratuity depends on whether you are a government or non-government employee.

  • If you are a government employee (central or state), your entire gratuity amount is exempt from tax under Section 10(10) of the Income Tax Act.
  • If you are a non-government employee and your employer fall under the Payment of Gratuity Act, then your gratuity amount is exempt from tax up to the least of the following three limits:

- Rs. 20 lakh

- Actual gratuity received

- Last drawn salary (for 15 days) x Number of years of service


If you are a non-government employee and your employer fall under the Payment of Gratuity Act, then your gratuity amount is exempt from tax up to the least of the following three limits:

- Rs. 10 lakh

- Actual gratuity received

- Average salary for last 10 months x Number of years of service

Conclusion

Gratuity is a valuable benefit that rewards you for your long-term service to an organisation. It is essential to understand how it is calculated, taxed and claimed so that you can plan your finances accordingly. You can use online tools like Gratuity Calculator to estimate your gratuity amount based on your salary and service tenure. You can also consult a tax expert or a financial planner to optimise your tax savings and investment options for your gratuity income.

 

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