Gratuity

What Is Gratuity? A Simple Guide to Calculation & Benefits

Gratuity is a monetary benefit provided by employers to employees as recognition for their long-term service to an organization. It represents a financial token of appreciation that acknowledges an employee’s dedication and loyalty over the years. This lump-sum payment serves as a financial safeguard for employees during their retirement or when they leave the organization.

As a component of an employee’s gross salary, gratuity differs from regular compensation since it is not paid periodically but rather as a one-time payment when the employee departs from the organization. The amount varies from person to person based on the employer’s policies and is typically calculated as a percentage of the employee’s total wages or salary for their entire period of service.

The Payment of Gratuity Act, 1972, which was passed by the Indian Parliament on August 21, 1972, and implemented on September 16 of the same year, governs gratuity payments in India. This legislation mandates gratuity payments as a legal obligation for employers covered under the Act. The law applies to all central and state government departments, defense establishments, local governing bodies, railways, ports, mines, oilfields, plantations, and factories. Additionally, private organizations employing 10 or more people during the preceding 12 months also fall under its purview.

Generally, employees become eligible for gratuity after completing a minimum of five years of continuous service with the same employer. However, this requirement is waived in specific circumstances such as an employee’s death or disability due to accident or disease. In such cases, the gratuity amount is provided to the employee’s nominee.

Employers may choose to pay gratuity directly from their funds or through a gratuity insurance plan. When using insurance, the insurance company disburses the payment once the employee qualifies for the benefit. This arrangement helps organizations manage their financial obligations while ensuring employees receive their entitled benefits.

Gratuity payments significantly enhance an employee’s retirement planning by providing a substantial lump-sum amount upon completion of the required service period. The calculation of gratuity is based on the employee’s salary and follows specific formulas outlined in the Act. Though the exact amount differs based on employment terms and company policies, the standard calculation typically involves 15 days of wages for each completed year of service.

For organizations not covered under the Act, gratuity payments remain optional rather than mandatory. Nevertheless, many such employers still choose to offer gratuity benefits as part of their employee compensation packages to recognize long-term service and foster loyalty.

In essence, gratuity represents a significant financial benefit that rewards employees for their sustained contribution to an organization while providing them with financial support for their post-employment phase. The specific terms, calculation methods, and tax implications of gratuity payments are governed by relevant legislation and vary according to employment contexts and organizational policies.

Who is eligible for gratuity?

Employees must meet specific criteria to qualify for gratuity benefits under Indian law. The primary requirement is the completion of at least five years of continuous service with the same employer. This five-year rule forms the foundation of gratuity eligibility, establishing a threshold that rewards long-term commitment to an organization.

Notably, certain exceptions exist to this five-year requirement. The completion of continuous service is not necessary if employment termination results from death or disablement due to accident or disease. In such unfortunate circumstances, the gratuity becomes payable to the employee’s nominee or, if no nomination exists, to their heirs.

The Payment of Gratuity Act applies to various employment sectors, including factories, mines, oil fields, plantations, ports, railways, motor transport undertakings, companies, shops, and other establishments employing 10 or more workers. Furthermore, if an organization employed 10 or more individuals on any day in the preceding 12 months, it becomes liable to pay gratuity. Even if the workforce subsequently decreases below this threshold, the organization remains obligated to fulfill its gratuity payment responsibilities.

For calculating the completion of five years of continuous service, a year constitutes:

• 240 working days for employees in most establishments
• 190 working days for employees working in mines and similar fields

Continuous service encompasses periods of interruption caused by legitimate absences such as strikes, lockouts, accidents, authorized leaves, layoffs, and termination not initiated by the employee. This inclusive definition ensures that reasonable work interruptions do not disqualify employees from receiving their rightful benefits.

Upon meeting eligibility requirements, gratuity becomes payable in several situations:

• Superannuation
• Retirement or resignation
• Death or disablement due to accident or disease
• Termination of employment
• Voluntary retirement scheme
• Layoff due to retrenchment

The gratuity amount payable to an eligible employee shall not exceed three lakhs and fifty thousand rupees, although for central government employees, this limit has been increased to ₹25 lakh.

For employees in seasonal establishments who do not work throughout the year, employers must pay gratuity at the rate of seven days’ wages for each season. This special provision recognizes the unique employment patterns in seasonal industries while ensuring workers receive appropriate benefits.

Employees working under fixed-term contracts may be excluded from gratuity eligibility unless their contract specifically states otherwise. Moreover, gratuity may be denied in cases of misconduct or certain offenses committed by the employee.

To claim gratuity benefits, employees must submit a formal application to their employer, typically using Form I. If the employer fails to disburse the gratuity amount within 30 days after employment termination, they become liable to pay interest as specified by government regulations.

How is gratuity calculated?

The calculation of gratuity follows specific formulas determined by whether an employer falls under the Payment of Gratuity Act, 1972. These calculations account for an employee’s tenure and salary components to determine the final gratuity amount.

Gratuity calculation formula under the Act

For employees whose organizations are covered under the Payment of Gratuity Act (those with 10 or more employees in a single day during the preceding 12 months), the formula is:

Gratuity = (15 × Last Drawn Salary × Number of Completed Years of Service) ÷ 26

In this formula, “last drawn salary” exclusively includes basic salary plus dearness allowance (DA). Any other income components are not considered for calculation purposes. The denominator 26 represents the standard number of working days in a month under the Act.

Regarding service duration, any period exceeding six months is rounded up to a full year. For instance, if an employee worked for 12 years and 8 months, their tenure would be calculated as 13 years for gratuity purposes. Conversely, employment of 12 years and 3 months would count as 12 years.

Formula for non-covered employees

For organizations not covered under the Payment of Gratuity Act, a different formula applies:

Gratuity = (15 × Last Drawn Salary × Number of Years of Service) ÷ 30

The primary difference lies in the denominator—30 days instead of 26—resulting in a slightly reduced gratuity amount. For these organizations, salary calculation may include basic salary, DA, and commissions received on sales. Unlike the covered formula, only completed years are considered without rounding partial periods.

Example calculation

To demonstrate both formulas in practice:

Example 1 (Under the Act): Consider an employee with a last drawn salary of ₹77,000 who has worked for 12 years and 8 months. As this exceeds 6 months beyond 12 years, we count it as 13 years.

Gratuity = (15 × 77,000 × 13) ÷ 26 = ₹5,77,500

Example 2 (Not Under the Act): For an employee with an average salary of ₹80,000 over the last 10 months who worked for 10 years and 4 months:

Gratuity = (15 × 80,000 × 10) ÷ 30 = ₹4,00,000

The 4 months are not counted because they’re below 5 months, so the service period remains 10 years. Had it been more than 5 months, it would have been rounded to 11 years.

The calculation demonstrates why employees covered under the Act receive higher benefits—primarily because of the lower denominator (26 versus 30), which results in a larger gratuity amount.

What is the Payment of Gratuity Act, 1972?

The Payment of Gratuity Act, 1972 represents a pivotal social security legislation enacted by the Parliament of India on August 21, 1972, and implemented on September 16 of the same year. This statute establishes a comprehensive framework mandating gratuity payments to employees across various sectors throughout India.

Fundamentally, the Act functions as a social security measure designed to provide welfare benefits to employees working in industries, companies, and organizations. It creates a uniform pattern for gratuity payments nationwide, thereby preventing disparate treatment of employees who may transfer between states due to service requirements.

The legislation extends its jurisdiction to all divisions of central, state, and local governments, alongside military establishments and local governing bodies. Private organizations may fall under its purview upon meeting specific criteria. Particularly, the Act applies to factories, mines, oilfields, plantations, ports, railway companies, and establishments employing ten or more persons on any day during the preceding twelve months.

Importantly, once an establishment becomes subject to this Act, it continues to be governed by these regulations even if employee numbers subsequently fall below ten. The Act mandates a payment equivalent to 15 days’ wages for every completed year of service, or partial year exceeding six months.

The core objectives behind this legislation include:

• Making employees financially secure upon retirement or service termination
• Ensuring uniform gratuity payment standards across all industries
• Establishing a consistent computation framework and eligibility criteria

Through this Act, gratuity transforms from a discretionary benefit into a statutory right, compelling employers to acknowledge and monetarily appreciate an employee’s long-term service and dedication. This recognition comes in the form of a lump sum payment that supports employees during their post-employment phase.

The legislation categorically defines relevant terms including “continuous service,” “employee,” “employer,” and specifies the controlling authorities responsible for overseeing implementation. It meticulously outlines the calculation methodology, payment procedures, and protection mechanisms to safeguard employee interests regarding their gratuity entitlements.

Is gratuity taxable in India?

Gratuity received in India is subject to income tax regulations with specific exemptions outlined in the Income Tax Act, 1961. The tax treatment varies based on employment sector and circumstances of receipt, with different rules applying to government versus private sector employees.

Tax exemption under Section 10(10)

The Central Board of Direct Taxes (CBDT) issued Notification No. S.O. 1213(E) on March 8, 2019, increasing the maximum tax-exempt gratuity amount from ₹10 lakh to ₹20 lakh. This enhanced exemption applies exclusively to gratuity payments made for events occurring on or after March 29, 2018. The qualifying events include:

• Retirement
• Death
• Resignation
• Disablement due to injury or illness

Any amount received as gratuity becomes taxable as income under the head “Salaries” for employees. In case of an employee’s death, the gratuity paid to nominees or legal heirs is treated as their income under “Income from Other Sources”.

Taxation for government vs private employees

For government employees, including central and state government staff, defense personnel, and employees of local authorities, gratuity received upon superannuation, retirement, or termination is fully exempt from income tax regardless of the amount.

Conversely, taxation for private sector employees depends on whether they fall under the Payment of Gratuity Act, 1972:

For employees covered by the Act, the least of these three amounts is tax-exempt:

• Actual gratuity received
• 15 days’ salary for each year of service (calculated as last drawn salary × years of employment × 15/26)
• ₹20 lakh

For employees not covered by the Act, the tax-exempt amount is the least of:

• Actual gratuity received
• Average salary of last 10 months × years of service × ½
• ₹20 lakh [53]

Essentially, any gratuity amount exceeding the applicable exemption limit becomes taxable income. Proper calculation of the tax-exempt portion remains crucial for accurate financial planning and tax compliance. Private sector employees typically face more complex tax treatment compared to their government counterparts, yet both benefit from significant tax advantages designed to preserve the financial security provided by gratuity benefits.

How to claim your gratuity amount?

Claiming gratuity involves a straightforward process that must be completed properly to ensure timely disbursement. Once eligible, employees must follow a systematic procedure to receive their gratuity amount from their employer.

Step 1: Submit application to employer

The claiming process begins with submitting a formal application to the employer. Eligible employees or their authorized representatives must apply within 30 days from the date when gratuity becomes payable. Despite this timeframe, a claim remains valid even if filed after the stipulated period. For retirement or superannuation cases where the date is known in advance, employees may submit their application up to 30 days before this date. The application must be in the prescribed format, typically Form I, as mandated by regulations.

Step 2: Employer calculates and acknowledges

Upon receiving the application, the employer must acknowledge it and initiate the calculation process. The employer is obligated to determine the gratuity amount within 15 days of receiving the application. Alternatively, some sources indicate a 30-day timeframe for the employer to calculate the amount and issue a notice to both the employee and the controlling authority. This notice must specify the calculated gratuity amount. The calculation follows the standard formula based on the employee’s last drawn salary and years of service as per the provisions of the Gratuity Act.

Step 3: Payment within 30 days

After acknowledgment and calculation, the employer must disburse the gratuity amount within 30 days from the date of receiving the application. Should the employer fail to meet this deadline, they become liable to pay simple interest in addition to the gratuity amount. This interest accrues from the due date until the actual payment date at the rate notified by the Central Government for long-term deposits. Notably, this interest payment requirement may be waived if the delay results from the employee’s fault and the employer has obtained appropriate permission from the controlling authority. This defined payment period ensures employees receive their rightful gratuity promptly after becoming eligible.

Key Takeaways

Understanding gratuity is essential for both employees and employers in India, as it represents a significant financial benefit that rewards long-term service and provides retirement security.

• Gratuity eligibility requires 5 years of continuous service with the same employer, though exceptions apply for death or disability cases.

• Calculation formula varies by coverage: Organizations under the Act use (15 × salary × years) ÷ 26, while non-covered use ÷ 30 instead.

• Tax exemption limit is ₹20 lakh for private employees, while government employees enjoy complete tax exemption on gratuity payments.

• Claim within 30 days of eligibility and employers must pay within 30 days, or face interest penalties for delays.

• Coverage applies to organizations with 10+ employees during any day in the preceding 12 months, making it mandatory rather than optional.

The Payment of Gratuity Act, 1972 transforms gratuity from a discretionary benefit into a statutory right, ensuring financial security for employees who dedicate years of service to their organizations. Proper understanding of eligibility, calculation methods, and claiming procedures helps maximize this valuable retirement benefit.

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