Income Tax Rules for Gratuity Exemption in India

What Is Gratuity?

Gratuity is paid to the employee from the employer after a long period of service to acknowledge and appreciate their continuous service. It is a lump sum amount and is paid when an employee goes through the following situations:

• Retires from employment
• Resigns after completing the minimum service requirement
• Becomes disabled due to illness or accident
• Passes away (in this case, it is paid to the nominee or legal heir)

Gratuity is added to the statutory benefits and is paid under the Payment of Gratuity Act, 1972. The Gratuity Act applies to organisations with ten or more employees.

Eligibility for Gratuity

The employees need to complete 5 years of service at an organisation to be eligible for gratuity. But the 5-year service requirement can be overlooked under the following circumstances:

• The employee's death
• Permanent disability of the employee due to an accident or illness

In such cases, gratuity becomes payable to the nominee or family members regardless of service duration.

How Gratuity Is Calculated

The gratuity is dependent on the employee's last salary and the years of service they have completed at the organisation. Here is the formula to calculate the gratuity under the Payment of Gratuity Act:

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

Where:

• Last Drawn Salary includes basic salary plus dearness allowance
• 15 represents 15 days of salary for each year of service
• 26 represents the number of working days in a month

Example

If an employee has completed 20 years of service with a salary of ₹50,000, this is the following calculation:

Gratuity = (50,000 × 15 × 20) ÷ 26
Gratuity ≈ ₹5,76,923

Income Tax Rules for Gratuity Exemption

The Government partially or fully exempts the gratuity from taxes depending on the type of employment and the amount received. The Income Tax Act talks about the exemption rules under Section 10(10). The employees are divided into these 3 categories for tax purposes.

1. Government employees
2. Employees covered under the Payment of Gratuity Act
3. Employees not covered under the Act

Tax Treatment for Government Employees

For the government employees who are working in the central and state governments:

• Gratuity received upon retirement or death is fully exempt from tax

This gratuity income tax exemption applies regardless of the amount received. Gratuity received by government employees is fully exempt from tax. Employees of public sector undertakings (PSUs) are generally treated as non-government employees, and their exemption is subject to applicable limits under income tax rules.

Tax Rules for Employees Covered Under the Gratuity Act

For employees covered under the Payment of Gratuity Act, the exemption is limited to the least of the following three amounts:

1. ₹20 lakh (maximum statutory exemption limit)
2. Actual gratuity received
3. Gratuity calculated using the statutory formula

Gratuity formula under the Act:

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

Any amount exceeding the eligible exemption limit becomes taxable under the head Income from Salary.

Tax Rules for Employees Not Covered Under the Gratuity Act

For employees not covered by the Act, the exemption calculation differs. The Gratuity income tax exemption is the least of the following:

1. ₹20 lakh
2. Actual gratuity received
3. Half a month's salary for each completed year of service

For this category, the formula is:

Gratuity = (Average Salary of Last 10 Months × 1/2 × Years of Service)

Here, the average salary includes basic salary, dearness allowance (to the extent it forms part of retirement benefits), and commission based on a fixed percentage of turnover.

Maximum Gratuity Income Tax Exemption Limit

The government increased the maximum tax-free gratuity limit to ₹20 lakh. This tax-free limit of ₹20 lakh is the maximum exemption allowed per individual across all employers during their lifetime. If the employee is receiving the gratuity from multiple employers, the combined exemption should not exceed this limit, and any amount that exceeds ₹20 lakhs is taxable according to the income tax rules.

Taxation of Excess Gratuity Amount

The employees can be eligible for gratuity relief under section 89 of the Income Tax Act, which helps reduce the tax burden on lump sum payments that are received. Here is what to do if the gratuity amount exceeds the exemption.

• The excess amount from the gratuity is added to the taxable income of the employee
• The added excess is then taxed as per the applicable income tax slab

Tax Relief Under Section 89

Section 89 provides relief when an employee receives salary or benefits relating to earlier years in a lump sum.

Since gratuity is accumulated over several years but paid at once, this provision allows taxpayers to spread the tax impact over previous years for calculation purposes. It can reduce the tax amount for individuals who are receiving large amounts of gratuity payments.

Gratuity for Private Sector Employees

The gratuity taxation for the private sector employees depends on which category is applicable to them, and most of the medium- and large-sized organisations are covered under the act, making calculation and tax exemption rules simpler. Here are the categories the private sector employees fall into:

• Covered under the Payment of Gratuity Act
• Not covered under the Act

The employees are required to check their employer's coverage status to determine how they will be taxed.

Gratuity and Nominee Payments

If an employee passes away while in service, gratuity is paid to the nominee or legal heir. To ensure that their family is not left to pay the taxes during financially difficult times after the employee's death, the government approaches it in the following way:

• Gratuity received by a nominee or legal heir on the death of an employee is generally exempt from income tax

Difference Between Gratuity and Other Retirement Benefits

Gratuity is different from other retirement benefits. Here is a table talking about it:

Importance of Understanding Income Tax Rules for Gratuity

It is important for the employee to be aware of the income tax rules to have a clear idea of which ones apply to them:

• To estimate your post-retirement income accurately
• To avoid unexpected taxation
• To optimise tax relief benefits
• To plan investments using retirement proceeds

Common Mistakes Employees Should Avoid

The employees can make a few mistakes when they are managing gratuity taxes, and being aware of the rules can help them avoid tax compliance issues by:

• The employees may assume the entire gratuity amount is tax-free
• The employees ignore the ₹20 lakh exemption cap
• Not claiming Section 89 relief
• Not including the taxable portion in the income tax returns
• Misunderstanding coverage under the Gratuity Act

Conclusion

The employees can use gratuity as a solid retirement benefit and use its beneficial nature to its full extent. The taxation of the gratuity amounts relies on many factors, which include the employee's category and the amount they received.

The income tax rules that were placed to keep the exemption in check ensure the employees are receiving stable tax relief without breaking the compliance rules in the statutory limit. The employees need to understand the eligibility conditions, exemption limits and calculation methods to make better decisions and plan their retirement comfortably.