The Union Cabinet recently approved a proposal to enhance the limit of tax-free gratuity to Rs20 lakh, from Rs10 lakh. The proposal will need parliamentary approval to come into force.

Once approved by the Parliament, this will come as a major relief, especially to those who spend many years working in a single organisation, which results in a significant amount in gratuity.

Most employees do not have a clear understanding of gratuity. In most cases, the amount you receive as salary is less than what’s mentioned in the joining letter from the organisation you work for. This is because the full amount also includes components like contribution to retirement benefits such as provident fund and gratuity. Read on to understand some more important basics about gratuity.

What is gratuity?

It is a defined benefit, which means that the payment, based on a certain defined formula, will be guaranteed if the basic conditions are met. In India, gratuity is a benefit offered by organisations employing more than 10 employees, according to the Payment of Gratuity Act, 1972.

According to the law, an organisation has to pay gratuity to an employee who has served it continuously for at least 5 years. For each year of service, the organisation has to pay an amount equalling 15 days of last drawn salary. Salary here means basic salary plus dearness allowance plus commission, if commission is a fixed percentage of sales. Moreover, if a person works for over 6 months in the last year of service, it will be considered as a complete year for gratuity calculation. For instance, if a person completes 7 years and 6 months of continuous service, gratuity paid will be for 8 years.

For gratuity calculations, a month of work is calculated as 26 days. So the 15-day salary will be calculated as (monthly salary*15)/26. This number multiplied by the number of years in service will be the gratuity amount payable.

A similar calculation applies if gratuity is to be paid at retirement.

In case an employee dies, the minimum 5 year-service clause is not applicable and the amount accrued is to be paid to the nominee or legal heir of the employee. All these payments are to be made within 30 days of the last working day of the employee. If the payment is delayed beyond 30 days, the law states that the employer will have to pay an interest on the amount.

The employer is expected to pay the gratuity either from its own funds or from a group gratuity scheme, where an insurance company manages the gratuity fund. The organisation deposits the gratuity amount with the insurer, which is then invested to earn returns. Typically, this amount is invested in fixed income or debt instruments to avoid the risk of market volatility.

How is gratuity amount taxed?

Under the income Tax Act, gratuity is taxed under the head ‘income from salary’. The portion of salary received as gratuity can be exempt from tax under section 10(10) of the Income-tax Act, 1961, depending on various factors. But if gratuity is received by an employee of a central, state or local government agency, it is fully exempt when withdrawn on death or retirement.

Under the current regime, where the Payment of Gratuity Act is applicable, the least of the following received by the employee is exempt from tax: Rs10 lakh; actual gratuity received; or 15 days’ salary based on the salary last drawn multiplied by the number of years in employment.

In case of death of an employee and gratuity being paid to the nominee or legal heir, the tax exemption will remain the same, but the income will be considered under the head of ‘income from other sources’.

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