What is Gratuity in a salary: Calculation and Eligibility

Loyalty is rarely unrewarded. If you stay invested long-term, many investment instruments can earn returns and help you build a wealth corpus. Similarly, if you stay with one employer for years, the employer may provide several benefits as a token of appreciation. If you are awarded monetary benefits, it is called gratuity.

Although gratuity is a familiar term, some confusion still exists. For example, many wonder if employers are required to pay gratuity or if it is optional. Does the employer pay gratuity out of their own pocket, or is there an employee contribution? Let us find out.

What is gratuity?
 

Gratuity is a monetary reward given by employers to employees as a token of appreciation for their long-term service. Governed by the Payment of Gratuity Act, 1972, gratuity is a legal obligation for employers in India.

In simple words, gratuity represents a financial thank-you for an employee's dedication and loyalty. Employers typically pay gratuity either directly from their funds or through a gratuity insurance plan. In the latter case, an insurance company disburses the payment when the employee qualifies. To be eligible for gratuity, an employee must complete at least five years of continuous service with the same employer. This benefit is also provided in cases of retirement, resignation after the stipulated period, or unfortunate events like the employee's death or disability.

How does gratuity work?
 

When an employee joins a company, they are automatically enrolled in the organisation’s gratuity scheme. At the time of their exit, whether due to resignation, retirement, or unfortunate circumstances like death or disability, the gratuity process begins automatically. Employers may either fund gratuity directly from their reserves or manage it through a specialised insurance provider.

The employee or nominee (in case of death) typically submits a formal claim or application. The employer then calculates the amount and communicates the lump-sum payment to the employee.

Keep in mind that if the employee leaves before meeting the eligibility criteria, they forfeit the gratuity.

Key purpose of gratuity
 

Gratuity acts as more than just critical financial support. Its primary purposes include:

• Recognising loyalty: Acknowledging long-term dedication and commitment by employees.
• Promoting financial security: Providing a financial cushion after retirement, resignation, or unforeseen events.
• Supporting families: Offering immediate support to families in case of an employee’s untimely demise.
• Building stronger relationships: Encouraging employees to stay longer with the organisation.

Advantages of gratuity 
 

Gratuity benefits employees in multiple ways:

• Guaranteed post-employment benefit: Employees receive a legally entitled payout after fulfilling minimum service requirements.
• Partial tax exemption: A tax-free portion of gratuity increases the final earnings an employee receives upon leaving the organisation.
• Financial planning support: Gratuity contributes to building a broader retirement plan along with provident fund and pension savings.
• Predictable legal entitlement: Unlike bonuses, gratuity is governed by law, which means you, as an employee, have clarity on future payouts.

Eligibility criteria for gratuity
 

· Continuous service: Completion of at least five years with the same employer.

· Retirement or superannuation: Eligibility upon retirement or superannuation.

· Resignation: Leaving the organisation after fulfilling the five-year requirement.

· Death or disability: Payment to the employee’s nominee if they pass away or suffer a disability.

Understanding Gratuity Act, 1972
 

The Payment of Gratuity Act, 1972, governs gratuity payments in India. The act aims to provide financial security to employees who dedicate several years to one organisation.

Key highlights of the act include:

• Applicability to establishments with 10 or more employees.
• The five-year continuous service rule does not apply in case of an employee's death or disablement.
• Penalties for employers failing to pay gratuity within 30 days of it becoming due.
• Protection of gratuity from being forfeited except in cases involving employee misconduct.

Understanding the act helps employees know their rights, and employers meet their obligations responsibly. 

Calculating gratuity
 

Gratuity calculations depend on your last drawn salary and years of service. The formula differs slightly based on whether your employer falls under the Gratuity Act. Let’s look at both scenarios carefully:

Calculation of gratuity for employees covered under the Gratuity Act
 

If your organisation falls under the Gratuity Act, use this formula:

Gratuity = (15 x last drawn salary x years of service) ÷ 26

Where: 

• Last drawn salary includes basic salary and dearness allowance
• 15 represents 15 days’ salary for each completed year
• 26 denotes the number of working days in a month

For example, if your last drawn salary is ₹50,000, and you have worked for 10 years, the gratuity would be:

(50,000 × 15 × 10) ÷ 26 = ₹2,88,461.54 (around 2.8 lakh)

Calculation of gratuity for the employees not covered under the Gratuity Act
 

The formula used here is:

Gratuity = (15 x last drawn salary x years of service) ÷ 30

In this formula:

• 30 represents the total days in a month, unlike 26 working days.

So, for a last drawn salary of ₹50,000 and 10 years of service, gratuity would be:

(15 × 50,000 x 10) ÷ 30 = ₹2,50,000

Thus, gratuity is slightly lower in this scenario.

Gratuity calculation in case of death of an employee
 

In case an employee passes away during service, gratuity depends on the years served but follows a fixed slab structure:

The family or nominee receives this amount directly.

Is gratuity taxable?
 

Let’s understand how taxation works on gratuity:

Tax on gratuity
 

Gratuity received by employees may attract income tax depending on the category of employment and the amount received.

• For government as well as private-sector employees, gratuity becomes taxable if it exceeds the prescribed exemption limit.
• Any taxable portion is added to the employee’s income under the head “Income from Salary” and taxed according to the applicable slab rate.

Tax exemptions on gratuity
 

Government employees: Tax exemption on gratuity is now up to ₹25 lakh (Before January 1, 2024, it was ₹20 lakh).

Private-sector employees covered under the act: Exemption depends on the least of:

·       Eligible gratuity (as per the formula above)

• Actual gratuity received
• ₹20 lakh

Private-sector employees not covered under the act: Exemption depends on the least of:

• ₹20 lakh
• Actual gratuity received
• Half month's salary for each completed year of service is exempt.

The remaining amount, if any, is taxed under “Income from Salaries” according to the applicable slab rate.

Maximum limit on gratuity amount
 

As discussed earlier, for central government employees, the maximum gratuity exemption limit is ₹25 lakh. For private sector employees, the maximum tax-free gratuity limit remains ₹20 lakh. Any amount above this is considered ex-gratia, which is voluntary and not legally enforced.

To simplify gratuity and financial planning, you can also use a gratuity calculator online. Just input the following basic details, and the calculator does the math:  

• Employment period: It's vital to record exact years and months of service for precise calculations.
• Monthly salary: Enter your final salary. This figure typically combines basic pay and daily allowance (DA).
• Commission on sales: For those earning sales incentives, it's crucial to add this monthly sum.

After inputting all these details, the calculator shows an estimated gratuity amount and reveals what you can anticipate from your employer.

Gratuity rules
 

In India, gratuity on salary becomes payable when an employee ends their employment after continuous service of at least five years. This payment occurs upon superannuation, retirement, resignation, or due to an employee's death or disablement in an accident or disease. Notably, the five-year requirement does not apply in cases of death or disablement.

For situations involving death or disability from accidents or illness, the nominee or legal heir gets the payment. If this nominee stands as a minor, the assistant labour commissioner invests the money in a term deposit in a nationalised bank until the minor reaches adulthood.

Employees eligible for gratuity can apply within 30 days of its payability. If they know their retirement or superannuation date, they may apply even earlier. A delay in application doesn't invalidate the claim, provided there's a genuine reason for the delay. The employer has an obligation to disburse the gratuity amount within 30 days of its payability.

For claims made by a nominee or heir, the employer might seek evidence or a witness to confirm the identity of the claimant or the authenticity of the claim. Upon getting the evidence, the employer acknowledges the claim.

Conclusion
 

Gratuity in salary is a significant component of an employee's compensation structure. It is a testament to an employee's dedication and years of service. It signifies the employer's acknowledgement of the value that long-term employees bring. This financial token appreciates years of hard work and fortifies the employee's financial future. 

Speaking of securing your future, proactive financial planning with reliable salary accounts [KM1] is also beneficial. With an IDFC FIRST Bank Corporate Salary Account, you can enjoy higher interest rates, monthly interest payouts to grow your wealth faster, and avail all common salary account services completely free of cost. These features  greatly amplify your savings over time. In addition, you enjoy a higher daily transaction limit of ₹6 lakhs and cash withdrawal limit of ₹2 lakhs to effectively manage your expenses and enjoy exclusive access to 20+ OTT platforms and attractive discounts across 40 brands with Times Prime. 

Combined with unmatched convenience and the mobile banking app, it becomes the perfect financial companion. Its value-added features complement modern lifestyles and offer more than just a safe haven for your funds.