Is Gratuity Taxable Under the Income Tax Act?

Gratuity is the amount paid to an employee at the time of retirement for their service to the company. In addition to being paid salaries from time to time, it is always nice when the employee’s efforts towards the company are acknowledged by the employer. Generally, gratuity is paid to the employee after the completion of a term of 5 years.

 

Furthermore, the question “ Is gratuity taxable? ” arises when the concept of gratuity is discussed. Gratuity is tax exempt up to a margin of Rs.20 Lakh as per the amendment that was recently approved. A deeper understanding of what gratuity is, what its eligibility criteria are, what the income tax levied on it is, etc will give you a clear picture of tax on gratuity in India. 

 

An employee puts in time and effort that contributes to the growth and development of a company, and therefore, deserves recognition that could be shown in the form of gratuity paid at the time of retirement. 

 

Earlier, gratuity was not a mandatory aspect but paid as a token of gratitude and appreciation for the services provided by the employee. However, the Payment of Gratuity Act of 1972 made it mandatory for companies to fulfill their obligation towards employees through the payment of gratuity at retirement. 

 

So, is gratuity taxable? This will require understanding how gratuity works and this article will give you a deeper understanding of the same. 

Gratuity doesn’t come under the purview of monthly payments of salary. It is paid on the occurrence of events mentioned below:

• Superannuation- When an employee has attained the age of retirement it is referred to as superannuation. 

• Resignation or retirement. 

• Disablement or death as a result of an accident or illness. In this case, the prescribed time frame of 5 years for the payment of gratuity will not be applicable. However, interns and temporary employees do not qualify to receive gratuity.

A company either pays gratuity out of its own budget or subscribes to a group insurance policy. Gratuity is often confused with Employee Provident Fund. However, the amount paid as gratuity to the employee is paid entirely by the employer. Gratuity is calculated as a percentage of the salary and is kept aside in a gratuity account that is payable to the employee at the time of retirement. Whereas, the Employee Provident Fund takes a part of the employee’s salary and accumulates it as savings for retirement. 

 

All businesses that have above ten employees are required to follow the Payment of Gratuity Act. The gratuity amount provided by the employer poses as a superannuation benefit for the employee leaving the company. In case of retirement, layoff, retirement/voluntary retirement, superannuation, disablement, termination, reduction or death, gratuity will be paid out to the employee. In the event of the death of the employee, the gratuity will be paid to the employee’s nominee.

The Central Board of Direct Taxation sent out a notification that clearly stated that the gratuity exemption limit has been increased to Rs.20 Lakh effective from 29th of March, 2018. Due to the rise in margin of the gratuity exemption limit, the gratuity amount on which tax is levied is reduced. This benefits employees who earn a higher salary and are close to retirement. Moreover, even employees who have a longer period of time left for their retirement, will stand to gain through the amendment. 

The answer to the question, “ Is the gratuity amount taxable?” can be understood through a thorough breakdown of the aspects of gratuity. The benefits of gratuity can be enjoyed by employees who have rendered their services to a company for a period of five or more years. However, in the case of the death or disability of the employee that prevents them from working further, the regulations surrounding the payment of gratuity are eased. 

The eligibility criteria for individuals to receive gratuity is as follows: 

• Must be an earning employee at a company 

• Must have rendered services for a period of at least five years at a company 

• Should have resigned or retired from the company 

• Should be qualified for superannuation/resignation. 

 

Additionally, the conditions for considering continuous employment is as follows:

• If an employee works for about 190 days at an organization that functions for 6 days or less a week or is a mine, it is considered as a year of continuous service. In any other instance, 240 days will be considered. 

• If an employee works for about 95 days at an organization that functions for 6 days or less a week or is a mine, it is considered as 6 months of continuous service. Under any other conditions, 120 days will be considered. 

• If an employee works for about 75% of the days while the organization is in function. This is applicable for seasonal employment cases.

Is Gratuity taxable or not? The gratuity paid to an employee is viewed as a portion of salary and is therefore, taxable under the Income Tax Act. However, the tax on gratuity is limited since the government offers exemptions on the tax on gratuity under certain conditions. If the person that’s supposed to receive the gratuity passes away, then in that case, the amount is given to the employee’s nominee. The nominee is liable to pay tax on the gratuity received that falls under the category of income from other sources while filing for income tax. 

The tax exemptions on gratuity differ on the basis of whether an employee is covered under the Payment of Gratuity Act or 1972 or not. The income tax exemptions can thus be categorized as follows:

• Tax exemptions on gratuity received by employees working in government sectors

• Tax exemptions on gratuity received by employees working in private sectors

1. Income Tax Exemptions on Gratuity Received by Employees of Government Sector

The gratuity provided to employees that work in a government sector and are on their retirement, termination or superannuation are fully exempted from paying tax. This is applicable to employees of state government, central government, defense sector and other local authorities. 

2. Income Tax Exemptions on Gratuity Received by Employees of Private Sector 

Is gratuity taxable for private employees? Well, that depends on whether the employees working in the private sector qualify under the Payment of Gratuity Act or not. Based on that criteria, tax exemptions are provided. 

3. IT Exemptions for Employees Covered Under the Payment of Gratuity Act

Employees that are covered under the Payment of Gratuity Act are exempted from paying taxes under selected conditions. Given below are possibilities among which the one that is the least is eligible for tax exemption:

• Gratuity of Rs.20 Lakhs

• Last salary received inclusive of basic salary plus dearness allowance(DA) multiplied by the duration of employment further multiplied by the number of working days in a month. 

• Actual gratuity amount received. 

 

If the gratuity amount paid to the employee exceeds the maximum limit, tax will be levied. 

 

Here’s an example to help you understand better:

Considering, Mr A receives a monthly salary of Rs.1,20,000 inclusive of basic salary and dearness allowance, and has been working for about 18 years and 8 months, the gratuity received would be Rs.12,50,000. 

4. IT Exemptions for Employees Not Covered Under the Payment of Gratuity Act

Even for employees that do not fall under the Payment of Gratuity Act, there is no law that speaks against the payment of gratuity.  They will be qualified for tax exemptions under certain conditions. Whichever of the following possibilities is the least, that would qualify for a tax exemption:

• Actual gratuity amount received

• Gratuity of Rs.20 Lakhs

• Average salary of last 10 months inclusive of dearness allowance and basic salary multiplied by the duration of employment further multiplied by salary of half a month. 

 

If the gratuity amount received by the employee surpasses the maximum limit, tax will be levied on that amount.

 

Given below is an example to give you a clearer idea: 

Assuming Mr B’s average salary for the last ten months is Rs.1,00,000, and he has been working for about 21 years and 7 months, the gratuity he would receive is Rs.12,00,000. 

As per the amendment, for those that are covered under the Payment of Gratuity Act, the maximum cap for gratuity to be tax exempt is Rs.20,00,000. For those that do not fall under that Payment of Gratuity Act, the maximum cap is Rs.10,00,000. If the amount surpasses the gratuity exemption limit, tax will be levied on the surplus amount. 

In case of the demise of the employee, the gratuity will be paid out to the employee’s nominee as per the following: 

• If the employee has rendered service to the company for less than a year, twice the basic pay is paid as gratuity. 

• If the employee has worked at a company for more than a year but less than a term of 5 years, six times the basic pay is paid out as gratuity. 

• If the employee has rendered service to the company for above 5 years, but less than a term of 11 years, twelve times the basic pay is paid as gratuity. 

• If the employee has worked at an organization for more than eleven years but less than a period of 20 years, twenty times the basic pay is paid out as gratuity. 

• If the employee has rendered service to the company for over 20 years, half of the salary on the completion of every six months that amounts to a maximum of 33 times the salary amount will be paid as gratuity.

If an employee is terminated from employment owing to damage to the employer’s property, willful negligence, and other reasons, the value of destruction caused will be deducted from the amount paid out as gratuity. In order to safeguard yourself from such liabilities, it is wise to subscribe to an insurance policy.

Instead of manually calculating your gratuity amount, you can use the taxable gratuity calculator which will give you the taxable gratuity amount in addition to your total gratuity amount. The calculator will help you get an estimate of the gratuity you will stand to receive at your retirement or when you leave a job after years of service. However, the actual gratuity payout may differ depending on various factors.