Gratuity is one of the most valued retirement benefits offered to employees in India. It serves as a monetary expression of gratitude from the employer for the long-standing service rendered by the employee. Whether an individual is employed in the public or private sector, gratuity provides financial support post-retirement. However, the method of calculating gratuity and the tax implications differ based on the nature of employment and are governed primarily by the Payment of Gratuity Act, 1972 and the Income Tax Act, 1961.
This article outlines how gratuity is calculated for government and non-government employees, explains the applicable tax treatment, and concludes with a mnemonic to help remember the entire framework easily.
What Is Gratuity?
Gratuity is a lump-sum financial benefit payable by the employer to an employee as a mark of appreciation for services rendered over a sustained period. Under the Payment of Gratuity Act, 1972, an employee becomes eligible to receive gratuity after completing at least five years of continuous service with the same employer. However, this five-year condition does not apply in cases of death or disablement.
Gratuity is generally paid at the time of retirement, resignation (after completing five years), or in unfortunate cases of death or permanent disability.
Method of Calculation of Gratuity
The formula used to calculate gratuity depends on whether the employee is working in an establishment covered under the Payment of Gratuity Act or not.
For Employees Covered under the Payment of Gratuity Act
The formula is:
Gratuity = (15 / 26) × Last Drawn Salary × Number of Completed Years of Service
- “15” represents 15 days’ salary for every year of service.
- “26” is the assumed number of working days in a month.
- Salary includes basic pay and dearness allowance.
- Only completed years of service are considered, and partial years are usually ignored or rounded down.
For example, if an employee’s last drawn monthly salary is ₹40,000 and they have worked for 21 years, the gratuity would be calculated as:
(15 / 26) × 40,000 × 21 = ₹4,84,615
For Employees Not Covered under the Gratuity Act
For establishments not covered under the Act, the formula is slightly different:
Gratuity = (½ × Average Salary of Last 10 Months) × Number of Completed Years of Service
The average salary includes:
- Basic pay
- Dearness allowance
- Commission, if based on a fixed percentage of turnover
If the average salary over the last ten months is ₹50,000 and the employee has worked for 21 years, the gratuity is:
½ × 50,000 × 21 = ₹5,25,000
Tax Treatment under the Income Tax Act, 1961
The tax exemption on gratuity varies based on the type of employment. The relevant provisions are found under Section 10(10) of the Income Tax Act, 1961.
Government Employees
For employees of the Central Government, State Government, defence services, or local authorities, gratuity received on retirement or death is completely exempt from income tax under Section 10(10)(i). There is no monetary limit on the exemption.
Non-Government Employees Covered under the Gratuity Act
As per Section 10(10)(ii), for private sector employees covered under the Payment of Gratuity Act, the tax exemption is limited to the least of the following three:
- Actual amount of gratuity received
- ₹20,00,000 (statutory maximum limit)
- Amount calculated using the prescribed formula: (15/26) × Last Drawn Salary × Completed Years of Service
Any amount received beyond the lowest of the three is taxable under the head “Income from Salary.”
Non-Government Employees Not Covered under the Gratuity Act
Under Section 10(10)(iii), employees who are not covered under the Gratuity Act are also eligible for exemption, but the calculation method changes. The tax exemption is the least of the following:
- Actual amount of gratuity received
- ₹20,00,000 (statutory maximum limit)
- Half-month’s average salary of the last 10 months multiplied by the number of completed years of service
Again, any amount exceeding the exemption limit is included in the employee’s taxable income.
Special Considerations
- In the case of multiple employers, the total tax-exempt gratuity from all sources cannot exceed ₹20 lakh.
- In the unfortunate event of an employee’s death, the entire gratuity amount received by legal heirs is tax-exempt, irrespective of the amount or the type of employment.
- For retired employees receiving gratuity in installments or delayed payouts, tax is applicable only in the year of receipt.
Summary: Government vs Non-Government
| Category | Tax Exemption | Formula | Exemption Limit |
|---|---|---|---|
| Government Employees | Fully exempt | Not applicable | No limit |
| Non-Govt (Covered under Act) | Least of three amounts | (15/26) × Salary × Years | ₹20 lakh |
| Non-Govt (Not covered under Act) | Least of three amounts | ½ × Avg. salary × Years | ₹20 lakh |
Mnemonic to Remember: “GRATUITY FORM”
To remember the key points related to gratuity calculation and tax treatment, use the mnemonic “GRATUITY FORM”:
- G – Government employees get full exemption (Section 10(10)(i) applies)
- R – Received amount compared with limits (actual, formula, ₹20L)
- A – Amount exempt is the least of three (for non-govt employees)
- T – Twenty lakh is the max exemption limit under the Act
- U – Under Section 10(10) of Income Tax Act
- I – Income from Salary if amount exceeds exemption
- T – Ten-month average salary for non-covered employees
- Y – Years of service considered (rounded down)
- F – Formula changes based on Act coverage
- O – Only Basic + DA (not gross salary) used
- R – Retirement, Resignation, Death, Disablement – all applicable
- M – Minimum 5 years of service needed (except death/disablement)
