What is Gratuity?

Gratuity is a lump-sum payment made by an employer to an employee as a token of appreciation for the services rendered. It is a statutory benefit governed by the Payment of Gratuity Act, 1972. The Act mandates that every employer with 10 or more employees must pay gratuity to eligible employees when they leave the organisation after completing a minimum of 5 years of continuous service.

Gratuity is payable on superannuation (retirement), resignation, termination (other than for misconduct), or in case of death or disablement due to accident or disease. In the case of death or disablement, the 5-year minimum service requirement is waived.

Who is Eligible for Gratuity?

• The employee must be working in an organisation that employs 10 or more employees on any day during a 12-month period. Once the Act applies to an establishment, it continues to apply even if the workforce subsequently falls below 10.
• The employee must have completed at least 5 years of continuous service with the same employer. This requirement is waived in the event of death or permanent disablement.
• Both permanent and contractual employees are covered, provided the establishment employs 10 or more workers.
• For the purpose of counting 5 years, if an employee has worked for more than 6 months in the last year of service, it is rounded up to a full year.

Gratuity Formula

For employees covered under the Payment of Gratuity Act:

Gratuity = (15 x Last Drawn Salary x Years of Service) / 26

Where 15 = 15 days of salary per completed year of service, Last Drawn Salary = Basic Salary + Dearness Allowance (DA), 26 = working days in a month (26 days standard).

For employees not covered under the Act (e.g., organisations with fewer than 10 employees), the formula uses 30 days instead of 26:

Gratuity = (15 x Last Drawn Salary x Years of Service) / 30

Note: Only Basic Salary and DA are counted for gratuity - allowances like HRA, bonus, or commission are excluded.

Tax Exemption on Gratuity

Gratuity received by government employees is fully exempt from tax. For private sector employees, the gratuity amount is exempt from income tax up to a limit of ₹20 lakh (revised in 2019 from the earlier ₹10 lakh). The exemption is calculated as the minimum of:

• Actual gratuity received
• ₹20,00,000 (statutory maximum)
• 15/26 x last drawn salary x number of completed years of service

Any gratuity amount beyond ₹20 lakh is taxable as "income from salaries" in the year of receipt.

Payment of Gratuity Act - Key Provisions

• Gratuity must be paid within 30 days from the date it becomes payable. Delayed payment attracts simple interest at the rate prescribed by the government.
• The employer can forfeit gratuity (wholly or partially) in case of wilful omission, gross negligence, misconduct causing financial loss, or conviction for an offence involving moral turpitude.
• An employee can nominate a beneficiary for their gratuity entitlement. The nomination can be updated at any time.
• The maximum gratuity payable under the Act is ₹20 lakh - if the calculated amount exceeds this, the employer is not bound to pay more (though they may choose to do so as an ex-gratia).

Advantages of the Gratuity Scheme

• Rewards loyalty: Incentivises employees to stay with an organisation for the long term.
• Financial security: Provides a meaningful lump sum at the time of retirement or career transition.
• Tax-efficient: Up to ₹20 lakh is completely tax-free, making it one of the most tax-efficient retirement benefits.
• Statutory guarantee: Being a legal entitlement, it cannot be arbitrarily denied by the employer for eligible employees.
• Inflation-linked: Since it is based on the last drawn salary rather than a fixed corpus, it naturally adjusts for salary growth over the years of service.