Know What is Gratuity, Which is Deducted From Salary

Understanding Gratuity: A Comprehensive Guide

Gratuity is a significant component of employee compensation in India. It serves as a form of acknowledgment for an employee’s dedicated service over a substantial period.

Though not legally mandated for all employers, gratuity is a prevalent practice, particularly within organized sectors.

This detailed guide explores gratuity’s concept, eligibility criteria, calculation methods, tax implications, and common misconceptions, providing a comprehensive understanding of this important financial benefit.

What is Gratuity?

Gratuity is a financial benefit provided by an employer to an employee as a gesture of appreciation for their long-term service.

This payment is typically made upon retirement, resignation, or termination of employment. Although gratuity is not a legally mandated requirement for all sectors, it is a common practice in many Indian organizations, especially in the formal and organized sectors.

Historical Context and Purpose

The concept of gratuity is rooted in the idea of rewarding loyalty and long-term service. Historically, it has been a way for employers to express gratitude towards employees who have dedicated several years of their career to the organization. This practice also helps in fostering employee loyalty and motivation.

Eligibility for Gratuity

To be eligible for gratuity, employees must meet specific criteria. These criteria ensure that only those who have demonstrated long-term commitment to their employer receive this benefit.

Minimum Service Requirement

• Five Years of Continuous Service: The primary eligibility criterion for gratuity is that the employee must have completed at least five years of continuous service with the same employer. This rule applies to most employees under the Payment of Gratuity Act, 1972. However, in the case of an employee’s death or disability, gratuity is payable irrespective of the five-year condition.

Definition of Continuous Service

• Uninterrupted Employment: Continuous service means that the employee has been employed without any significant breaks. Short-term leaves, whether paid or unpaid, generally do not interrupt continuity. However, the term “continuous service” does not include periods of leave without pay that extend beyond six months.

Calculation of Gratuity

The amount of gratuity an employee is entitled to is calculated based on a specific formula. This formula helps determine a fair and consistent amount that reflects the employee’s tenure and last drawn salary.

Formula for Gratuity Calculation

The formula used for calculating gratuity is:

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

• Last Drawn Salary: This is the salary that the employee was receiving at the time of their departure, including basic salary, dearness allowance (DA), and commission. It does not include other allowances such as house rent or travel allowances.
• Number of Years of Service: This is the total number of years the employee has worked with the employer. Partial years are rounded off to the nearest whole number.

Detailed Example

Let’s consider an employee with the following details:

• Last Drawn Salary: Rs. 50,000 per month
• Years of Service: 10 years

Using the formula:

Gratuity = 50,000 * 10 * (15/26) = 2,88,462

Thus, the employee would be eligible for a gratuity amount of Rs. 2,88,462.

Tax Implications of Gratuity

The tax treatment of gratuity is a crucial consideration for employees, as it affects the net amount received. The taxability of gratuity depends on several factors, including the amount received and the employee’s status.

Exemption Limits

• Tax Exemption Limit: Under Section 10(10) of the Income Tax Act, gratuity received up to Rs. 20 lakhs is exempt from tax. This limit is applicable to employees covered under the Payment of Gratuity Act, 1972. If the gratuity amount does not exceed this limit, it will not be subject to income tax.

Taxable Amount

• Amount Exceeding Rs. 20 Lakhs: Any gratuity amount exceeding Rs. 20 lakhs is taxable. The excess amount is added to the employee’s taxable income and taxed according to the applicable income tax slab rates.

Special Cases

• Government Employees: For government employees, gratuity is fully exempt from tax, regardless of the amount received.
• Employees Not Covered Under Payment of Gratuity Act: For employees who are not covered under the Payment of Gratuity Act, different rules may apply. It is advisable to consult a tax professional for accurate information.

Deductions from Salary Related to Gratuity

While there are no direct deductions from salary specifically for gratuity, employers often make contributions to a gratuity fund. This fund is used to ensure that gratuity payments can be made when due.

Gratuity Fund Contributions

• Employer Contributions: Employers may contribute to a gratuity fund on behalf of the employees. This fund is typically set up to meet future gratuity liabilities. These contributions might be reflected in the salary slip as part of the employer’s obligations but are not directly deducted from the employee’s salary.
• Accounting and Disclosure: The contributions to the gratuity fund are usually accounted for as part of the company’s financial statements and might be disclosed as an employee benefit expense.

Common Misconceptions About Gratuity

Understanding gratuity involves dispelling several misconceptions. Addressing these misconceptions helps clarify what employees and employers can expect regarding this benefit.

Misconception 1: Gratuity is Mandatory

• Reality: Gratuity is not legally mandated for all employers. However, it is a widespread practice, especially in the organized sectors. Employers who are not covered under the Payment of Gratuity Act might not be required to pay gratuity, although they may choose to do so as a part of their employee benefits package.

Misconception 2: Gratuity is Fully Taxable

• Reality: Only the portion of gratuity that exceeds Rs. 20 lakhs is taxable. The amount within this limit is exempt from tax under Section 10(10) of the Income Tax Act.

Misconception 3: Gratuity is Based on Gross Salary

• Reality: Gratuity is calculated based on the last drawn salary, which includes basic salary, dearness allowance, and commission, but excludes other allowances such as house rent and travel allowances.

Final Remarks

Gratuity is a significant part of an employee’s compensation, reflecting long-term service and commitment. Understanding the eligibility criteria, calculation methods, and tax implications associated with gratuity is crucial for both employees and employers. By grasping these aspects, employees can better plan their finances and retirement, while employers can ensure compliance with applicable regulations.

Additional Information

The Payment of Gratuity Act, 1972

• Overview: The Payment of Gratuity Act, 1972, governs the payment of gratuity in India. It outlines the eligibility criteria, calculation methods, and payment procedures for gratuity. Employers covered under this Act must comply with its provisions to ensure fair treatment of employees.

Employees Provident Fund (EPF)

• Distinct from Gratuity: The Employees Provident Fund (EPF) is a separate retirement benefit scheme and should not be confused with gratuity. EPF contributions are made by both the employer and employee and are intended for retirement savings, whereas gratuity is a lump sum payment made at the end of employment.

Non-Transferability

• Gratuity and Employment Changes: Gratuity is not transferable from one employer to another. It is payable by the employer with whom the employee has served. If an employee changes jobs, they are entitled to receive gratuity from their previous employer, provided they meet the eligibility criteria.

FAQs

What is the difference between gratuity and bonus?

• Gratuity: Gratuity is a retirement benefit given for long-term service, paid when an employee leaves the company after completing the required service period.
• Bonus: A bonus is a performance-based reward given periodically (usually annually) based on individual or company performance.

Is gratuity mandatory?

• No: Gratuity is not legally mandated for all employers. It is, however, a common practice in many sectors. Employers who are covered under the Payment of Gratuity Act, 1972, are required to adhere to its provisions.

How is gratuity calculated for part-time employees?

• Inapplicability: Gratuity is generally not applicable to part-time employees. It is designed for full-time employees who have provided long-term service to the organization.

Can I claim gratuity if I resign from my job?

• Yes: Employees who meet the eligibility criteria (minimum of five years of continuous service) can claim gratuity upon resignation, retirement, or termination.

What happens to gratuity if a company closes down?

• Company Closure: In the event of company closure, gratuity is typically paid from the gratuity fund, if one exists. If not, it becomes the responsibility of the employer to settle the gratuity dues. Employees should ensure they claim their dues before the company’s closure is finalized.

Additional Tips

Start Saving for Retirement Early

• Long-Term Planning: Starting early with retirement savings helps accumulate a substantial corpus over time. Consider contributing to retirement savings plans and investing wisely to ensure financial security in retirement.

Diversify Your Investment Portfolio

• Risk Management: Diversifying investments across various asset classes can help manage risks and enhance returns. A well-balanced portfolio can provide better financial stability and growth over the long term.

Consult with a Financial Advisor

• Personalized Planning: A financial advisor can provide tailored advice and help plan your retirement goals effectively. They can assist in optimizing your investment strategy and ensuring that you meet your long-term financial objectives.

By understanding gratuity and its implications thoroughly, employees can make informed decisions regarding their career and financial planning. This knowledge ensures that both employees and employers handle gratuity matters appropriately, aligning with legal requirements and personal financial goals.

Disclaimer

The information provided in this article is intended for general knowledge and informational purposes only. It does not constitute professional advice. For specific queries or detailed advice related to gratuity, consulting with a tax or legal professional is recommended.