Gratuity Finance: Understanding the Basics
Gratuity is a lump sum benefit paid to an employee by their employer as a token of appreciation for the services rendered during their tenure. It’s essentially a retirement benefit, although it can be paid out earlier in certain circumstances. In India, the Payment of Gratuity Act, 1972, governs the payment of gratuity, setting the minimum eligibility criteria and calculation methods.
Eligibility for Gratuity
To be eligible for gratuity, an employee generally needs to have completed at least five years of continuous service with the organization. There are exceptions, such as cases of death or disablement due to accident or illness, where the five-year requirement is waived.
Calculating Gratuity
The calculation of gratuity depends on whether the employee is covered under the Payment of Gratuity Act, 1972. For employees covered under the Act, the formula is:
Gratuity = (Last Drawn Salary × 15/26) × Years of Service
Here, “Last Drawn Salary” includes basic salary, dearness allowance (DA), and any other components considered part of the salary for this purpose. The fraction 15/26 represents 15 days’ salary for each completed year of service, assuming a 26-day working month.
For employees not covered under the Act, the gratuity calculation is usually based on half a month’s average salary for each completed year of service. The specific formula may vary based on the company’s internal policies.
Tax Implications of Gratuity
Gratuity is taxable under the Income Tax Act, 1961, but there are exemptions. The exemption limit depends on whether the employee is a government employee or a non-government employee.
- Government Employees: Gratuity received by government employees (central, state, or local authority) is fully exempt from tax.
- Non-Government Employees Covered under the Gratuity Act: The least of the following is exempt:
- Actual Gratuity Received
- ₹20,00,000 (Rupees Twenty Lakhs)
- 15 days’ salary based on last drawn salary for each completed year of service (or part thereof exceeding six months).
- Non-Government Employees Not Covered under the Gratuity Act: The least of the following is exempt:
- Actual Gratuity Received
- ₹10,00,000 (Rupees Ten Lakhs)
- Half month’s average salary for each completed year of service.
Any amount exceeding the exemption limit is taxable as salary income in the hands of the employee.
Gratuity Funds and Management
Companies often create gratuity funds to manage their gratuity obligations. They can contribute to an approved gratuity fund, which is managed by trustees. The contributions are usually tax-deductible as business expenses. Effective management of these funds is crucial to ensure that the company can meet its gratuity obligations to employees in the future.
Importance of Gratuity
Gratuity serves as a significant financial safety net for employees upon retirement or separation. It helps them to meet their post-employment expenses and maintain their standard of living. For employers, offering gratuity demonstrates their commitment to employee welfare, contributing to a positive work environment and employee retention.
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