Income Tax Exemption on Gratuity: Understanding the Rules and Benefits

Gratuity is a significant component of an employee's retirement benefits, provided by an employer as a token of appreciation for the services rendered during employment. In India, gratuity is subject to taxation under the Income Tax Act, but there are certain exemptions available. This blog will explain the tax exemptions available on gratuity, the applicable limits, and how you can benefit from these provisions.

What is Gratuity?

Gratuity is a lump sum payment made by an employer to an employee as a gesture of gratitude for their long-term service. The payment is typically made when an employee retires, resigns, or passes away. Gratuity is governed by the Payment of Gratuity Act, 1972, which applies to establishments with 10 or more employees.

Gratuity is calculated based on the employee’s last drawn salary and the number of years of service.

Taxation of Gratuity in India

The tax treatment of gratuity depends on various factors, including the type of organization and the length of service. While gratuity is generally taxable, income tax exemptions are available under specific conditions, as per the Income Tax Act, 1961.

The Income Tax Act provides three different categories for taxation of gratuity:

1. Gratuity Paid by a Government Employer

2. Gratuity Paid by a Non-Government Employer (Covered by the Payment of Gratuity Act)

3. Gratuity Paid by a Non-Government Employer (Not Covered by the Payment of Gratuity Act)

Tax Exemption on Gratuity: Key Provisions

1. Gratuity Paid by Government Employers

Gratuity received by an employee working in a government department (central or state) is fully exempt from tax, regardless of the amount or duration of service. This exemption applies to both permanent and contractual employees of the government.

• Exemption: 100% exempt under Section 10(10) of the Income Tax Act.

2. Gratuity Paid by Non-Government Employers (Covered by the Payment of Gratuity Act)

For employees working in a private company or non-government organization, gratuity is subject to tax exemptions, but only to a certain limit. The exemption depends on whether the organization is covered under the Payment of Gratuity Act, 1972.

The exempt amount is determined by the following formula:

• Gratuity Exemption Limit: The minimum of the following three values:

  1. Actual Gratuity Received

  2. 15 days of last drawn salary for each completed year of service

  3. ₹20,00,000 (as per the latest update from the Income Tax Act)

• Salary: Salary is defined as basic salary + dearness allowance (DA).

• Completed Year of Service: A year of service is calculated as a period of 12 months or more.

Example:If you worked in a private company for 15 years and received a gratuity of ₹8,00,000, and your last drawn basic salary was ₹40,000 with a dearness allowance (DA) of ₹5,000, then the tax-exempt gratuity will be:

• Gratuity received = ₹8,00,000

• 15 days of last drawn salary per year of service = ₹40,000 + ₹5,000 = ₹45,00015 days salary=45,000÷26×15=₹25,961.53×15=₹3,89,422.91\text{15 days salary} = 45,000 ÷ 26 × 15 = ₹25,961.53 × 15 = ₹3,89,422.91 (Note: 26 is the number of working days in a month, used for the calculation of daily salary)

• Exemption limit = ₹20,00,000 (The exemption is capped at ₹20 lakh for any employee covered under the Payment of Gratuity Act.)

In this case, the entire gratuity amount of ₹8,00,000 is exempt from tax, as it is lower than the exemption cap of ₹20,00,000.

3. Gratuity Paid by Non-Government Employers (Not Covered by the Payment of Gratuity Act)

In cases where an employee is working for a private employer who is not covered under the Payment of Gratuity Act, gratuity is still taxable, but it may be eligible for exemption under Section 10(10) of the Income Tax Act. However, the exemption is limited to:

• Exemption Limit: The exemption is available only up to ₹3,50,000, regardless of the years of service or salary.

This limit applies when the employer is not legally bound to pay gratuity under the Payment of Gratuity Act. In such cases, the exemption is lower than that provided to employees working in covered establishments.

How to Calculate Gratuity and Claim Tax Exemption?

Step 1: Determine the Gratuity Amount

To calculate gratuity, the following formula is used:

• Gratuity Amount = (Last drawn salary × 15 days × Number of years of service) ÷ 26

Step 2: Determine Exempt Amount

Once the gratuity amount is calculated, the exempt amount is determined based on the conditions mentioned above:

• The lower of the actual gratuity received, 15 days of salary for each year of service, or ₹20,00,000 (or ₹3,50,000 if the employer is not covered by the Gratuity Act).

Step 3: Claim the Exemption

To claim the exemption, ensure the correct information is reported in your Income Tax Return (ITR) under the appropriate section. If you are employed with a government organization, the entire amount is exempt. For private sector employees, the tax-exempt portion should be mentioned, and the taxable portion will be added to your total income and taxed accordingly.

Key Points to Remember

1. Government Employees: Gratuity is 100% exempt for government employees under Section 10(10).

2. Private Sector Employees: The tax exemption for gratuity paid by private employers is subject to specific limits. The exemption is higher for those working in organizations covered under the Payment of Gratuity Act.

3. Taxable Portion: Any amount received as gratuity beyond the exemption limit is taxable and will be added to your total income.

4. Claiming Exemption: To claim the exemption, ensure that the gratuity amount and the exempted portion are accurately reflected in your ITR.

5. Reinvestment: There is no provision to reinvest gratuity in a tax-saving instrument for claiming exemptions, unlike other retirement benefits.

Conclusion

Gratuity is a crucial retirement benefit that provides financial security to employees when they retire or leave their jobs. While gratuity is generally taxable, the Income Tax Act offers significant exemptions under Section 10(10) for both government and private-sector employees. If you’re eligible, ensure that you claim the maximum exemption allowed to reduce your tax liability and retain more of your hard-earned money.

Always consult a tax expert or financial advisor to ensure proper tax planning and the accurate reporting of gratuity in your income tax return.