Is Gratuity Taxable in India? Rules and Exemptions

Gratuity in India is a monetary benefit provided by employers to employees for long service, typically upon retirement, resignation, or other specific circumstances. This payment aims to provide financial support to employees after their tenure with an organization. While gratuity serves as a significant financial resource for individuals, it is generally subject to taxation in India. However, specific exemptions can reduce or eliminate the taxable amount, depending on the employee’s category and the amount received.

Eligibility and Calculation of Gratuity

The Payment of Gratuity Act, 1972 (PGA) governs the eligibility and payment of gratuity in India. An employee becomes eligible for gratuity after completing at least five continuous years of service with the same employer.

Gratuity becomes payable under various circumstances, including an employee’s superannuation, retirement, resignation, death, or disablement due to accident or disease. In cases of death or disablement, the five-year service condition does not apply, allowing the employee or their nominee to receive the benefit regardless of the service duration.

The calculation of the gross gratuity amount is based on a specific formula under the PGA. For eligible employees, it is calculated as 15 days’ wages for every completed year of service or part thereof exceeding six months. The “last drawn salary” or “wages” for this purpose includes the basic salary and dearness allowance, but excludes other allowances like house rent allowance or travel allowance.

To illustrate, if an employee’s last drawn salary (basic + dearness allowance) is ₹30,000 per month and they have completed 20 years of service, the gross gratuity is calculated. This involves dividing the monthly salary by 26 (representing working days in a month), multiplying by 15 days, and then by the number of completed service years. For example, (₹30,000 / 26) 15 20 years would yield the total gross gratuity amount payable by the employer.

Tax Exemptions for Gratuity

The Income Tax Act, 1961, provides specific rules for the tax exemption of gratuity, which vary based on the employee’s classification. Understanding these distinctions is important for determining the portion of gratuity that remains untaxed.

Gratuity received by employees of the Central Government, State Government, or local authorities is fully exempt from income tax.

For non-government employees covered by the Payment of Gratuity Act, 1972, the least of three amounts is exempt from tax. The first is the actual gratuity received by the employee. The second is a statutory limit, which currently stands at ₹20 lakh. The third calculation involves 15 days’ salary for each completed year of service, based on the last drawn salary (basic + dearness allowance).

To determine the exempt amount for non-government employees covered by the PGA, one would compare these three figures. For example, if an employee received ₹18 lakh in gratuity, the statutory limit is ₹20 lakh, and their 15 days’ salary calculation for their service period amounts to ₹19 lakh, the lowest of these—₹18 lakh—would be fully exempt. If the actual gratuity received was ₹21 lakh, the maximum exempt amount would be limited to ₹20 lakh.

Non-government employees who are not covered by the Payment of Gratuity Act, 1972, also have specific exemption rules. For this category, the least of three amounts is exempt from tax. The first is the actual gratuity received. The second is the same statutory limit of ₹20 lakh.

The third criterion for non-PGA employees is half month’s average salary for each completed year of service. For this calculation, “salary” is defined differently, referring to the average salary of the last 10 months immediately preceding the month of retirement or resignation. This average salary includes basic pay, dearness allowance, and commissions based on a fixed percentage of turnover.

Consider a non-PGA employee who received ₹15 lakh in gratuity, where the statutory limit is ₹20 lakh. If their half month’s average salary over 10 months for their 25 years of service calculates to ₹16 lakh, the lowest figure, which is ₹15 lakh, would be fully exempt. If the actual gratuity was ₹22 lakh, the exemption would be capped at ₹20 lakh, with the remaining ₹2 lakh becoming taxable.

Tax Treatment of Gratuity

The portion of gratuity that does not qualify for exemption, as determined by the rules outlined in the Income Tax Act, 1961, becomes taxable income for the employee. This non-exempt amount is categorized under “income from salary” and is added to the individual’s total income for the financial year in which it is received. This inclusion directly impacts the employee’s overall tax liability.

The taxable gratuity amount is subject to the individual’s applicable income tax slab rates for that assessment year. For instance, if an individual falls into a higher tax bracket, the taxable portion of their gratuity will be taxed at that higher rate. This can significantly increase the total tax payable by the individual in the year of receipt.

Employers are required to account for the taxable portion of gratuity when calculating Tax Deducted at Source (TDS). The employer will deduct TDS on the non-exempt gratuity amount. This deduction occurs at the time of payment to the employee.

The details of the gratuity paid, including both the exempt and taxable portions, are reported by the employer in Form 16, which is an annual certificate of TDS. Employees must report the taxable gratuity amount in their Income Tax Return (ITR) for the relevant assessment year.