Explained: What is dearness allowance?

It was October 2023 when the central government announced that it would increase the dearness allowance (DA) for all central government employees by 4% over the existing rate of 42% of the basic pay/pension.

Since then, many states have followed suit and announced a similar increase in DA for their respective state government employees.

Let’s deep dive into the topic to understand what exactly is dearness allowance and who benefits from such DA hikes.

What is the purpose of paying dearness allowance?

Dearness allowance is a component of salary that is paid to both current employees to offset the impact of inflation. On the other hand, the retired government employees or the pensioners receive dearness relief (DR), similar to DA. 

The purpose of paying DA is mainly to help employees maintain their standard of living amid rising prices.

It is important to note here that the employees and pensioners of private sector employees are not entitled to receive dearness allowance.

DA is calculated as a percentage of the basic salary and is a key component of an employee’s take-home salary.

Since DA is paid to hedge the impact of inflation, the amount of the component may vary according to the location of the employee – urban, rural or semi-urban.

Different types of dearness allowance

Dearness allowance can be divided into two separate categories depending on whether the employee belongs to a public sector company or is a central government department.

Industrial dearness allowance

 Industrial dearness allowance is given to employees of public sector undertakings (PSUs). It is updated every quarter of the financial year taking into consideration the Consumer Price Index (CPI). 

CPI is a measure of the average change in prices over time that consumers pay for a basket of goods and services.

Variable dearness allowance

Variable dearness allowance is given to only central government employees. This allowance is also revised taking into consideration the change in CPI, but is reviewed twice a year – in January and in July.

It is also different as it is made of three elements -- consumer price index, variable dearness allowance and base index. The variable dearness allowance remains fixed until the basic minimum wages are changed by the government. Similarly, the base index allowance also remains fixed. The only major change in calculation of variable dearness allowance happens due to the CPI changes.

Calculation of DA

The formula to calculate dearness allowance was changed in the year 2006. There are two different methods to calculate dearness allowance -- one for central government employees and other for public sector employees.

Dearness allowance formula for Central Government employees

{(Average of All-India Consumer Price Index for the last 12 months – 115.76)/115.76} × 100

Dearness allowance formula for employees of central public sector companies

{(Average of All-India Consumer Price Index for last 3 months – 126.33)/ 126.33} × 100

Taxation of dearness allowance

As per the provisions of the Income Tax Act, 1961, dearness allowance is fully taxable in the hands of the salaried employees. The amount would be taxed at their current income tax slab rates.

Moreover, it is mandatory for employees to state their tax liability with respect to the dearness allowance separately at the time of filing the income-tax return.

Also, if an employee is provided with rent-free unfurnished accommodations by the employer then the portion of the dearness allowance is considered as a part of retirement benefits and is included in the employee’s salary.