April 26, 2023

What is Gratuity - Meaning, Formula, Eligibility, Rules, & How to Calculate

Gratuity is a monetary benefit payable to an employee who has completed more than 5 years of full-time employment at a particular organisation as per The Payment of Gratuity Act 1972. Employees are eligible for gratuity at the time of retirement or resignation only when they complete 5 or more years with the company (or if the employee has completed 240 days in the 4th year).

However, in case of a disability due to an accident or death, the 5-year rule is relaxed or altered as per the company policy. Gratuity is dependent on several factors, such as the last drawn salary of the employee, the number of years in service, and the guidelines that are in place at the time of calculating gratuity.

In this article, we will discuss the general rules about gratuity, like eligibility, payment process, the formula for calculating gratuity, gratuity taxation rules, and other details around gratuity.

Some Important Points about Gratuity in India

It is important in the Gratuity Act that the employee can enjoy the Gratuity amount only after completing 5 years of uninterrupted service.
The maximum Gratuity, an employee, can receive (tax-free) is up to INR 30,00,000 as per the amendment introduced in the Financial Budget 2019.
All employers must comply with the Gratuity Act to pay employees their Gratuity amount at resignation, retirement, disablement, or death.
The employer has a right to reject the gratuity payment of an employee in case their services have been terminated for fraud, misconduct, or any other illegal matters.
Gratuity is applicable to firms/organisations that have 10 or more employees.

What Is Gratuity in Salary, and How Does It Work?

Gratuity is a cash component given to an employee by an employer in regard to the service they have provided to the company. This amount is paid to the employee during separation from the company after at least 5 years of continuous service (full-time employment).

The term considered for gratuity is from the time of employment (starting date of the employee at the organisation) to the final working day of the employee at the establishment (this includes the notice period served). The employer solely contributes the gratuity amount and is part of the employee's overall CTC (cost to the company).

An employer either pays the gratuity amount from their own company's account or opts for an insurance provider who gives a general gratuity insurance plan and pays the resultant amount to the employees. The gratuity amount is totally paid for by an employer and is not deducted from the employee's salary in any way.

As per regulations, the employer should disclose the gratuity contribution that will be made by including it in the CTC, which should be in addition to the salary paid to the employee. This ensures that the company cannot take any contribution from an employee towards this amount.

In terms of gratuity contribution, there is no specific set percentage the employer should pay towards the gratuity of an employee. However, as per regulations, a standard gratuity should be at least 50% of the employee's basic salary (this does not include other CTC components like allowances and others).

Eligibility Criteria for Gratuity

Gratuity is paid to an employee only when the eligibility criteria are fulfilled, which are as follows:

An employee must have completed 5 years of uninterrupted service in the same organisation at the time of resignation or retirement.
The company has a minimum of 10 employees.
The employee should be eligible for superannuation.
The employee has had an unfortunate incident that has left them disabled or dead (this can also be outside company property). In this case, even if the employee has not completed 5 years of continuous services, they are eligible for full payment of gratuity to either the employee or the nominee.

Some organisations are covered under the Gratuity Act 1972, whose employees may be less than 10. Even organisations not covered in the gratuity act can pay gratuity to their employees as per their policy.

Forfeiture of Gratuity

An employer has a right to forfeit the Gratuity of an employee even after completing the 5-year service clause in the below circumstances.

Suppose the employee has been terminated from the company due to fraudulent activity, inappropriate conduct, or any act of violence. In such cases, the employee has the right to stop the complete or partial payment of gratuity.
To forfeit the gratuity, the employer should be terminated from their services, explaining the reason for the termination. Therefore, it is important to mention the reason for the forfeiture of gratuity to avoid any further hassles.
Suppose the organisation has been taken over or transferred from one entity to another. In that case, the employee may not be eligible for gratuity if they have not completed 5+ years at the organisation.However, if the company is a business expansion of the same entity, they will be liable to pay gratuity to the employee.

Gratuity Calculation

When calculating Gratuity, there is no specific rule or fixed number of percentage the employer needs to contribute towards gratuity.

But as per the Payment of Gratuity Act 1972, employers can consider a specific formula for calculating gratuity. Three particular aspects determine the gratuity formula:

The calculation of gratuity as per the Gratuity Act 1972.
The calculation of gratuity for a company/entity that is not covered under the Gratuity Act.
Calculation of gratuity in case of death or disability of an employee.

Let us have a look at all three formulas in greater detail.

The Calculation of Gratuity for the Organisations Covered under the Gratuity Act of 1972

For an organisation that is covered under the Gratuity Act of 1972, an employee who has completed 5+ years of service at the company is eligible for a gratuity amount that is:

15 days of the last drawn salary amount for each completed year of service, contributed by an employee or partly completed with more than 6 months of service, which is further divided by 26.

So the formula for calculating gratuity in this case is:

Gratuity= (15 _ last drawn salary _ years of service ) / 26

For example, Mr X has been employed with ABC company for the last 11 years and 7 months. His last drawn salary was INR 65,000 (Basic Pay+ Dearness Allowance)

Mr X's Gratuity Amount= (15 _ 65,000 _ 12 / 26) = INR 450,000

The Calculation of Gratuity for Organisations That Are Not Covered under the Gratuity Act

Suppose the organisation or entity is not considered under the Gratuity Act of 1972. In that case, the formula will be - 15 days of the last drawn salary for each fully completed year of service, which is further divided by 30.

Thus, Gratuity = (15 _ last drawn salary _ completed years of service) / 30

For example, Mr X has been employed with BCD company for 15 years and 8 months, and this organisation has a total of 8 employees only. His last drawn salary is INR 30,000, which also includes his sales commission as well. (Basic pay + Dearness allowance + Sales commission)

Mr X's Gratuity amount will be = (15 _ 30,000 _ 15) / 30 = INR 225,000

Calculation of Gratuity in Case of Death of an Employee

In case of a death of an employee, the deceased employee is eligible for Gratuity based on the number of services completed by him. The amount of gratuity in such cases has an upper cap of INR 20,00,000 as per the Gratuity Act of 1972.

Detailed information on Gratuity payment that is paid in case of a death of an employee is explained in the below chart.

Years of Service	Gratuity Payable
Less than a year	2* Basic salary
1 Year or more but less than 5 years	6* Basic salary
5 years or more but less than 11 years	12* Basic salary
11 years or more but less than 20 years	20* Basic salary
20 years or more than 20 years	Half of the basic salary for every 6 months of service. It is subject to a maximum of 33 times the basic salary.

Tax Rules and Regulations on Gratuity

Now to the moot point, is gratuity taxable? The answer is yes. The tax calculation of Gratuity depends on the type of employee who is going to receive the Gratuity.

The total amount of Gratuity is exempted from income tax for an employee working in a government organisation.
An employee eligible for Gratuity and working in a private organisation would enjoy a tax exemption on a Gratuity amount of a maximum of INR 30 lakhs, but only once.If you have already claimed tax exemption on your gratuity amount, you will not be eligible for the exemption a second time.
For the Gratuity amount that is paid in case of death or disability of an employee, the taxation on gratuity is calculated for the receiver as per the head - income from other sources.

Latest Improvements in Gratuity Act

The Ministry of Labour and Employment, under the Four Labour Code, implemented updates to the Gratuity Act of 1972, and these laws came into force as of 1 April 2021.

According to the new regulations, there were several updates to the Cost to the Company (CTC) of the employees, and required restructuring to ensure that:

The organisation pays a minimum of 50% of the salary of the employee's basic pay as gratuity. If the employee's basic pay is below 50%, then the employers have to restructure the salary as per the new regulations to be 50% of the CTC.
The gratuity amount does not include any bonuses, pension contributions, contributions towards employment provident fund, house rent allowance, conveyance allowance, overtime or other parameters. Only the basic amount will be considered for gratuity.
The employee will have to complete 5 years of continuous employment at the establishment to receive gratuity (the company should also pay gratuity to an employee if they have completed more than 4 years and 6 months or 194 days at the company).
The law also states that the maximum work hours per week is 48 hours, and the employee has to be paid overtime for working above these hours.
The ceiling for tax-free gratuity amount was increased from INR 20,00,000 to INR 30,00,00 as per the Financial Budget 2019.

Gratuity Payment Procedure

Initiation

An employee should fill up the Gratuity claim application with an employer whenever they are planning to resign or retire from services at the company.

Employees need to remember that gratuity initiation should ideally start during their notice period and should get in touch with the organisation's HR or relevant department to initiate this.

Acknowledge and Calculate the Amount:

As soon as an employer receives an application, they must start working on gathering the details and calculating the full and final amount of Gratuity.

The employer is liable to inform the employee and the concerned department and provide the date when the gratuity will be paid.

Pay Out

As soon as all the internal formalities of an organisation are completed, the payment of Gratuity should be made. An employer has 30 days time period for payment of Gratuity after sending an acknowledgement to an employee.

FAQs

What kind of employees does the Gratuity Act 1972 cover?

Every state in India except for Jammu and Kashmir (this may change as per the new law that declares J&K and Ladakh as separate territories) is covered under the Gratuity Act of 1972.

Employees of railway companies, shops, IT sector, factories, mining sector, ports, or any other establishments wherein the number of employees exceed 10 are eligible for Gratuity under the Gratuity Act 1972. All employees working in the government sector are covered under this act, including state and central government agencies.

Is an employee eligible for Gratuity if they resign after 4.5 years of service?

Every employee, whether in the private or government sector, should complete 5 years of uninterrupted service to enjoy the benefit of Gratuity.

However, in case of a disability or death, the employer needs to pay the Gratuity amount to an employee or their nominee, as per the gratuity act rules and regulations.

As per the Madras High Court Ruling, an employee is eligible for Gratuity if they complete 240 days of service in the 4th year. However, it is always advisable to crosscheck with your organisation's HR department and get clarity on this rule.

What is the time frame to release the payment of Gratuity from an employer?

Once an employee has initiated and filled up the details about the Gratuity, then the employer should acknowledge the same and prepare a detailed report about the total Gratuity amount and breakup and send the same to the concerned department along with the employee.

Once the acknowledgement is done, the payment should be released within 30 days. Failure to do so will result in the employer having to pay the fine per the interest rate mentioned in the Gratuity At 1972 to the employee and the Gratuity amount owed to the employee.

What is an upper limit for the Gratuity amount?

For all the employees working in a government organisation, the upper limit of Gratuity is increased to INR 30,00,000 according to Financial Budget 2019, which Interim Finance Minister Mr Piyush Goal introduced. This upper limit is applicable only for tax-free gratuity payments and doesn't mean that that is the total amount that should be paid to the employee.

E.g., if an employee's total payment of gratuity is above INR 30,00,000, the employer has to pay the full amount. However, the employee can get only INR 30,00,000 tax-free in this case, while anything above this will be taxed as per income tax regulations.

Do I lose my gratuity amount if the employer goes bankrupt?

In ideal situations, the employer has to make provisions to ensure that the gratuity is paid to each employee in case the company is shut down or goes bankrupt.

The employer cannot deny gratuity to any employee even if they are out of funds or bankrupt, and no court order can put a stay on the gratuity payment for the employee. The employee can take legal action against the employer if the gratuity is not paid on time.