Managing employee benefits is an important part of maintaining a motivated and satisfied workforce, yet many businesses overlook gratuity. Businesses struggle to understand and manage gratuity payments, potentially leading to costly compliance errors. As an employer, have you ever wondered how much you might owe your employees in gratuity after years of service? Or perhaps you’ve overlooked the complexities of tax calculations that come with it?
Gratuity is a valuable benefit that can be both a motivator for employees and a challenge for employers. Understanding its calculation and tax implications is not just good practice. It’s also essential for staying compliant and ensuring fair treatment. In this blog, we’ll break down everything you need to know about gratuity, from eligibility criteria and calculation methods to tax rules that can impact your business. Armed with this knowledge, you’ll be able to avoid mistakes and streamline your HR processes.
A gratuity in HR is a financial benefit given by an employer to an employee who has served the company for a certain number of years, typically five or more. It is paid as a lump sum at the time of retirement, resignation, or death and serves as a token of appreciation for the employee’s long-term service. Gratuity is an important part of an employee’s retirement benefits, offering them financial support when they leave the organisation.
Gratuity is important because it rewards loyalty and service. For employers, gratuity is not just about meeting legal requirements; it’s also about ensuring that employees feel valued for their dedication. This benefit provides employees with a sense of financial security when they retire or leave the company.
Example: An employee who has worked for an organisation for 10 years will receive a gratuity based on the company’s policies and their tenure. This payment serves as recognition of their contributions and helps them secure their finances after leaving the company.
Gratuity strengthens the employer-employee relationship and ensures long-term satisfaction for those committed to the organisation.
Gratuity is a statutory benefit under the Payment of Gratuity Act, 1972. To qualify for gratuity in HR, employees must meet certain eligibility criteria set out by the Act. This ensures that gratuity is rewarded to those who have shown long-term commitment to the organisation. Below are the most important criteria:
Five Years of Continuous Service: To be eligible for gratuity, an employee must complete five continuous years of service with the same employer. This includes working in a regular or permanent capacity and excludes interruptions like leave, which might break the continuity.
Termination of Employment: Employment termination must not be voluntary; it should occur due to reasons such as resignation, retirement, or, in some cases, death or disablement.
Exceptions to the Rule:
While the five-year service requirement applies to most employees, there are exceptions to this rule. Gratuity in HR may still be payable under certain circumstances, such as early termination of employment for valid reasons or in cases of death or disability.
Early Termination: Employees who resign before completing five years of service are not entitled to gratuity. However, if the resignation is due to illness, disability, or other valid reasons, the employee may still be eligible.
Death or Disablement: If an employee passes away or becomes permanently disabled during employment, the family or the employee (in case of disablement) is eligible for gratuity, regardless of the five-year service condition.
Understanding these rules ensures that both employers and employees are aware of when gratuity is payable and under what circumstances it can be denied or given. This clarity also helps in making financial plans for both parties.
Understanding how to calculate gratuity in HR is necessary for both employers and employees to ensure fairness and transparency. The gratuity amount is determined using a straightforward formula:
(Last drawn salary × Number of years worked × 15) / 26
Let’s break down the formula into its key components, each of which contributes to determining the final amount.
1. Last Drawn Salary
This refers to the salary an employee receives upon leaving the company. The last drawn salary should include both the basic salary and the dearness allowance (DA). It’s important to note that other components, such as bonuses, overtime pay, or commission, are not included in this calculation.
For example, if an employee’s last drawn salary was ₹50,000, this value will be used in the formula.
2. Number of Years Worked
The employee's tenure is a significant factor. The calculation considers the number of full years an employee has worked in the company. If the employee has completed more than six months in a year, it’s rounded off as one full year. So, if an employee worked for 4 years and 8 months, it would be considered 5 years of service.
For example, an employee who has worked for 6 years and 2 months will have 6 years considered for gratuity calculation.
3. The Number 15
The number 15 is used in the formula to indicate the number of days of gratuity entitlement for each completed year of service. Gratuity is calculated based on 15 days of salary for each year worked. This is a fixed multiplier used to ensure fairness across all employees.
This means that the employee is entitled to 15 days of salary as a gratuity for each year of service.
4. The Number 26
The number 26 refers to the number of working days in a month. In India, a standard working month has 26 working days, excluding weekends and public holidays. The formula uses this to determine the proportional value of gratuity based on the number of working days in a month.
Essentially, by dividing by 26, we ensure that the gratuity is spread out over the full month of work.
Example of Gratuity Calculation
Let’s take an example to illustrate how all these components work together.
Suppose you have an employee with the following details:
Last Drawn Salary: ₹50,000 (basic salary + DA)
Years of Service: 6 years
Now, we’ll apply the formula:
(Last Drawn Salary × Number of Years Worked × 15) / 26
(50,000 × 6 × 15) / 26
= (4,500,000) / 26
= ₹1,73,076.92
So, in this case, the employee would be entitled to a gratuity of ₹1,73,076.92.
This example shows how simple it is to calculate the gratuity amount once you understand the components and formula.
By breaking down the calculation this way, you can see how each element, salary, years worked, and standard multipliers, contributes to the final gratuity. Gratuity is not only a benefit for employees but also a statutory responsibility for employers, ensuring fair compensation upon leaving the company.
Gratuity is a significant financial benefit for employees, but it’s also important to understand its taxation rules. While gratuity serves as a valuable retirement benefit, the amount an employee receives may be subject to tax, depending on the circumstances. Let’s explore how gratuity is taxed, its exemptions, and how it impacts an employee’s tax liabilities.
Taxability of Gratuity for Employees
In India, gratuity is taxable depending on whether it is received under the Payment of Gratuity Act, 1972 or another scheme.
For employees covered under the Payment of Gratuity Act, the gratuity received is tax-exempt up to a certain limit. However, for employees not covered by the Payment of Gratuity Act, gratuity is taxable under income tax laws, with some conditions allowing for exemptions.
The amount of gratuity that is eligible for exemption depends on the amount and the duration of the employee’s service.
Exemption Limits under Section 10(10) of the Income Tax Act
Section 10(10) of the Income Tax Act, 1961, lays down the exemptions for gratuity. Here are the main points:
For Government Employees: Gratuity received by government employees is fully exempt from tax, regardless of the amount or tenure of service.
For Non-Government Employees: The tax exemption is available up to the following limits:
Other Employees.: Least of (₹20 lakhs / eligible gratuity / actual gratuity received)
Example: How the Taxation Works Based on the Amount of Gratuity
Let’s look at a simple example to understand how taxability works for an employee:
Suppose an employee has worked for 15 years at a company, and their last drawn salary (including basic and DA) was ₹50,000. The total gratuity received is ₹4,32,692.
Step 1: Calculate the Taxable Gratuity
According to the formula:
Gratuity = (Last Drawn Salary × Years of Service × 15) / 26
Gratuity = (50,000 × 15 × 15) / 26 = ₹4,32,692.Step 2: Compare with the Exemption Limit
The exemption limit under Section 10(10) is ₹20 lakh. Since ₹4,32,692 is less than ₹20 lakh, the employee is eligible for the entire amount of ₹4,32,692 to be exempt from tax. The employee will not pay tax on the gratuity amount in this case.
However, if the gratuity amount exceeds ₹20 lakh, the excess over ₹20 lakh would be taxable.
The Impact of Gratuity on Employees' Tax Liabilities (Exempt and Taxable Amounts)
The taxation of gratuity can affect an employee’s tax liabilities, especially if they receive a substantial gratuity amount after long years of service. Here’s how it impacts the tax calculation:
Exempt Amount: The amount of gratuity eligible for exemption (based on the rules mentioned above) will not be considered for income tax. The exempt portion is not added to the employee's taxable income.
Taxable Amount: If the gratuity amount exceeds the exempt limit or is not covered under the Payment of Gratuity Act, the excess amount is treated as income and is taxed at the employee’s applicable income tax rate.
Let’s consider another example: An employee has worked for 20 years and receives a gratuity of ₹25 lakh. The employee’s last drawn salary is ₹60,000. According to the rules, the employee is entitled to exemption of ₹6,92,308 and the remaining ₹18,07,692 will be taxable, subject to the income tax slab rate applicable.
Gratuity in HR is a key employee benefit that provides financial security after retirement or during resignation. However, understanding its taxability is important for both employees and employers. Employers must stay informed about these tax rules to ensure they comply and to help their employees with tax planning.
Gratuity is an important part of an employee's financial security, but many employers make mistakes in handling it, which can lead to legal and financial complications. These mistakes often stem from a lack of understanding of the rules or the improper calculation of gratuity payments. Let’s discuss the most common mistakes employers make and how to avoid them.
1. Incorrect Calculation of Gratuity
One of the most common mistakes is failing to calculate the gratuity amount properly. Employers may miscalculate the employee’s last drawn salary or misinterpret the years of service when calculating the gratuity. This can result in underpayment or overpayment, both of which can lead to issues later on.
2. Failure to Account for Eligibility Criteria
Many employers overlook the mandatory eligibility requirement of a minimum of five years of continuous service for employees to be eligible for gratuity. Employees who leave the company before reaching this milestone are not entitled to a gratuity. Employers may mistakenly pay gratuity to an employee who has not met this requirement, leading to financial losses.
3. Not Maintaining Proper Records
It’s essential to maintain proper records of employees’ tenure, salary, and the dates of their exit. If these records are not maintained accurately, it can cause confusion and disputes when it’s time to calculate gratuity. Missing or incomplete documentation can also lead to non-compliance with the Payment of Gratuity Act.
4. Ignoring the Tax Implications
Some employers fail to account for the taxability of gratuity, especially if the amount exceeds the exempt limit. This can lead to both the employer and the employee being caught off guard when tax liabilities arise. Employers need to ensure they inform employees about the tax implications of gratuity.
5. Failure to Update Gratuity Policies Regularly
Gratuity policies should be reviewed regularly to keep up with changes in labour laws or company policies. Employers often make the mistake of not updating their gratuity policies, leading to outdated information or benefits. This can cause discrepancies in how gratuity is calculated and paid.
Example: Mistakes Leading to Disputes and Claims
A large IT firm where an employee resigned after four and a half years of service, just short of the mandatory five-year requirement for gratuity. The company mistakenly paid the employee gratuity, as they had not properly reviewed the eligibility rules. This may lead to a dispute when the company realises the mistake after the employee has left. The company was forced to recover the amount paid out, which led to tension and legal complications.
Gratuity is an important employee benefit, but handling it improperly can lead to serious issues. By ensuring proper calculation, maintaining accurate records, and keeping policies up-to-date, employers can avoid common mistakes and reduce the risk of disputes.
Managing gratuity in HR payments is necessary for maintaining compliance and building trust with employees. It’s about doing things right from the beginning, ensuring employees are paid fairly, and avoiding any legal complications. Here are some key practices for handling gratuity in your organisation.
1. Ensure Compliance
It is important to understand eligibility, the correct calculation method, and the statutory rules for payments. Regularly reviewing and updating policies to reflect any changes in the law will help avoid mistakes.
Being clear with employees about gratuity policies also helps. When employees know exactly what they’re entitled to, it fosters trust and reduces the chances of disputes.
2. Maintain Accurate Employee Records
Accurate, up-to-date records are key to gratuity management. Employers must track each employee’s start date, service duration, and salary, as these details are crucial for correctly calculating gratuity.
Accurate records ensure that the calculation process is free of delays or errors. Incomplete or incorrect records can lead to disputes, legal complications, or even penalties. Maintaining organised records helps prevent such issues.
3. Using Software or HR Tools to Automate Gratuity Calculations
Calculating gratuity manually can be time-consuming and prone to mistakes. That’s where HR software and automation tools come in. These tools allow employers to ensure accurate and efficient gratuity calculations.
HR software automates the tracking of an employee’s tenure and salary changes and calculates gratuity accordingly. This not only saves time but also ensures that no mistakes are made. By integrating software tools, employers can streamline the process and guarantee that gratuity is paid out promptly and correctly.
By adopting these practices, employers can effectively manage gratuity payments, maintain positive relationships with their employees, and comply with the law.
Managing gratuity doesn’t have to be complicated or stressful. By following the right practices and keeping accurate records, you can ensure that your business complies with regulations and maintains good relationships with your employees. However, without the right tools, handling gratuity can quickly become a burden.
This is where Craze can make all the difference. Craze HR software helps automate gratuity calculations, ensuring you’re always compliant while saving you time and reducing the risk of errors. With Craze, you can effortlessly manage employee records, stay on top of changes in regulations, and streamline your HR processes—all from one platform.
Make gratuity management easy and hassle-free. Let Craze handle the details so you can focus on what matters most: your team and your business. Get started with Craze today!
