Is Gratuity Taxable? What You Need to Know Before You Retire

After putting in several years in an organization, the benefit of gratuity certainly becomes a deserved one for you. However, once the gratuity is credited to your account, it is natural for you to wonder if it would become a taxable income.

The quick answer would be, it depends.

If gratuity would be a part of your taxable income or not depends upon your:

• Employment status
• Tenure of service
• Gratuity amount

Everything will be explained clearly in simple terms without any technical lingo in the coming sections.

What Is Gratuity?

Gratuity is basically a gift in the form of a lump sum paid to the employee by the employer as a gesture of gratitude towards their loyal and dedicated service. The amount is paid when the individual resigns from his service or retires or passes away due to accident or sickness.

The Payment of Gratuity Act, 1972 regulates the gratuity benefit in India. This act is applicable in:

• Factories
• Mines
• Oilfields
• Plantations
• Ports
• Railways
• Shops
• Establishments where there are ten or more employees

An establishment which qualifies for gratuity once remains eligible for it until such time its number of employees goes down to less than ten.

However, for an employee to be eligible for gratuity, he/she needs to have worked for a period of five years in the organisation.

Some cases qualify an employee for gratuity despite him/her having not met this criterion. An example is when the employee dies or suffers permanent disablement in his/her work.

How Is Gratuity Calculated?

Before delving into tax exemptions on gratuity, it is important to know how the amount is determined.

When an employee is covered by the Payment of Gratuity Act, then:

Gratuity = (Last salary × 15/26) × Years of service

• The salary considered in the calculation includes basic pay and dearness allowance.
• Here, the number 26 refers to the number of working days in a month.
• 15 refers to half a month’s pay for each completed year of service.

When an employee is not covered by the act (those working in organisations with less than ten employees):

Gratuity = (Last salary × 15/30) × Years of service

• Here, the difference is in the use of 30 instead of 26.

This formula is crucial because of the relationship it has to the exemption limit.

Gratuity Tax Exemption in India

That is the crux of the matter, and the answer lies in analyzing three different types of employees.

1. Employees of the Government Sector

If you are employed with the central government, the state government, or the local authorities, then the entire gratuity is tax-exempt without any upper ceiling.

Irrespective of whether the gratuity paid to you is ₹5 lakh or ₹50 lakh, not a single penny will be included in your income for taxation purposes. This has been the policy adopted by the Income Tax Act, 1961, under Section 10(10)(i).

2. Employees Who Are Eligible for Gratuity Under the Payment of Gratuity Act, 1972

In respect of those employees whose gratuity falls under the Payment of Gratuity Act, 1972, the gratuity is only partially exempted.

It means that the least of the following three amounts will be exempted:

• Actual gratuity payable
• ₹20 lakh (present statutory limit, effective from 2019)
• 15 days' pay for each complete year of employment (formula stated above)

Example: Assuming that you have put in a total of 25 years in service and your last drawn monthly basic and Dearness Allowance is Rs.60,000.

Gratuity calculated using the above formula = (60,000 × 15/26) × 25 = ₹8,65,385

As it comes out to be less than ₹20 lakhs, so no tax needs to be paid. The entire amount of ₹8,65,385 is exempted from tax.

But, if in case the amount of gratuity received is ₹22 lakhs, then the additional amount of ₹2 lakhs (Rs.22 lakhs – ₹20 lakhs) will become taxable.

3. Non-Covered Employees under the Payment of Gratuity Act

Employees in private sectors who work with organisations which are not registered under the Act passed in 1972 get some tax relief.

Their exemption will be the lowest of:

• Actual gratuity received
• ₹20 lakh
• Half-monthly average of salaries earned for every year of completed service Here, average salary includes the average of the last 10 months' salary (Basic salary + DA + Commission on basis of percentage of turnover).

What You Need to Know About ₹20 Lakh Exemption Limit for Gratuity

Under Section 10 (10C), the maximum tax-exempt gratuity was limited to ₹10 lakh until the last quarter of 2018. This limit was raised by two times to ₹20 lakh through a notification under the Payment of Gratuity (Amendment) Act, 2018.

It was about time for this change to happen because of the growing salary rates, many employees were reaching the ₹10 lakh limit even with modest tenure and facing tax liabilities when it comes to their retirement benefit.

The existing limit of ₹20 lakh relates to an employee's lifetime gratuity from one or several employers. In case of claiming exemption for gratuity from a previous employer, the difference between this limit and the previously claimed amount will be eligible for future receipts.

For instance, if you have already received ₹7 lakh in tax-free gratuity, then you may claim the remainder of the ₹20 lakh limit for future receipts from other companies.

When Is the Time to Receive Gratuity? When Is It Taxable?

Normally, tax on gratuity is due upon its receiving. In accordance with the Income Tax Act, it falls into the category of "Salary Income" of the financial year when it was earned.

In the case where the gratuity payment is made in installments (though rare), it will be taxed in the year when it is received.

A key fact to note here is that if an employee dies and the gratuity is claimed by the nominee/legal heir, then the entire gratuity will be exempt from taxation for the person receiving it. The family will not have to pay any tax if the gratuity is received because of the death of the employee.

Taxation of Gratuity When You Quit Your Job

Yes, the same rules apply if you retire, quit your job, or are laid off.

But if you quit before serving for at least five years (with exceptions for death and disability), then you may not be eligible for the payment under the Payment of Gratuity Act.

In some instances, the employer may choose to make an ex-gratia payment to the employee. This is fully taxable as it does not qualify as gratuity under the Act.

Gratuity Taxation Under the New Tax Regime

In India, under the newly introduced tax regime (announced in Budget 2020; made default from 2023-24), most exemptions and deductions are no more available. But, the gratuity exemption available under Section 10(10) continues under the new regime too.

That’s indeed a good news for taxpayers. Under the old tax regime, or the new tax regime – both ways, your gratuity exemption stands protected.

How to Show Gratuity in Your Tax Return

While filling your ITR, keep the following in mind:

• Gratuity amount will be shown by your employer in your Form 16 as part of salary components
• The exempted gratuity amount will be shown separately under Section 10(10)
• The taxable gratuity amount only needs to be included in your gross income
• The amount in your tax return matches with what is indicated in your Form 16 and Form 26AS

If you notice any discrepancies, like if your employer has deducted TDS from your gratuity without taking into account the exemption available under Section 10(10), then you may claim an exemption on that amount during your tax filing process.

Things to Avoid While Calculating Your Gratuity Tax

Considering the entire gratuity tax-free. Not all gratuity is tax-free.

This is valid for government employees alone. Others must remember that only the amount up to the limit computed will be exempt from taxes.

1. Overlooking previous gratuity exemptions

In case you have changed jobs and sought tax exemption from previous gratuity payments, then the overall lifetime limit of ₹20 lakh will apply. Overlooking past exemptions might result in an error in filing ITR.

2. Misconstruing ex-gratia payments with gratuity

While these two are distinct terms, ex-gratia payments lack statutory backing and are subject to taxation. Gratuity, however, falls under the Payment of Gratuity Act and is subject to certain exemptions.

3. Not filing an ITR in case of gratuity receipt

Even if the gratuity is wholly exempt from taxes, it may take your total income above a certain limit, necessitating ITR filing.

Key Takeaways

• Gratuity is taxable in India, but significant exemptions apply based on the employee category.
• Government employees enjoy full exemption with no ceiling.
• Private sector employees under the Payment of Gratuity Act get exemption up to ₹20 lakh (or the calculated amount, whichever is lower).
• Employees not covered by the Act also get partial exemption using a slightly different formula.
• The ₹20 lakh ceiling is cumulative across all employers in a lifetime.
• Gratuity received by nominees due to death of an employee is fully tax-free.
• The exemption is available under both old and new tax regimes.

Conclusion

Understanding how gratuity is taxed helps you plan your finances more accurately as you approach retirement or a job change. If your gratuity amount is on the higher side, consulting a chartered accountant before filing can save you from errors and ensure you claim every bit of relief you are entitled to.