Personal Finance

Will employees gain if gratuity rules are tweaked?

Anand Kalyanaraman | Updated on August 30, 2020

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Gratuity is a reward for the years of service put in by an employee; tax benefits depend on the type of employer

The Centre is said to be mulling a key change in the rules pertaining to gratuity payment by employers.

So, for an employee to be eligible for gratuity benefit, the minimum period of service could be reduced from the current five years to one-three years, say reports.

This is in keeping with the changing dynamics of the job market where many employers and employees prefer shorter-term engagements, rather than the practice of decades-long service.

If the threshold for getting gratuity benefit is reduced, it could act as a boost for many, including short-tenure and contract workers — especially in the present times when many employees are being laid off due to the coronavirus impact.

A lower period of service will be another major relaxation after the doubling in the maximum limit on gratuity payment, from ₹10 lakh to ₹20 lakh, a few years ago. As it stands, here’s how the gratuity benefit works and the tax benefits associated with it.

Reward for loyalty

Gratuity is like a retention bonus — a reward for employee loyalty given by the employer. Just that this reward is mandated by law and not at the discretion of the employer.

So, if you stay on with your employer for five years or more, you are entitled to receive gratuity when you retire, resign or are retrenched. Note that the service has to be continuous in nature, that is, at one stretch.

So, if you work with an employer for three years, resign, but later rejoin and work another thee years before leaving again, you will not be entitled to gratuity despite a service record of more than five years. That’s because the period of service was broken and not continuous.

The monetary reward to be paid by an employer in recognition of an employee’s years of service is laid down by the Payment of Gratuity Act, 1972. Most establishments employing 10 or more workers come under the Act. Once an organisation comes under the Act, it will remain so, even if the number of employees falls below 10.

Roughly said, you get half a month’s Basic and Dearness Allowance (DA) for every completed year of service as gratuity. Here’s how it is calculated: (Number of years of service) x (Last drawn monthly Basic and DA) x 15/26.

So, if you have served 25 years and draw a monthly Basic and DA of ₹30,000 when you leave the job, you get gratuity of ₹4,32,692, calculated as 25 x 30,000 x 15/26. If you serve more than six months in the last year of employment, it is considered as a full year of service.

For instance, service of 24 years, eight months will be considered as 25 years.

Your employer can choose to pay you more, but the maximum amount of gratuity according to the Act cannot exceed ₹20 lakh. Amounts paid above this will be in the nature of ex gratia.

There are exceptions and legal rulings that relax the five-year continuous service rule. One, the rule is waived if an employee dies or is disabled.

Next, the Madras High Court in the Mettur Beardsell case had ruled that if an employee completes four years and 240 days in service, he will be eligible for gratuity.

Tax break

You get a favourable tax treatment under Section 10(10) of the Income Tax Act on the gratuity amount you receive.

If you are a government employee, the entire amount you get is exempt from tax. If you are not a government employee, but are covered under the Act, the tax exempt amount is the lower of the following: a) Actual gratuity received; b) 15 days Basic and DA for each completed year of service or part thereof in excess of six months (as per calculations in the above example); c) ₹20 lakh.

Say, in the example above, your employer paid you gratuity of ₹5,00,000, which is more than the ₹4,32,692 actually payable under the law. You will enjoy tax exemption on ₹4,32,692 and the balance ₹67,308 will be subject to tax.

Consider another example in which the gratuity payable to you as per the formula comes to ₹25 lakh and the employer pays you the amount.

But the current cap on gratuity payable and tax exemption is ₹20 lakh. So, ₹20 lakh will be tax exempt and the balance ₹5 lakh will be taxed. Note that the total tax exemption on gratuity amount received, including those from previous employers in earlier years, cannot exceed ₹20 lakh.

Employees not covered under the Payment of Gratuity Act also get tax benefit if their employers give them gratuity.

But in such cases, the tax exempt amount is the lower of the following: a) Actual gratuity received b) 15 days Basic and DA for each completed year of service calculated as (number of years of service) x (average monthly salary in the last 10 months of employment) x (15/30). c) ₹ 20 lakh.

Note that in such cases, the number of years of service will be only the full years in service; part-year service will not be considered even if it exceeds six months in a year.

For instance, service of 24 years, eight months will be considered as 24 years.

Published on August 30, 2020

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