Gratuity and its allowable exemption limit

In this article I have discussed the various provisions regarding gratuity and its taxation-

Gratuity is a retirement benefit. It is generally payable at the time of cessation of employment and on the basis of duration of service. To discuss the tax treatment of the gratuity, the employees have been divided in two types, government and non-government.

In case of government employees, any death cum retirement gratuity received by Government employees (i.e. Central or State Government employees, or employees of a local authority, but not employees of a statutory corporation) is wholly exempt from tax under section 10(10)(i)

To discuss the tax treatment of Gratuity received by a non government even more comprehensively, we have sub-divided non-government employees into, employees covered under the Payment of Gratuity Act 1972 and the employees who are not covered under the Payment of Gratuity Act 1972.

In the case of employees covered by the payment of gratuity act, 1972, any gratuity received by such employees is exempt from tax to the extent of the least of the following –

1) 15 days’ salary (7 days’ salary in the case of employees of a seasonal establishment) based on salary last drawn for each year of service (i.e. 15 days’ salary * Length of Service)

2) Rs. 10,00,000/-

3) Gratuity actually received

The least of the above three is exempt from tax. Gratuity in excess of the aforesaid limits is taxable in the hands of the assessee. However, the assessee can claim relief under section 89.

In the above calculation, the length of service is estimated as follows – If the period of service is 6 months or less than 6 months it shall be ignored for this purpose. Conversely, if the period of the service is more than 6 months, it shall be taken as one full year. To illustrate, if the employee has worked for 25 years, 5 months and 29 days, the length of service shall be taken as 25 years. But if the employee has worked for 25 years, 6 months and 1 day, the length of service shall be taken as 26 years.

Salary for the purpose of aforesaid limits means salary last drawn by an employee and includes dearness allowance but does not include any bonus, commission, house rent allowance, overtime wages and any other allowance. In the above calculation “15 days’ salary” is calculated by dividing the last drawn salary by 26 i.e. maximum number of working days in a month. For instance, if the monthly salary at the time of retirement is Rs. 30,000/-, 15 days’ salary would come to Rs. 17,307/- [i.e. Rs. 30,000 * 15/26].

If the “15 days’ salary” was to be determined for a piece-rated employee, the daily wages shall be computed on the average of the total wages received by him for a period of three months immediately preceding the date of retirement. For this purpose, the wages paid for any overtime work shall not be taken into account. 

In the case of employees not covered by the payment of gratuity act, 1972, any gratuity received by such employees is exempt from tax to the extent of the least of the following –

1) Half month’s average salary for each completed year of service

2) Rs. 10,00,000/-

3) Gratuity actually received

The least of the above three is exempt from tax. Gratuity in excess of the aforesaid limits is taxable in the hands of the assessee. However, the assessee can claim relief under section 89.

In the above calculation each “completed year of service” is determined as follows – For calculating the length of service, any fraction of the year shall be ignored. To illustrate, if the employee has worked for 25 years, 6 months and 15 days, the length of service would still be taken as 25 years.

Average monthly salary for the aforesaid calculation is determined on the basis of average salary for the ten months immediately preceding the month in which the employee has retired. For instance if a person retires on March 16 201, average salary will be considered on the basis of salary drawn from May 1, 2011 to February 28, 2012. Salary for this purpose means basic salary. It includes dearness allowance if the terms of employment so provide (or if dearness allowance is taken into account for computing retirement benefits). It also includes commission if commission is payable at a fixed percentage of turnover achieved by an employee.

In a situation where gratuity is received from two or more employers by a non-Governmental employee (not covered by the Payment of Gratuity Act either in the same year or in different years), the maximum amount of exemption under section 10(10)(iii)  during the lifetime of the concerned employee cannot exceed the notified amount i.e., Rs. 10,00,000.

Any gratuity paid to an employee while he continues to remain in service (whether or not after he has put in a minimum specified period of service) is not exempt from tax, though the assessee can claim relief under section 89.

Gratuity received by family member after the death of the employee – If gratuity is paid after the death of an employee (say X is the employee), then the case may fall in one of the following situations –

*After the death of X.

In Situation 1, the gratuity becomes due (and is paid) during the lifetime of X. Therefore, it is taxable in the hands of X. However, he can claim exemption under section 10(10).

In Situation 2, gratuity becomes due on June 30, 2011 at the time of retirement. It is taxable in the hands of X even if it is received by his legal heirs on July 11, 2011 after his death. After claiming exemption under section 10(10)(ii)/(iii), the balance shall be included in the salary income of the X. It is incorrect to state that in this case income is taxable in the hands of Mrs. X as income from other sources.

In situation 3, X dies on July 6, 2011 while in service. Gratuity is sanctioned after his death on July 6, 2011. It cannot be taxed in the hands of deceased employee X as it becomes due and is paid after his death. This amount is not taxable in the hands of legal heirs also as it does not partake the character of income in their hands but is only a part of the estate developing upon them. It is incorrect to state that income is taxable in the hands of Mrs. X as income from other sources.

Aashish Ramchand 

Email: connect@makemyreturns.com