Gratuity is a lump sum amount an employee gets when she retires, resigns, dies or becomes disabled due to an accident or disease, provided she had worked for at least five continuous years for the same employer. In other words, it’s a financial reward or gratitude an employee gets from an employer for rendering her service to the company for a continuous period.

Companies in specific industries such as mines, oil fields, factories, shops and plantations or shops having more than 10 employees are mandatorily required to pay gratuity to their employees under the Payment of Gratuity Act, 1972. Employers who are not covered by this Act can also pay gratuity.

There are different rules for calculating gratuity and the tax to be paid on it, for government employees, for those covered under the Act and for those not covered under the Act.

Here is how to calculate gratuity and the amount of tax exemption an employee covered under the Act can avail on the amount paid.

Calculating gratuity

Gratuity is calculated based on two factors—the number of years an employee completes with an organisation and her last drawn salary at the organisation.

Here, salary includes basic salary and dearness allowance, and all other components are excluded.

To calculate the amount of gratuity, multiply the total number of years served with 15 days of salary. But remember 15 days’ salary is arrived at by dividing the last month’s salary by 26 and multiplying the product by 15. This adjustment is not available for workers not covered by the Payment of Gratuity Act.

So, if your last drawn salary was ?50,000 (basic and dearness allowance) and the employment tenure was 12 years, you will be eligible for a gratuity of {(50,000/26)x15}x12 or Rs3,46,154.

Exemption on gratuity

The Income-tax Act, 1961 exempts gratuity from tax up to a certain limit. Your tax-free gratuity amount is the lowest of three things—the eligible gratuity, actual gratuity received and ?20 lakh, which is the upper tax-free limit set by the government.

Earlier, gratuity up to ?10 lakh was exempt from tax. This was extended to ?20 lakh for employees covered by the Payment of Gratuity Act through an amendment in 2018. Union finance minister Arun Jaitley recently announced in a tweet that the increase to ?20 lakh would also be made applicable to employees not covered by the Payment of Gratuity Act and to all government employees, and not just to those covered under the Act.

Suppose your employer paid you Rs12 lakh as gratuity. Taking the example discussed earlier, you would be eligible for a gratuity of ?3,46,154. Here, the lowest of the eligible gratuity amount ( ?3,46, 154), ?12 lakh (actual gratuity received) and ?20 lakh, the upper tax-free limit set by the government will be tax-exempt. Here the lowest amount is ?3,46,154, which will be exempt from tax, and the remaining ?8,53,846 will be taxable as per your applicable income-tax slab rate.