Taxation on Gratuity

Gratuity is one of the most meaningful retirement benefits available to Indian employees, designed to reward continuous service. Governed by the Payment of Gratuity Act, 1972 and taxed under Section 10(10) of the Income-tax Act, gratuity continues to be central to employee compensation in FY 2026-27. With the new tax regime under Section 115BAC as the default and the gratuity exemption ceiling enhanced to ₹20 lakh, both employers and employees need to understand the legal and tax provisions clearly.

Legal Framework — Payment of Gratuity Act, 1972

The Payment of Gratuity Act applies to factories, mines, oilfields, plantations, ports, railways, shops and establishments employing ten or more persons. An employee becomes eligible for gratuity on rendering continuous service of not less than five years, except in cases of death or disablement where the five-year requirement does not apply.

• Gratuity is payable on superannuation, resignation, retirement or termination after five years of continuous service.
• On death of the employee, gratuity is paid to the nominee regardless of service length, and disablement claims are similarly relieved from the five-year condition.
• Continuous service includes periods of authorised leave, lay-off, maternity leave up to the prescribed period, and absence due to accident in the course of employment.
• Employers must obtain insurance from LIC or any other approved insurer for gratuity liability, except in specified cases.

Computation of Gratuity Amount

The amount of gratuity payable under the Act is computed as 15 days of last drawn wages for each completed year of service, with a part year exceeding six months treated as a full year. The formula is:

1. Gratuity = (Last drawn monthly wages × 15 × completed years of service) divided by 26.
2. Where 26 represents the working days in a month for the purpose of the formula.
3. For employees not covered under the Payment of Gratuity Act, the half-month formula is generally used — half month's average salary for each completed year of service.
4. The maximum statutory ceiling under the Act is ₹20 lakh.

Tax Treatment Under Section 10(10)

Gratuity received is taxed under the head 'Income from Salary'. Section 10(10) of the Income-tax Act provides three categories of exemption:

• Government employees (Central, State and local authority) — entire gratuity received on retirement, death or termination is exempt from tax.
• Employees covered by the Payment of Gratuity Act — exempt to the extent of the least of (a) ₹20 lakh; (b) actual gratuity received; and (c) 15 days' wages for each completed year of service computed under the Act formula.
• Other employees — exempt to the extent of the least of (a) ₹20 lakh; (b) actual gratuity received; and (c) half month's average salary for each completed year of service.

Special Situations and Nuances

1. Death gratuity received by the nominee is fully exempt in the hands of the nominee.
2. Gratuity received from more than one employer in the lifetime is exempt cumulatively, not per employer; the ₹20 lakh ceiling is a lifetime cap.
3. Where the employee is dismissed for misconduct involving moral turpitude, gratuity may be forfeited fully or partially under the Act.
4. Salary for the purpose of the formula includes basic salary plus dearness allowance, and for employees not covered by the Act, also includes commission as a fixed percentage of turnover.
5. Employer's contribution to an approved gratuity fund is deductible under Section 36(1)(v).

Interaction With the New Tax Regime

The exemption under Section 10(10) is available in both the old tax regime and the new tax regime under Section 115BAC. Unlike many Chapter VI-A deductions, the gratuity exemption is treated as an exemption from gross income and is not lost when an employee opts for the new regime. This makes structured retirement and exit planning equally relevant under both regimes in FY 2026-27.

Compliance Aspects for Employers

• Maintain accurate records of date of joining, salary structure, leaves and breaks in service for every employee.
• Recognise gratuity liability in financial statements based on actuarial valuation under Ind AS 19 or AS 15.
• Settle gratuity within 30 days of it becoming payable, with simple interest for delays under the Act.
• Report gratuity exemption correctly in Form 16 and the Form 24Q quarterly TDS return.
• For approved gratuity funds, comply with Part C of the Fourth Schedule to the Income-tax Act.

Conclusion

Gratuity is a thoughtful balance between worker welfare and structured retirement provisioning. For FY 2026-27, both employers and employees should treat gratuity as a planned event rather than a year-end surprise. Maintain accurate service and salary data, fund the liability through approved schemes, and reconcile the Section 10(10) exemption carefully when filing the return. Done right, gratuity becomes a quiet but powerful pillar of an Indian employee's financial security.