Taxation on Gratuity

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Taxation on Gratuity

Gratuity received on retirement, resignation, or death is exempt from income tax up to ₹20 lakh under Section 10(10) of the Income-tax Act, 1961 — but the exact exempt amount depends on which of three legal categories you fall into, how salary is defined, and whether a lifetime cap from a previous employer has already been used. This guide works through the Payment of Gratuity Act, 1972 formula, all three Section 10(10) categories, real Rs. examples, and the employer compliance steps that apply in FY 2026-27 / AY 2027-28.

Legal Framework: Payment of Gratuity Act, 1972

The Payment of Gratuity Act, 1972 (PGA) is the baseline statute that defines eligibility, the computation formula, the statutory ceiling, and the employer's obligation to fund and pay gratuity on time.

The Act applies to:

• Factories, mines, oilfields, plantations, ports, and railways
• Shops and establishments employing ten or more persons on any day during the preceding twelve months

Once an establishment crosses the ten-employee threshold, it remains covered even if headcount later falls below ten. State government rules extend the Act to additional categories in several states, so always check the relevant state notification before assuming a small establishment is excluded.

What "wages" means under the Act matters enormously for the formula. Section 2(s) of the PGA defines wages as basic salary plus dearness allowance (DA). It excludes HRA, bonus, commission, overtime, and any other allowances. This is narrower than the "salary" definition used for other compensation purposes.

Employers are required to obtain a gratuity insurance policy from the Life Insurance Corporation of India (LIC) or any other approved insurer, or alternatively set up an approved self-managed gratuity fund, unless specifically exempted. This ensures funds are ring-fenced and available when an employee exits.

Eligibility: The Five-Year Rule and Its Exceptions

An employee becomes entitled to gratuity on completing continuous service of not less than five years, subject to the triggering event being:

• Superannuation (reaching retirement age)
• Resignation
• Retirement
• Termination after five years of service

Critical exceptions — the five-year condition does not apply in cases of:

1. Death — gratuity is paid to the nominee (or legal heir if no nomination) regardless of how short the service was
2. Disablement — physical or mental incapacity rendering the employee unable to work

"Continuous service" under the Act is more forgiving than it sounds. It includes:

• Authorised leave (earned leave, casual leave, sick leave)
• Maternity leave up to the period prescribed under the Maternity Benefit Act
• Lay-off periods under the Industrial Disputes Act
• Absence due to accident in the course of employment

A common misunderstanding: if an employee works 4 years and 8 months, the five-year condition is not met (the six-month rounding rule applies only to completed-year calculations within the formula, not to the eligibility threshold itself). Make sure you count the eligibility period separately from the formula's year-rounding logic.

How Gratuity is Calculated: The Act Formula vs. the Non-Act Formula

For Employees Covered Under the Payment of Gratuity Act

The statutory formula is:

> Gratuity = (Last drawn monthly wages × 15 × Completed years of service) ÷ 26

Here:

• Last drawn monthly wages = basic salary + DA on the date of exit (not an average, not the highest drawn)
• 15 represents 15 days of wages per year of service
• 26 is the assumed number of working days in a month (based on a six-day working week)
• Completed years of service: a part year exceeding six months is rounded up to a full year; six months or less is ignored

Example of rounding: 22 years and 7 months → treated as 23 years. 22 years and 5 months → treated as 22 years.

The statutory ceiling on the gratuity amount payable under the Act is ₹20 lakh. An employer may pay more by way of ex-gratia, but the Act does not compel it. The ₹20 lakh ceiling was last enhanced by a Central Government notification; employers should verify the current notified figure since it can be revised by executive order without an amendment to the Act.

For Employees Not Covered by the Act

Where the Act does not apply (e.g., an establishment with fewer than ten employees, or a category not yet notified), the formula commonly used and accepted by the Income Tax Department for Section 10(10)(iii) purposes is:

> Gratuity = Half month's average salary × Completed years of service

Here average salary means the average of the last ten months' salary, and for this category salary includes basic + DA + commission as a fixed percentage of turnover — a wider definition than under the PGA.

Tax Treatment Under Section 10(10): Three Categories

Section 10(10) of the Income-tax Act creates three mutually exclusive categories. Your category determines both the definition of "salary" and the exemption formula.

Category 1 — Government Employees

Any gratuity received by an employee of the Central Government, State Government, or a local authority is entirely exempt from income tax, with no monetary ceiling. There is no formula calculation required. The full amount, irrespective of how large, is excluded from gross total income.

Note: Employees of statutory bodies (PSUs, autonomous bodies) are generally not treated as government employees for this purpose unless specifically notified. A PSU employee falls in Category 2 or 3, not Category 1.

Category 2 — Employees Covered Under the Payment of Gratuity Act

Exempt to the extent of the least of:

1. ₹20 lakh (lifetime aggregate ceiling)
2. Actual gratuity received
3. 15 days' wages × completed years ÷ 26 (the Act formula applied with last drawn wages = basic + DA)

Only the excess over this least-of amount is taxable under the head "Income from Salary."

Category 3 — Other Employees (Not Covered by PGA)

Exempt to the extent of the least of:

1. ₹20 lakh (lifetime aggregate ceiling)
2. Actual gratuity received
3. Half month's average salary × completed years of service (average salary = last 10 months' average of basic + DA + fixed commission)

Worked Examples: Calculating the Exact Exempt Amount

Example A — Mid-Career Exit, PGA-Covered Employee

Priya, a factory manager, retires after 18 years and 4 months of service. Last drawn basic salary: ₹70,000/month. DA: ₹14,000/month. Total wages for formula = ₹84,000/month. Employer pays ₹8,00,000 as gratuity. She has never received gratuity from any previous employer.

Because the actual amount paid (₹8,00,000) is less than both the formula amount and the ceiling, the entire gratuity is exempt.

Example B — Long-Service Employee, Ceiling Kicks In

Rajesh, a senior manager at a listed company (PGA-covered), retires after 32 years and 8 months of service. Last drawn basic + DA: ₹1,30,000/month. Employer pays ₹27,00,000 as gratuity (above the Act ceiling, partly ex-gratia). No prior gratuity from another employer.

The ₹7,00,000 taxable amount is added to Rajesh's salary income for AY 2027-28 and taxed at his applicable slab rate. His employer must deduct TDS on this ₹7,00,000 as part of monthly TDS computation and report it in Form 24Q.

Example C — Gratuity From Two Employers, Lifetime Cap

Sunita worked at Firm A for 12 years and received ₹9,00,000 gratuity in FY 2021-22. She claimed ₹9,00,000 as exempt at that time (the ceiling was lower then, but the full ₹9L was within limit). She is now retiring from Firm B after 15 years of service and receives ₹18,00,000 gratuity in FY 2026-27.

The ₹20 lakh ceiling is a lifetime aggregate across all employers, not a fresh ₹20 lakh per job. Sunita must disclose the previously utilised exemption in her AY 2027-28 return (and her employer should factor this into Form 16 if she has informed them of prior gratuity).

Example D — Death Gratuity (Nominee's Hands)

Vikram, a 34-year-old engineer, passes away after 3 years and 2 months of service. His nominee receives ₹3,50,000 as death gratuity from the employer.

The entire ₹3,50,000 is exempt in the hands of the nominee — no formula test, no ceiling test applies to death gratuity received by the nominee. The five-year service condition and the Section 10(10) least-of formula are both inapplicable. This is an important protection for families.

Special Situations You Need to Know

Disablement

Where an employee is permanently disabled in an accident or disease arising out of employment, gratuity is payable without the five-year condition, calculated under the same Act formula.

Forfeiture for Misconduct

Under Section 4(6) of the PGA, gratuity may be forfeited — wholly or in part — where the employee's services have been terminated for an act involving moral turpitude or an act of violence causing damage or destruction to employer property. The forfeiture is not automatic; the employer must follow due process and record the decision. A dismissal for poor performance or operational reasons does not justify forfeiture.

Commission-Based Employees (Category 3)

For Category 3 employees whose remuneration includes commission as a fixed percentage of turnover, that commission forms part of "salary" for the exemption formula. If Anand earns a base of ₹50,000/month and a fixed 1% commission on ₹80 lakh annual turnover (= ₹80,000/year = ₹6,667/month), his average monthly salary for the formula is ₹50,000 + ₹6,667 = ₹56,667. Variable or discretionary commission is excluded.

Gratuity Under the New Tax Regime — FY 2026-27

The Section 10(10) exemption is fully preserved under the new tax regime under Section 115BAC. This is not a deduction under Chapter VI-A, which is where most new-regime disallowances sit. It is an exemption from the definition of income, and the Finance Act has not disturbed it.

What this means practically:

• Whether an employee opts for the old regime (with deductions like 80C, 80D) or the new regime (lower slab rates, fewer deductions), the gratuity exemption calculation remains identical
• Employees need not factor gratuity tax treatment into the old-vs-new regime comparison — it is neutral
• Employers computing TDS on salary under Section 192 should apply the Section 10(10) exclusion before arriving at net taxable salary, irrespective of which regime the employee has declared for the year

This makes gratuity structuring relevant under both regimes, and employers should not assume the new-regime choice reduces the importance of accurate gratuity tracking.

Employer Compliance Obligations in FY 2026-27

Funding the Liability

Employers have two compliant options:

1. Group gratuity scheme with LIC or an approved insurer — premium paid is a business expense; the policy also covers mortality risk for death gratuity
2. Approved gratuity trust (Part C, Fourth Schedule, Income-tax Act 1961) — a registered irrevocable trust governed by CBDT approval; employer contributions are deductible under Section 36(1)(v) up to the amount certified as the annual service cost in the actuarial valuation

The employer's annual contribution to an approved gratuity fund is deductible as a revenue expenditure, reducing taxable profits. The deduction is capped at the actuarial contribution; any excess contribution in a given year is carried forward and allowed in subsequent years.

Actuarial Valuation and Accounting

Under Ind AS 19 (Employee Benefits), listed companies and entities applying Indian Accounting Standards must measure the gratuity liability using the Projected Unit Credit method. The discount rate applied is based on market yields on government bonds of matching maturity. The actuarial gain/loss goes into Other Comprehensive Income (OCI).

Under AS 15 (Revised), applicable to companies not yet on Ind AS, similar actuarial valuation principles apply. Small companies applying AS 15 (Level II or III) may use a simplified approach but must still recognise the liability on an accrual basis — not just on cash payment.

Practical step: Commission a licensed actuary (a Fellow of the Institute of Actuaries of India) to perform the valuation before the financial year closes. Do not estimate the liability by applying the Act formula to current headcount — that understates liability and creates audit issues.

Payment Timeline and Late-Payment Consequences

Under Section 7(3) of the PGA, gratuity becomes payable within 30 days from the date it becomes due. If the employer fails to pay within 30 days, simple interest at the notified rate is payable for the period of delay. The employee can file an application before the Controlling Authority (generally the Labour Commissioner or Assistant Labour Commissioner of the jurisdiction) to recover both the principal and interest.

Beyond civil liability, wilful failure to pay is an offence under Section 9 of the Act, punishable with imprisonment and/or fine. Defaults by companies attract personal liability of the director/officer responsible for compliance.

TDS and Form 16 Reporting

When gratuity is paid:

1. Determine the exempt portion under Section 10(10) using the appropriate category
2. Include the taxable portion in the employee's Form 16 (Part B) under "Income chargeable under the head Salaries"
3. Report the exempt portion in the "Exempt allowances" section of Form 16 (Part B) with the Section 10(10) reference
4. Reflect the TDS on the taxable portion correctly in Form 24Q (Q4) for the financial year of payment

Employees receiving large taxable gratuity should ensure their employer has correctly classified the amounts, and cross-check Form 26AS / AIS (Annual Information Statement on the income tax portal) to confirm the TDS credit is visible before filing the AY 2027-28 return.

Common Mistakes and Pitfalls to Avoid

1. Using the wrong salary definition The most frequent error is applying the broad "salary" (including HRA, bonus) in the PGA formula instead of the narrower basic + DA. This inflates the computed exempt amount and triggers scrutiny in assessments.

2. Ignoring the lifetime ceiling Employees who have worked at multiple companies sometimes claim full exemption at each employer without disclosing past gratuity receipts. The ₹20 lakh cap is cumulative. Excess exemptions can result in demand notices and interest under Section 234B/234C.

3. Treating all PSU employees as government employees PSU employees are not Section 10(10)(i) government employees. A bank employee, ONGC executive, or BHEL engineer falls under Category 2 or Category 3, not Category 1. Getting this wrong exempts too much.

4. Rounding the eligibility period the same as the formula years The five-year eligibility threshold must be a strict five calendar years. The six-month rounding rule applies only to counting formula years once eligibility is established. Paying gratuity (and exempting it) before five years are complete — except in death/disablement cases — is non-compliant.

5. Missing the 30-day payment deadline Employers processing gratuity through a slow HR approval chain routinely exceed 30 days. Set up a process whereby the gratuity application triggers a defined workflow with escalation if the deadline approaches.

6. Not maintaining nomination records Absence of a valid Form F nomination creates delays in death gratuity cases. Obtain completed nominations at onboarding and update them whenever an employee reports a change in family status.

7. Employer contributing to an unapproved gratuity fund Contributions to a fund not approved under Part C of the Fourth Schedule are not deductible under Section 36(1)(v) — they are only deductible on actual payment to the employee. This creates a timing mismatch and inflates taxable profit unnecessarily.

Key Takeaways

• Section 10(10) provides gratuity exemption under three categories — government employees (fully exempt), PGA-covered employees (least-of-three formula), and others (half-month average salary formula). Category determines everything.
• The ₹20 lakh ceiling is a lifetime limit, not per employer. Employees who receive gratuity from more than one employer must track utilised exemption and disclose it to subsequent employers.
• Death gratuity is fully exempt in the nominee's hands with no formula test and no five-year service condition — a vital protection for dependants.
• The Section 10(10) exemption survives the new tax regime under Section 115BAC. Choosing the new regime for FY 2026-27 does not cost the employee the gratuity exemption.
• Employers must pay within 30 days of the due date; delays attract simple interest and expose the responsible officer to prosecution under Section 9 of the PGA.
• Actuarial valuation under Ind AS 19 / AS 15 is mandatory for proper accounting; the Act formula is a payment floor, not a liability measurement tool.
• Approved gratuity fund contributions are deductible under Section 36(1)(v); unapproved arrangements lose this timing benefit and create avoidable tax inefficiency.