Imagine that you have spent a great deal of time and energy in a company. After everything you’ve done, it’s time to retire or find something else to contribute to. It would be fantastic if you were monetarily rewarded at the end of this journey.
A gratuity is like a monetary thank-you note from your employer; it’s a token of appreciation. Gratuity is critical for your retirement benefits, and understanding it will have a significant influence on your financial planning.
So let’s get started and work through the nuances of gratuity together!
What is gratuity?
A gratuity is an additional sum that an employer gives an employee on top of their regular salary. This payment is intended as a token of gratitude for the worker’s diligent efforts and commitment to the business. It is governed by the Payment of Gratuity Act of 1972.
Factory workers, miners, oilfield workers, plantation workers, port workers, railway company employees, and businesses with ten or more employees are all covered by this law. All government jobs can also benefit from it. India as a whole is subject to the act, with the exception of Jammu and Kashmir.
Gratuity rules: To be eligible for a gratuity, an employee must have worked for the company for at least five years. Nevertheless, if an employee becomes disabled or dies due to a serious illness or accident, this requirement will not be enforced.
While gratuities and pensions serve as financial security post-retirement, the main difference between gratuities and pensions is their structure and payout. In contrast to a pension, which provides a steady income stream to the retiree monthly, a gratuity is a one-time payment made by the employer when the worker leaves or retires.
Also read: The concept of EPF – All you need to know about this tax-saving fund
Eligibility for gratuity
The following criteria must be met for an employee to be eligible for gratuity under the Payment of Gratuity Act of 1972:
Continuous service: A minimum of five years of continuous service with the same employer is required of the employee. An employee is expected to maintain continuous service unless unforeseen circumstances prevent them from doing so, such as illness or an accident.
Termination of employment: Gratuity is payable to the employee upon retirement, resignation, or superannuation.
In case of death or disablement: Gratuity will be paid to the employee’s nominee or heir in case of disability or death, regardless of the employee’s length of service.
Any individual that an employee designates as a gratuity nominee has the right to collect the gratuity pay. Gratuity nomination is the process of designating an individual to receive gratuity benefits in the event of the nominee’s untimely death or disability. Nominating someone at the beginning of a job is a good way for employees to avoid problems later.
Contractual employment: If an employee’s contract with their principal employer lasts longer than five years, the principal employer will pay the employee a gratuity.
Seasonal establishment: Employees of a seasonal business are qualified if they have worked for at least 75% of the total number of days that the business was open for business during that season.
Remember that your employer’s specific regulations and policies may differ from these broad guidelines. For more specific information, checking the company’s policy or contacting the HR department is recommended.
Gratuity calculation
Calculating gratuity is a critical aspect of retirement benefits, and understanding it requires a detailed look at its formula. The gratuity calculation formula is given by:
Gratuity = Last Drawn Salary 15 Number of years of service26
For the purposes of this computation, the number of years of service is rounded to the closest whole year, and the last drawn salary is the employee’s base pay plus dearness allowance.
For example, the calculation would only consider 15 years of service if an employee’s total service was 15 years plus one month and 15 days.
And suppose the last drawn salary of the employee was ₹26,000, including basic pay and dearness allowance. The gratuity will be calculated as
Gratuity = 26,000 15 1526 = 58,50,00026= ₹2,25,000
Conducting an actuarial valuation of gratuity alongside the basic calculation is common practice. Businesses use this financial assessment to find out how much their future gratuity obligations are worth. It requires guessing the future rates of attrition, mortality, and salary increments.
As a result, businesses can better prepare for these commitments and guarantee they have the necessary capital.
Gratuity for employees not covered under the Gratuity Act
Gratuity benefits are payable to all employees, including those excluded from the Payment of Gratuity Act but are part of the National Pension System (NPS). Guidelines for gratuities for NPS employees differ marginally.
Gratuity for NPS employees is computed by adding up all of their pay from the previous six months of work. You can receive a gratuity equal to up to 16.5 times your total salary. In this case, total compensation is the base salary that the government worker was getting either before retirement or on the day of their death.
Tax implications on gratuity
An essential component that workers must comprehend is the taxation of gratuity. Both the employee’s classification and the amount received determine how gratuities are treated by the tax system.
The full gratuity amount is exempt from taxes for government employees, including those working for both the central and state levels.
Gratuities paid to non-government employees covered under the Gratuity Act are exempt from income tax up to a certain point.
The least of the following three amounts is exempt from tax:
- Last drawn salary (basic + DA) * number of years of employment * 15/26 {Gratuity formula, explained above}
- ₹20 lakhs
- Actual gratuity received
Gratuities paid to non-government employees not covered under the Gratuity Act are exempt from income tax up to a certain point.
The least of the following three amounts is exempt from tax:
- Half month’s average salary * number of years of employment
- ₹20 lakhs
- Actual gratuity received
Any gratuity that goes above these limits will be subject to taxation.
Also read: Tax-efficient withdrawal strategies for retirement in India
Bottomline
Always keep in mind that your gratuity is a substantial financial asset, not just a farewell present from your employer. You can be better equipped to decide how to use your retirement benefits by being aware of its regulations, requirements, and computation. Additionally, knowing how to invest gratuity amounts can help your wealth grow.
Further reading: Unlocking prosperity: The transformative power of financial literacy
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