Gratuity Act in India: How It Impacts Your Finances

The Payment of Gratuity Act, 1972, plays a crucial role in safeguarding the financial security of employees in India. It is an important legislation designed to ensure that employees who complete a certain period of service with an organisation are rewarded with a lump-sum payment known as gratuity (when they leave). 

This provision can significantly impact both the employee’s retirement planning and overall financial security. In this article, we will take a deep dive into the Gratuity Act, its provisions, eligibility criteria, and its long-term effects on an employee’s finances.

What Is Gratuity?

Gratuity is a financial benefit given by an employer to an employee for their long and meritorious service to the organisation. It is paid as a one-time lump sum amount when an employee retires, resigns, or in cases of death or disability. The amount is paid in recognition of the employee’s contribution over a significant period of time.

In India, the Gratuity Act, 1972 governs this benefit and ensures that employees are provided with this financial security after completing a minimum of five years of continuous service. However, the Act also provides for certain exceptions where gratuity is paid even if the employee has not completed five years, such as in cases of death or disablement.

Key Provisions of the Gratuity Act

The Payment of Gratuity Act, 1972, lays down clear provisions regarding gratuity payments, ensuring fairness and uniformity across various industries. Here are the key components of the Act:

Eligibility for Gratuity

To be eligible for gratuity under the Act, an employee must meet the following conditions:

• Minimum Service Requirement: An employee must have completed at least five years of continuous service with the same employer. However, this requirement is waived in cases of death or disablement, where gratuity is payable regardless of the duration of service.
• Applicability to Certain Industries: The Act applies to all factories, mines, oilfields, plantations, ports, railways, motor transport undertakings, companies, and shops with ten or more employees. In other words, establishments with fewer than 10 employees are not required to follow the Act unless the relevant government extends its application.

Types of Termination Covered

Gratuity is payable to employees when their employment is terminated due to the following reasons:

• Superannuation (Retirement): When the employee reaches the retirement age as stipulated in the employment contract.
• Resignation or Voluntary Retirement: If the employee voluntarily leaves the organisation after completing the minimum service period.
• Death or Disablement: If the employee passes away or becomes permanently disabled, gratuity is payable to the nominee or legal heir, irrespective of the service duration.

Gratuity Calculation

The calculation of gratuity is straightforward. The formula for computing gratuity is:

Gratuity = (Last drawn salary × 15 × Number of years of service) ÷ 26

Here, the last drawn salary includes the basic salary and dearness allowance (DA), and the number 26 represents the number of working days in a month for the purpose of calculation. The factor of 15 denotes 15 days’ wages for each completed year of service.

For example, if an employee’s last drawn salary is ₹50,000 and they have served the organisation for 10 years, the gratuity payable will be:

Gratuity = (₹50,000 × 15 × 10) ÷ 26 = ₹2,88,461

Maximum Gratuity Limit

The Act has set a ceiling on the maximum gratuity amount payable to an employee. The upper limit for gratuity payments is ₹20 lakh. Any gratuity amount exceeding this limit is subject to income tax. This ensures that employees receive a substantial sum, but also accounts for inflation and rising costs.

Tax Exemption

Under the Income Tax Act, gratuity payments up to ₹20 lakh are exempt from tax for employees covered under the Gratuity Act. For government employees, gratuity is fully exempt from tax. However, any gratuity received above ₹20 lakh is taxable. This tax exemption is a significant financial benefit as it helps employees retain a large portion of their gratuity.

Impact of the Gratuity Act on Employee Finances

The Gratuity Act significantly impacts an employee’s finances in multiple ways, both in terms of direct financial benefits and long-term retirement planning.

Financial Security Post-Retirement

Gratuity serves as a crucial tool for financial planning after retirement. For an employee nearing retirement, the lump sum gratuity payment can serve as a buffer against post-retirement financial challenges. The amount can be used to pay off outstanding debts, create an emergency fund, or simply support the employee’s living expenses once they are no longer drawing a regular income.

Since gratuity is calculated based on the last drawn salary, it also reflects the employee’s cumulative contribution to the organisation over time. Thus, the longer an employee serves, the higher the gratuity amount, giving them greater financial freedom after retirement.

Tax Savings

The tax exemptions on gratuity payments are one of the key benefits for employees. As mentioned earlier, gratuity is tax-free up to ₹20 lakh, which means that employees can receive a large sum without worrying about tax deductions. For employees in higher tax brackets, this can result in significant tax savings.

Incentive to Stay Longer

Gratuity is calculated based on the number of years of service. Therefore, employees are encouraged to stay longer with their employer to maximise their gratuity payout. The more years of service an employee completes, the higher the gratuity they will receive. This incentivises long-term commitment to the organisation, benefiting both the employee (through higher financial security) and the employer (by retaining experienced and skilled workers).

A Safety Net for Family Members

In cases of death or permanent disability, gratuity ensures that the employee’s family or legal heirs are not left financially vulnerable. This provision is particularly beneficial for employees in hazardous professions, where the risk of accidents or disability may be higher. Gratuity provides a sense of security to employees knowing that their loved ones will receive a financial benefit should anything happen to them.

Financial Planning for Employers

For employers, the Gratuity Act ensures that they are financially prepared to make gratuity payments to eligible employees. Employers must set aside funds to meet their gratuity liabilities. In some cases, employers choose to purchase insurance policies to cover gratuity payments, ensuring that they have the necessary funds available when required. This reduces the financial burden on employers when large sums need to be paid out.

Compulsory Gratuity Insurance

The Act allows the relevant government to mandate employers to take out an insurance policy to cover gratuity payments. This means that employers are financially responsible for ensuring that gratuity payments are made, even if they face financial difficulties. It also protects employees, as they are guaranteed their gratuity even if the company faces insolvency or financial instability.

Gratuity and Employee Welfare

The Gratuity Act serves as a social welfare measure for employees, promoting financial stability after they leave the organisation. It also fosters a sense of loyalty and dedication, as employees are incentivised to work longer to receive this benefit. The Act also promotes fair treatment, as it ensures that all eligible employees receive gratuity, regardless of their position or the industry they work in.

Furthermore, the Act’s coverage extends to various sectors, including manufacturing, education, and services, ensuring that employees across industries benefit from this provision. This is particularly important in sectors with high employee turnover, as it provides a guaranteed benefit to workers who may not have other retirement savings or benefits.

Recent Amendments to the Gratuity Act

The Gratuity Act has undergone amendments to adapt to changing work dynamics and to align with rising inflation. One of the most significant changes in recent years was the increase in the gratuity ceiling limit from ₹10 lakh to ₹20 lakh. This increase was intended to ensure that employees receive a fair and reasonable payout in line with inflation and the increasing cost of living.

Also, the Act now allows maternity leave to be counted as part of continuous service, which was not the case before. This amendment ensures that female employees are not penalised for taking maternity leave and can still receive gratuity benefits after returning to work.

Conclusion

The Payment of Gratuity Act, 1972, is a significant piece of legislation that plays a vital role in ensuring the financial well-being of employees in India. The gratuity payment provides a much-needed safety net for employees after retirement, resignation, or in cases of death or disability. The Act ensures that employees are rewarded for their long and dedicated service, fostering loyalty and commitment while also helping them plan for the future.