Income Tax (IT) treatment of gratuity proceeds and calculation of exemption

How much income tax you pay on the amount you receiv as gratuity depends on the type your employer and your coverage under the Payment of Gratuity Act. This article explains the taxation provisions in detail.

In “What is Gratuity and how you benefit from it”, we understood what gratuity is. Now, let’s understand how gratuity proceeds are taxed in your hands.

Gratuity is a “salary” income

Any amount that you receive as gratuity is added to your income for that year under the head “Income from Salary”. However, exemption is available upto a certain amount under section 10(10) of the Income Tax (IT) Act.

To calculate this exemption, employees are classified in three categories:

Government employees (including employees of local authorities)
Employees covered under the Payment of Gratuity Act, 1972
Employees not covered under the Payment of Gratuity Act, 1972

1. Government employees (including employees of local authorities)

If you are a government employee, the entire amount you receive as gratuity is tax free – without any cap or upper limit.

2. Employees covered under the Payment of Gratuity Act, 1972

The minimum of the following three is exempt from income tax:

Gratuity amount actually received
15 days’ salary (based on the last drawn salary) for every completed year of service (or part thereof in excess of six months)
Rs. 3,50,000 (This would be increased to Rs. 10,00,000 soon – please read “What is Gratuity and how you benefit from it” for more details on this)

Here, a partial year of service is considered as 1 year if it is more than 6 months. Service of less than 6 months is ignored.

Example: If you have served for 14 years and 9 months, it is treated as 15 years. But if you have served for 14 years and 5 months (or 14 years and 6 months), it is counted as 14 years.

3. Employees not covered under the Payment of Gratuity Act, 1972

The minimum of the following three is exempt from income tax:

Gratuity amount actually received
Half months’ average salary for every completed year of service
Rs. 3,50,000 (This would be increased to Rs. 10,00,000 soon – please read “What is Gratuity and how you benefit from it” for more details on this)

Here, average salary for the 10 months immediately preceding the month of retirement needs to be calculated. You get half of that amount for each year of your service in the company.

Here, only completed years of service are considered as full years. A service of less than a year is ignored.

Example: If you have served for 14 years and 9 months, it is treated as 14 years. If you have served for 14 years and 5 months (or 14 years and 6 months), it is counted as 14 years as well.

Detailed illustration / example

Let’s say you are leaving a company in April 2010 after putting in 11 years and 8 months of service. You are getting a gratuity amount of Rs. 1,90,000. Here is your salary (basic + DA) for the month of retirement, and 10 months preceding it:

Month	Calendar Month	Salary
0 – Retirement	Apr 2010	Rs. 30,000
-1	Mar 2010	Rs. 30,000
-2	Feb 2010	Rs. 30,000
-3	Jan 2010	Rs. 30,000
-4	Dec 2009	Rs. 27,000
-5	Nov 2009	Rs. 27,000
-6	Oct 2009	Rs. 27,000
-7	Sep 2009	Rs. 27,000
-8	Aug 2009	Rs. 27,000
-9	Jul 2009	Rs. 27,000
-10	Jun 2009	Rs. 25,000

Now let’s see what your taxable gratuity would be under all the three cases.

1. You are a government employee

The entire Rs. 1,90,000 is tax-free for you.

2. You are not a government employee, but are covered under the Payment of Gratuity Act, 1972

The minimum of the following three is exempt from income tax:

1. Gratuity amount actually received: Rs. 1,90,000

2. 15 days’ salary (based on the last drawn salary) for every completed year of service (or part thereof in excess of six months):

15 days’ last drawn salary = Rs. 30,000 / 2 = Rs. 15,000

Years of service = 12

Thus, Rs. 15,000 * 12 = Rs. 1,80,000

3. Rs. 3,50,000

Thus, Rs. 1,80,000 is tax-free in your hands. The remaining Rs. 10,000 of the gratuity amount would be added to your income under the head “Income from salary”, and would be taxed as per the applicable income tax slab.

(To know the latest income tax slabs, please read “Income Tax (IT) Slabs / Brackets and rates”)

(To know how to calculate the income tax payable by you, please read “Calculating your income tax liability”)

3. You are not a government employee, and are not covered under the Payment of Gratuity Act, 1972

The minimum of the following three is exempt from income tax:

1. Gratuity amount actually received: Rs. 1,90,000

2. Half months’ average salary for every completed year of service:

Last 10 months’ average salary = ( (Rs. 30,000 * 3) + (Rs. 27,000 * 6) + (Rs. 25,000 * 1) ) / 10 = Rs. 2,77,000 / 10 = Rs. 27,700

Half of that = Rs. 13,850

Completed years of service = 11

Thus, Rs. 13,850 * 11 = Rs. 1,52,350

3. Rs. 3,50,000

Thus, only Rs. 1,52,350 is tax-free in your hands. The remaining Rs. 37,650 of the gratuity amount would be added to your income under the head “Income from salary”, and would be taxed as per the applicable income tax slab.

(To know the latest income tax slabs, please read “Income Tax (IT) Slabs / Brackets and rates”)

(To know how to calculate the income tax payable by you, please read “Calculating your income tax liability”)

A very important point to remember

Please note that the maximum exemption limit of Rs. 3,50,000 is a life-time limit. That is, this is the maximum amount of exemption available for gratuity received from various employers in your entire life. The limit is not for each gratuity received.

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