Gratuity:
Definition, Benefits, Comparison & Uses

Gratuity is a sum of money paid by an employer to an employee as a token of appreciation for their services, typically given upon retirement or resignation after completing a minimum of five years of continuous service. It serves as a financial benefit recognizing an employee's long-term commitment and contribution to an organization. The payment is governed by the Payment of Gratuity Act, 1972 in India, which establishes eligibility criteria, calculation methods, and maximum payment limits.

Gratuity is entirely funded by the employer and does not involve any contribution from the employee. Employers may choose to pay gratuity from their own funds or through group gratuity insurance coverage, particularly common in larger organizations where gratuity payments represent significant expenses.

Related terms: terminal benefit, superannuation, employee provident fund, retirement benefits

An employee becomes eligible for gratuity under the following circumstances:

• Completion of five years of continuous service with a single employer before resignation
• Eligibility for superannuation (reaching retirement age)
• Retirement from service
• Death or disability due to accident or illness (five-year service requirement waived)

The five-year service requirement is treated as complete when an employee has worked for four years and 240 days. However, contractual workers and interns are not eligible for gratuity as they are not considered permanent employees of the company.

Gratuity calculation depends on whether the employer is covered under the Payment of Gratuity Act, 1972. For employees covered under the Act, the formula is:

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

For employees not covered under the Act, the formula is:

Gratuity = (Last drawn salary × 15 × Number of years of service) / 30

Last drawn salary includes basic salary plus dearness allowance. The number 26 represents 30 days in a month minus four Sundays, while 30 represents the actual working days in a month. Service years are rounded up if six months or more are completed in the final year; otherwise, they are rounded down.

For example, if an employee's last drawn salary is ?25,000 and they completed 10 years of service, the gratuity amount for an organization covered under the Act would be: 25,000 / 26 × 15 × 10 = ?1,44,230.

The Payment of Gratuity Act initially stipulated a maximum tax-free gratuity limit of ?10 lakh. This was amended following the Seventh Pay Commission's recommendation and increased to ?20 lakh for an employee's entire working life. The 2019 interim budget announced a further increase in the tax-free gratuity limit to ?30 lakh, though this applies specifically to government employees.

Employers have the discretion to pay a higher gratuity than the amount calculated by the standard formula, but the tax-exempt portion cannot exceed ?20 lakh for private sector employees covered under the Act.

Taxation rules on gratuity vary based on the type of employee:

• Government employees (central, state, or local authority): The entire gratuity amount is exempt from income tax
• Private sector employees covered under the Gratuity Act: Tax exemption applies to the lowest of three amounts: ?20 lakh, the actual gratuity received, or the eligible gratuity calculated by formula
• Private sector employees not covered under the Act: Tax exemption applies to the lowest of three amounts: ?10 lakh, the actual gratuity received, or half-month's salary for each completed year of service

Any gratuity amount exceeding the exempt portion is taxable according to the employee's income tax slab. Gratuity falls under the head of "income from other sources" for taxation purposes.

Gratuity becomes payable when an employee leaves a firm due to retirement, resignation, or layoff after completing the minimum service requirement. The payout process involves three steps: the employee submits an application for gratuity, the employer calculates the amount and notifies both the employee and governing authority, and the company pays the gratuity within 30 days of receiving the application.

If the employer fails to pay within 30 days, the employee is entitled to receive simple interest on the amount. The gratuity amount must be paid in cash, or via demand draft or cheque only when specifically requested by the employee, nominee, or legal heir.

Gratuity nomination is the process by which an employee designates a beneficiary to receive the gratuity payment in the event of their death. According to the Payment of Gratuity Act, 1972, employees who complete one year of service must file a nomination by submitting Form F. Employees are allowed to appoint more than one nominee and can update their nomination by submitting Form H with written notice to the employer.

Proper nomination ensures the gratuity payment reaches the intended beneficiary without legal complications. In the absence of a nominee, the gratuity amount is paid to the legal heir of the employee, which may result in delays and administrative challenges.

An employer can refuse or forfeit gratuity payment only in specific circumstances related to employee misconduct. If an employee is terminated due to violent behavior within company premises, illegal activity, or any disorderly conduct that causes injury to fellow employees or damages company property, the employer has the right to forfeit the entire gratuity amount or a partial amount proportional to the loss sustained.

The Indian Penal Code considers non-payment of legally due gratuity a punishable offense. Employers who fail to pay gratuity without valid reason can face imprisonment for three months or more and/or a fine of ?10,000 to ?20,000. Employees can file a written complaint with the Controlling Authority if their gratuity is not paid within the stipulated timeframe.

A tronc is an arrangement for pooling and distributing tips, gratuities, and service charges to employees in the hotel and catering trade. The person responsible for distributing money from the tronc is known as the troncmaster. In the UK, when a tronc exists, the responsibility for deducting pay-as-you-earn taxes from distributions may lie with the troncmaster rather than the employer.

This system differs from statutory gratuity payments governed by employment law and typically applies to voluntary gratuities given by customers in service industries rather than employer-funded retirement benefits.

Gratuity is often compared to 3 related employment benefits:

Gratuity vs. Provident Fund

Gratuity vs. Pension

Gratuity vs. Tip