For every salaried employee, gratuity acts as a crucial financial cushion after retirement or resignation. However, very few people fully understand how gratuity is calculated, how it is taxed, and what part of it is tax-free. Let’s break it down step-by-step with expert insights to help you understand everything about gratuity taxation in India.
Who Is Eligible for Gratuity?
Under the Payment of Gratuity Act, 1972, any employee working in an organization that employs 10 or more people on any given day in a year is entitled to gratuity — provided they have completed at least five years of continuous service with the same employer.
However, this five-year condition does not apply in cases of death or permanent disability. In such cases, the employee or their nominee becomes eligible for gratuity regardless of the length of service.
How Is Gratuity Calculated?
For central and state government employees, gratuity is calculated as per their respective pension rules.
For others covered under the Payment of Gratuity Act, the formula is as follows:
Here:
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Last Drawn Salary includes Basic Pay + Dearness Allowance (DA), if applicable.
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26 represents the number of working days in a month.
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15 denotes 15 days’ salary for each completed year of service.
While calculating the service period, any fraction above six months is treated as a full year, and any fraction below six months is ignored.
Example:
If an employee’s last drawn basic + DA is ₹52,000 and they have worked for 20 years and 7 months:
How Much Tax Is Payable on Gratuity?
1. Government Employees
For employees of Central/State Governments, Defence, or Municipal Corporations, the entire gratuity amount is completely tax-free.
2. Employees Covered Under the Payment of Gratuity Act, 1972
For private-sector employees covered under this Act, the gratuity received is tax-exempt up to the lowest of the following three:
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Actual gratuity received.
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₹20 lakh (maximum lifetime exemption).
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Amount calculated under the formula: (Last drawn salary ÷ 26) × 15 × completed years of service.
If the employer pays more than this calculated amount, the excess amount becomes taxable as per the individual’s income tax slab.
3. Employees Not Covered Under the Gratuity Act
For those not covered under the Act (for example, employees of smaller organizations), the exemption is available up to the least of the following:
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Actual gratuity received.
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₹20 lakh.
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Half month’s average salary (based on the last 10 months) × completed years of service.
Tax-Free Limit: ₹20 Lakh Lifetime Cap
As per the recent amendment to the Payment of Gratuity Act, 1972, gratuity up to ₹20 lakh is completely tax-free.
However, this is a lifetime limit, not a per-employer limit.
For example:
If you received ₹10 lakh gratuity earlier and claimed exemption on it, you can claim a tax-free exemption on only another ₹10 lakh in the future.
If you receive more than ₹20 lakh in total during your lifetime (from one or more employers), the excess will be taxable.
Important Clarification on Salary Components
For tax exemption purposes, only Basic Salary and Dearness Allowance (DA) are considered.
Other allowances like HRA, LTA, Bonus, and Special Allowance are excluded from the gratuity calculation.
So even if your employer considers those allowances while paying gratuity, for tax purposes, they won’t be counted.
Example: Understanding Gratuity Taxation
Let’s assume:
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Basic + DA = ₹60,000
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Completed years of service = 25
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Gratuity received = ₹22 lakh
Tax-exempt calculation:
(₹60,000 ÷ 26) × 15 × 25 = ₹8,65,385
The exemption limit is the least of:
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Actual gratuity = ₹22,00,000
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Statutory limit = ₹20,00,000
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Calculated amount = ₹8,65,385
So, only ₹8,65,385 will be tax-free, and the remaining ₹13,34,615 will be taxable.
Expert Insight
According to Balwant Jain, a leading tax and investment expert, employees should plan their gratuity receipts wisely. If you have received gratuity earlier and claimed exemption, you must track your lifetime exemption limit of ₹20 lakh.
He also suggests that understanding the gratuity tax rules can help employees in better retirement planning and tax saving.
Key Takeaways
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Gratuity becomes payable after 5 years of continuous service.
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Up to ₹20 lakh gratuity is tax-free (lifetime cap).
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Entire gratuity is tax-free for government employees.
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For private employees, tax exemption depends on the Payment of Gratuity Act formula.
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Only Basic Pay + DA are considered for tax-free calculation.
In short: Gratuity is a significant retirement benefit, but knowing how it’s taxed can help you make smarter financial decisions. Understanding the calculation, lifetime limits, and tax exemptions ensures you get the most out of this well-earned reward.
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