Gratuity

Section numbers here are from the Income tax Act, 1961, the operative law for the current filing cycle. This article is for general information and does not constitute tax advice.

Three very different exemptions, depending on employer

Employee type	Exemption
Government employee (central, state, local authority)	Fully exempt, no rupee cap
Private sector, covered by the Payment of Gratuity Act, 1972	Least of: actual gratuity received, ₹20 lakh, or 15/26 × last drawn basic and DA × completed years of service
Private sector, not covered by the Act	Least of: actual gratuity received, ₹20 lakh, or half-month’s average salary (last 10 months) × completed years of service

The gap between the first two rows is total. A government employee never faces a ceiling; a private sector employee always faces the least of three figures, however generous the actual payout. The third row is easy to overlook entirely, because most guidance assumes every private employer is covered by the Act.

Worked example: same numbers, two formulas

Two employees, both with 22 completed years of service, both with ₹80,000 as the relevant monthly salary figure, both actually paid ₹15,00,000 in gratuity. One employer is covered by the Act, the other is not.

	Covered employer	Not covered
Formula	15/26 × ₹80,000 × 22	½ × ₹80,000 × 22
Formula result	₹10,15,385	₹8,80,000
Least of the three (exemption)	₹10,15,385	₹8,80,000
Taxable portion	₹4,84,615	₹6,20,000

Identical service, identical salary, identical payout, and the employee at the non-covered employer ends up with over ₹1,35,000 more taxable income purely because of which formula applies. Neither employee is anywhere near the ₹20 lakh cap, so in a case like this the cap is irrelevant; the formula is what actually decides the outcome.

Who is actually covered under the Act

The Payment of Gratuity Act applies to any establishment with 10 or more employees on any day in the preceding 12 months, and once it applies, it keeps applying even if headcount later drops below 10. Eligible employees need 5 years of continuous service, rounded up to a full year if the final year’s service exceeds 6 months.

If your employer is not covered: a different formula, and different rounding

An employer with fewer than 10 employees, or otherwise outside the Act, is not legally required to pay gratuity at all, but many do so voluntarily. Where they do, the exemption calculation switches from the 15/26 formula to half a month’s average salary for each completed year, based on the average of the last 10 months’ basic and DA rather than the last drawn figure. The ₹20 lakh cap still applies, and the actual amount received is still one of the three figures compared.

The rounding rule is also different, and works against the employee rather than for them. Under the Act, a final year of service exceeding 6 months rounds up to a full year. Outside the Act, the completed years are counted as they stand, with no rounding up for a part year, however close to a full year it runs. Someone with 21 years and 11 months of non-covered service is credited with 21 years, not 22.

The 20 lakh rupee cap is lifetime, not per job

This is the point that catches people out most. The ₹20 lakh figure is a lifetime ceiling aggregated across every employer, not a fresh limit that resets when you change jobs. Someone who received gratuity from an earlier employer and claimed exemption on it carries a reduced remaining cap into any later gratuity payout, career-long, not year-by-year or job-by-job. This holds whether the earlier payout came from a covered employer, a non-covered one, or a mix of both.

Anyone who has already received and claimed exemption on a gratuity payout once should keep that figure on record, because it directly reduces what a second or third employer’s payout can claim tax-free, and there is no automatic tracking of this across employers, it falls on the individual to declare it accurately.

Gratuity and leave encashment do not offset each other

Retirement often produces both a gratuity payout and leave encashment in the same financial year, along with other lump sums like commuted pension. Each has its own exemption provision and its own ceiling, computed entirely independently, covered in Leave Encashment. They do not interact, and using up the gratuity cap has no bearing on what remains available under the leave encashment cap, or vice versa.

Relief for a large lump sum

If the taxable portion of a gratuity payout is large, Section 89 relief, claimed via Form 10E, can reduce the tax impact of the bunching by spreading it against the years it effectively relates to. Worth checking whenever a retirement payout pushes a single year’s income unusually high, since the alternative is being taxed at slab rates on the whole lump sum in one year.