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In India, gratuity is not automatically tax-free. For an employee, it is salary income and section 10(10) may exempt all or part of a qualifying payment. For an employer, the question is different: a gratuity cost is deductible only under specific rules, such as a contribution to an approved gratuity fund or gratuity that became payable during the year. A general provision or reserve is usually disallowed.
The employee result depends on public-service status, coverage under the Payment of Gratuity Act, the amount received, salary definitions, completed service and the ceiling applicable to the relevant tax year. The employer result depends on the legal form of the payment, whether an approved fund is involved and whether a deduction was claimed earlier.
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Start with the correct taxpayer question
“How much gratuity is tax-free?” is an employee question. “Can the business deduct its gratuity expense?” is an employer question. These tests operate independently.
- Employee: gratuity is reported under the salary head. Section 10(10) can provide a full or partial exemption when the statutory conditions are met.
- Employer: the deduction is considered in calculating business profit. Sections 36(1)(v) and 40A(7) determine whether the payment or provision is allowable.
A payment can therefore be partly exempt for the employee while the employer’s accounting entry is not deductible, or an employer can obtain a deduction for an approved-fund contribution even though the eventual employee exemption must still be tested separately.
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How gratuity is treated in an employee’s income
Gratuity received while still employed
The Income Tax Department’s salary guidance treats gratuity as salary income. Salary is generally taxable on the due basis or the receipt basis, whichever is earlier. Gratuity received during service is described as fully taxable; the retirement exemptions discussed below do not turn an in-service payment into an exempt receipt.
Retirement categories matter
At retirement, the guidance separates employees into three categories:
| Employee category | General section 10(10) treatment | How the amount is determined |
|---|---|---|
| Government employee, other than an employee of a statutory corporation | Fully exempt, subject to the statutory category applying | The government-employee exemption applies rather than the private-sector formula |
| Non-government employee covered by the Payment of Gratuity Act | Exemption is limited to the least of the specified amounts | Actual receipt, the Payment of Gratuity Act-based calculation and the applicable ceiling |
| Other non-government employee | Exemption is limited to the least of the specified amounts | Actual receipt, the average-salary calculation and the applicable ceiling |
“Government employee” in this summary is not a label that can be extended to every public-sector worker. The stated category excludes employees of statutory corporations, so the legal status of the employer and the governing gratuity law must be checked.
Formula for a non-government employee covered by the Payment of Gratuity Act
For an employee covered by the Payment of Gratuity Act, the Department’s guide describes the exempt amount as the least of:
- the gratuity actually received;
- 15/26 multiplied by the last-drawn salary and the completed years of service, counting a part of a year exceeding six months as a full year; and
- the ceiling listed for the relevant tax year.
The current salary summary located for this topic lists a ceiling of ₹20,00,000 for the described non-government categories. That figure is tax-year-sensitive. Confirm the operative section 10(10) provision and any applicable notification before using it for a return, payroll calculation or employment settlement.
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What counts as last-drawn salary
For this calculation, the Department’s summary describes last-drawn salary as basic salary plus dearness allowance, while excluding bonus, commission, house rent allowance, overtime pay and other allowances, benefits or perquisites. Do not substitute total monthly gross pay for the statutory salary figure.
How completed service is counted
Suppose an employee has 14 years and 8 months of qualifying service. Because the part exceeds six months, the calculation described in the guide uses 15 completed years. A part of six months or less is not rounded up under that description.
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Assume, solely for illustration, that the last-drawn salary is ₹52,000, qualifying service is 14 years and 8 months, and gratuity received is ₹6,00,000. The statutory amount is:
15/26 × ₹52,000 × 15 years = ₹4,50,000.
The three limits would be ₹6,00,000 actually received, ₹4,50,000 under the formula and the applicable ceiling. The potential exemption is therefore ₹4,50,000, leaving ₹1,50,000 taxable, assuming the employee is in this category and all other conditions are satisfied. This is an illustration, not a personal tax computation.
Seasonal establishments
The Department’s summary notes a separate seven-day factor for employees of seasonal establishments in the stated calculation. Because the seasonal rule depends on the establishment and the precise statutory inputs, payroll should verify the applicable Payment of Gratuity Act provision rather than applying the 15/26 factor automatically.
Formula for other non-government employees
An employee who is not in the government category and is not covered by the Payment of Gratuity Act uses a different calculation in the Department’s guide. The exemption is the least of:
- the gratuity actually received;
- half a month’s average salary for every completed year of service; and
- the applicable ceiling, currently listed in the salary summary as ₹20,00,000 for the described non-government categories.
Average salary period
The relevant average is the average salary for the 10 months immediately preceding the month of retirement. Using the final month alone, or an annual average that includes earlier periods, can produce the wrong figure.
Salary components in this category
The guide describes salary for this purpose as basic pay, dearness allowance to the extent it forms part of retirement benefits, and turnover-based commission. Other components should not be added merely because they appear on a payslip.
Illustrative calculation
Assume an average salary of ₹60,000 over the relevant 10-month period, 12 completed years of service and actual gratuity of ₹5,00,000. Half a month’s average salary is ₹30,000, and the formula amount is ₹30,000 × 12 = ₹3,60,000. Subject to the category and conditions being correct, the potential exemption is the least of ₹5,00,000, ₹3,60,000 and the applicable ceiling: ₹3,60,000. The balance of ₹1,40,000 would be included in taxable salary.
Eligibility and exemption are separate checks
The Department’s salary guide describes a usual five-year continuous-service condition for gratuity liability on retirement, resignation or superannuation. It also states that this condition does not apply where employment ends because of death or disablement.
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That is an entitlement rule, not a blanket statement that every payment meeting five years is fully exempt. After establishing whether gratuity is payable, the employee must still identify the section 10(10) category, calculate the relevant limit and apply the current ceiling. In a death case, the service condition may be waived, but the tax treatment of the recipient and the statutory exemption still require separate review.
What an employer may deduct
Contribution to an approved gratuity fund
Section 36(1)(v) permits a deduction for an employer’s contribution to an approved gratuity fund created for the exclusive benefit of employees under an irrevocable trust, subject to the provision’s conditions and limits. The Income Tax Department’s statutory wording describes “any sum paid by the assessee as an employer by way of contribution towards an approved gratuity fund created by him for the exclusive benefit of his employees under an irrevocable trust”.
The important facts are the fund’s approval, the irrevocable-trust structure, the exclusive employee benefit and the fact that the amount is a qualifying contribution. An ordinary transfer to an internal reserve, bank account or management-controlled pool is not automatically an approved-fund contribution.
Gratuity that became payable during the year
Section 40A(7) generally disallows a provision made for gratuity payable on retirement or termination. One stated exception covers gratuity that became payable during the previous year. In practical terms, an employer should identify the year in which the employee’s gratuity liability became payable and retain the settlement and payment records supporting that timing.
Approved-fund provision exception
Section 40A(7) also recognises a provision for a contribution to an approved gratuity fund within its specified conditions. The exception is not a general permission to deduct every actuarial estimate or accounting accrual. The fund must meet the approval and structural requirements, and the amount must fall within the statutory rule.
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No second deduction
The statutory explanation prevents double deduction. If a provision was allowed earlier, the employer cannot claim the same amount again when it is later paid to the employee or contributed to the approved fund. The tax computation should track each amount from provision to payment and identify the year in which the deduction was actually obtained.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Provision, reserve and payment: a decision framework
| Employer entry or payment | Tax question | Likely treatment under the cited rules |
|---|---|---|
| Contribution to an approved gratuity fund under an irrevocable trust | Does it satisfy section 36(1)(v) and the fund conditions? | Potential deduction, subject to statutory limits and conditions |
| Gratuity that became payable during the previous year | Did the liability become payable in that year, and is the amount supported by records? | Covered by the stated exception to the general disallowance, subject to the law |
| General provision or reserve for future gratuity | Is it merely an accounting estimate without an approved-fund or payable-gratuity exception? | Generally disallowed under section 40A(7) |
| Amount already deducted through an earlier provision | Was a deduction claimed before the later payment or fund contribution? | No second deduction for the same amount |
How payroll and finance teams should check a gratuity case
- Identify the event: distinguish an in-service payment from retirement, resignation, superannuation, death or disablement.
- Classify the employee: determine whether the person is in the stated government category, covered by the Payment of Gratuity Act or another non-government category.
- Confirm service: calculate continuous service and apply the death or disablement exception where relevant.
- Build the correct salary figure: use last-drawn salary for the covered formula or the preceding 10-month average for the other non-government formula, including only the specified components.
- Apply all three employee limits: compare actual receipt, the category-specific formula and the ceiling applicable to the tax year.
- Separate employer accounting: label the amount as an approved-fund contribution, gratuity payable in the year or a general provision.
- Check deduction history: reconcile prior tax deductions so that a later payment is not claimed twice.
- Document the conclusion: retain the employment category, service computation, salary schedules, gratuity calculation, fund approval documents and payment evidence.
Common mistakes that change the result
- Calling all gratuity tax-free: in-service gratuity is fully taxable, and retirement exemption differs by category.
- Using gross salary: the statutory formulas use defined salary components, not every payslip item.
- Rounding service incorrectly: for the covered formula, a part exceeding six months is counted as a year under the Department’s description.
- Treating a reserve as a deduction: an accounting accrual does not become deductible merely because it appears as an expense.
- Assuming the ceiling never changes: ₹20,00,000 is the amount currently listed in the Department’s salary summary for the described non-government categories, not a timeless figure.
- Confusing eligibility with exemption: satisfying a five-year service test does not determine the exempt amount by itself.
- Ignoring prior deductions: section 40A(7)’s explanation addresses the risk of deducting the same gratuity provision again on payment.
Which documents support the tax treatment
An employee should retain the gratuity settlement statement, retirement or separation letter, service-period calculation, salary records used in the formula and evidence of any death or disablement circumstance. A government or statutory-employer classification should be supported by the employer’s legal status, not a job title alone.
An employer should retain the trust deed and approval evidence for an approved fund, contribution statements, employee-level gratuity calculations, board or payroll records showing when an amount became payable, payment proofs and a reconciliation of provisions claimed in earlier years. These records help demonstrate why an amount was deducted or disallowed.
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The Income Tax Department’s summary currently lists ₹20,00,000 as the ceiling for the described non-government categories, and its salary guidance describes the five-year condition with death and disablement exceptions. Summary pages and statutory pages can reflect different amendment histories or historical wording. Before filing or issuing a personalised calculation, verify the provision and notification applicable to the relevant financial year and assessment year, including the ceiling, salary definition and category language.
The safest conclusion is therefore conditional: an employee may receive a full or partial section 10(10) exemption, while an employer may claim a deduction only when section 36(1)(v) or an applicable section 40A(7) exception is satisfied. The receipt and the expense must be tested separately.
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