Hike in gratuity amount deferred: What it means for your financial planning

Private sector and government employees must review their retirement portfolio and track EPFO's announcements

A decision by the Employees' Provident Fund Organisation (EPFO) to defer a hike in retirement and death gratuity is said to be disheartening for government and organised sector employees. "This decision comes just a month after the EPFO announced a significant 25 per cent hike, raising the gratuity amount from Rs 20 lakh to Rs 25 lakh," says Harshita Agarwal Sharma, director of Lexlevel Services.

"Taxation of gratuity for government and organised sector employees is based on specific provisions of the Income Tax Act, 1961, and the legislative framework laid out in the Payment of Gratuity Act, 1972. The interpretation of 'wages' for gratuity calculation has evolved through judicial precedents to include Dearness Allowance (DA) as a component of wages," says Shyam Gopal, partner, Traya Law Partners LLP.

This gratuity hike was in response to the rise in government employees’ dearness allowance to 50 per cent of the basic pay, as per guidelines outlined in the Office Memorandum (OM) from the Department of Pension and Pensioners’ Welfare (DoP&PW). The reason for EPFO’s decision to defer the hike has not been explained. 

The deferment means employees will not yet see the expected increase in their retirement gratuity payouts. "This pause can significantly impact their financial planning and retirement savings. Employees should stay informed about further updates from the EPFO and the Ministry of Labour & Employment. It's also beneficial to understand the current rules and regulations regarding gratuity to make informed decisions," says Alay Razvi, partner, Accord Juris LLP.

Companies pay gratuities to employees who have worked with them for five years or more. The 1972 Payment of Gratuity Act governs the rules and the amount you are eligible for is based on a formula. Gratuity is payable not only at retirement, but also in various other situations such as superannuation, resignation, death or disablement, retrenchment, voluntary retirement, and termination.

According to the Gratuity Act, an employee will be entitled to gratuity if they have completed five years of continuous service or earlier in the case of separation on account of death or disablement. "Employees on a five-day workweek will be entitled to gratuity on completing four years and 190 days of continuous service, and those on a six-day workweek will be entitled to completing 4 years and 240 days of continuous service," says Padmanabhan Ananth, partner at Counselence. Some firms pay gratuity after 10 years of service. Termination of employment before completion of five years of service is an exception to the rule. 

Tax treatment of the gratuity amount depends if the employee works for the government or a private organisation. "Gratuity is subject to taxation, and amounts exceeding the exempt limit are taxable according to the employee's income slab. Section 10(10) of the Income Tax Act, 1961, outlines exemptions for various types of gratuity from income tax, subject to limits and conditions specified by the Central Government," says Aslam Ahmed, partner, Singhania & Co. 

The maximum gratuity payable that is exempted from Income Tax (by Section 10(10) of the IT Act) is Rs 20 lakh. Any higher amount payable by the employer towards gratuity will attract tax. The amount of gratuity received by any government employee (whether central/state/local authority) is exempt from Income Tax. Private sector employees have to pay Income Tax above the exemption limit. 

Here, the least of the following three amounts will be exempt from income tax: Rs 20 lakh, the actual amount of gratuity received, or the eligible gratuity. Gratuity received by employees on retirement or during the period of service is taxable under the heading “Income from Salary." "However, in the event of the death of the employee, the gratuity amount becomes payable to the heir/nominee of said employee, and such gratuity is then taxable under the heading “Income from Other Sources”," says Vipul Jai, partner, PSL Advocates & Solicitors.

Track EPFO announcements and policy changes. Make sure that your retirement plans and savings strategies are reviewed regularly. To protect your retirement savings against policy changes, financial experts recommend diversifying your retirement savings. When it comes to securing long-term financial stability, it is a good idea to seek advice from financial planners.

Personal finance advisors hope that EPFO will give explain its reasons for the deferment or publish a circular instructing employees how to implement the enhancement in gratuity benefits, according to experts.