Income Tax Exemption on Gratuity (2024)

Gratuity is a benefit given by the employer to employees. A recently approved amendment by the Centre has increased the maximum limit of gratuity. Now it is tax exempt up to Rs 20 lakh from the previous ceiling of Rs 10 lakh, which comes under Section 10(10) of the Income Tax Act. The CBDT Notification No. S.O. 1213(E), dated 8 March 2019, clarified that the exemption limit of Rs 20 lakh would be applicable to employees in the event of retirement or death or resignation or disablement on or after 29 March 2018.

Let us understand the impact of this amendment in comparison with the previous provisions.

Understanding the Basics of Gratuity

Gratuity is a monetary benefit given by the employer, but not paid as part of the regular monthly salary. The provisions of gratuity are governed by the Payment of Gratuity Act, 1972, and it is given on the occurrence of any of the following events.

  • On superannuation (means an employee who attains the age of retirement is said to be in superannuation)
  • On retirement or resignation
  • On death or disablement due to accident or disease (the time limit of 5 years shall not apply in the case of death or disablement of the employee) It is mandatory for the employee to have completed a minimum of five years in service to be able to receive gratuity. It is not available for interns or temporary employees.

Eligibility to Get Gratuity

The employer will pay gratuity when the employee satisfies the following conditions:

  • The employee should be drawing wages as a full-time employee of an organisation. An apprentice is not eligible to receive gratuity.
  • The employee should be in continuous service for a minimum of 5 years.
  • The employee can also get gratuity upon resignation, superannuation, disablement due to accident or disease, or death. The condition of 5 years is not applicable in the case of disablement or death.

Employees Covered Under the Payment of Gratuity Act

Every individual – working in a factory, mine, oil field, port, railways, plantation, shops & establishments, or educational institution having 10 or more employees on any day in the preceding 12 months – is entitled to gratuity.

Once the Act becomes applicable to an employer, even if the number of employees goes below 10, gratuity is still applicable.

Calculation of the amount of gratuity exempted from tax

The least of the following is exempt from tax:

  • Last salary (basic + DA)* number of years of employment* 15/26;
  • Rs. 20 lakhs (which has been hiked from Rs. 10 Lakh as per the amendment);
  • Gratuity actually received

Let us understand this through an illustration: The last salary drawn by Rohan is Rs.1 Lakh per month (basic + DA). He is entitled to receive a gratuity of Rs. 11 Lakhs. He has been in employment for the last 19 years and 7 months.

Sr. No.ParticularsPreviouslyAs Amended
1Last drawn salary (Basic + DA)1 lakh1 lakh
Number of years of employment20 (will be rounded off)20 (will be rounded off)
Gratuity1,00,000*20*15/26 = 11,53,8461,00,000*20*15/26 = 11,53,846
2Maximum exemption allowed10 lakhs20 lakhs (as amended)
3Gratuity actually received11 lakh11 lakh
Amount of exemption (least of the above)10 lakh11 lakh
Taxable gratuity1 lakh

Points to note:

  • 15 days salary based on the salary last drawn for every completed year of service or part thereof i.e. 15/26.
  • Number of years in service is rounded off to the nearest full year.

Employees Not Covered Under the Payment of Gratuity Act

There is no law that restricts an employer from paying gratuity to his employees, even if the organization is not covered under the Payment of Gratuity Act. The amount of gratuity payable to the employee can be calculated based on half month’s salary for each completed year.

Calculation of amount of gratuity exempted from tax

The least of the following are exempt from tax:

  • Last 10 month’s average salary (basic + DA)* number of years of employment* 1/2;
  • Rs. 20 lakhs (the exemption is enhanced from Rs. 10 lakhs to Rs.20 Lakhs even for employees not covered under the Payment of Gratuity Act w.e.f. 29.3.2018)
  • Gratuity actually received

Gratuity exemption for such employees would be computed as follows:

Raghav has been in employment for 25 years and 2 months. The average salary for the last 10 months is Rs. 90,000. The actual gratuity received by him is Rs. 11 Lakhs.

Sr. No.ParticularsAmount (Rs.)
1Average of last 10 month’s salary90,000
Number of years of employment25 (will be rounded off)
Gratuity90,000*25*1/2 = 11,25,000
2Maximum exemption allowed20 lakhs
3Gratuity actually received11 Lakhs
Amount of exemption (least of the three)11 Lakhs
Taxable GratuityNil

Points to note:

  • An average salary of previous 10 months is considered
  • Number of years in service is rounded off to the nearest full year

Government Employees

Gratuity paid by the government to government employees is fully exempt from tax.

Impact of the Amendment

The impact of the amendment is evident from the example. A hike in the ceiling limit of maximum exemption helps reduce the taxable gratuity amount. This amendment is going to benefit those earning higher salaries in the short run. However, if you have a long time left before your retirement, this amendment will benefit most employees.

Exemptions on Gratuity

The income tax exemptions on gratuity can be categorised as follows:

Exemptions on gratuity received by government sector employees

The gratuity given to employees working in a government sector upon their termination, retirement or superannuation are fully exempted from paying tax. It is applicable to employees of the central government, state government, defense sector, members of civil services and other local authorities.

Exemptions on gratuity received by private sector employees

The income tax exemption on gratuity given to employees working in the private sector depends on whether they are covered under the Payment of Gratuity Act or not.

When private sector employees are covered under the Act

The income tax exemption on gratuity received is the least of the following three:

  • Gratuity amount of Rs 20 lakhs
  • Last 15 days salary (consider no.of days in a month to be 26) x number of years of employment
  • Actual gratuity received

When private sector employees are not covered under the Act

The income tax exemption on gratuity received is the least of the following three:

  • Actual gratuity received
  • Gratuity of Rs 20 lakhs
  • Last 10 months average salary x number of years of employment x 1/2

For calculating gratuity use our calculator:

  • Gratuity Calculator
Income Tax Exemption on Gratuity (2024)

FAQs

Income Tax Exemption on Gratuity? ›

Note that the maximum tax-exempt gratuity limit is $20, so any employee who earned more than $20 in tips for the entire year must report their gratuity as part of their earnings.

What happens if you don't report cash tips? ›

Penalty for not reporting tips.

If you don't report tips to your employer as required, you may be subject to a penalty equal to 50% of the social security, Medicare, Additional Medicare, or railroad retirement taxes you owe on the unreported tips.

How do you prove tips as income? ›

You must report tips you received (including both cash and noncash tips) on your income tax return. Any tips you reported to your employer are included in the wages shown in box 1 of your Form W-2, Wage and Tax Statement. Add to the amount in box 1 only the tips you didn't report to your employer as required.

Is gratuity tax deductible? ›

An optional payment designated as a tip, gratuity, or service charge is not subject to tax. A mandatory payment designated as a tip, gratuity, or service charge is included in taxable gross receipts, even if the amount is later paid by the retailer to employees.

Are all tips subject to income tax withholding? ›

When tips are received by the employee from the employer, such as banquet tips or service charges, the amount is considered regular wages and is fully subject to UI, ETT, SDI, and PIT withholdings.

Will the IRS know if I don't report tips? ›

If it is determined in an examination that you underreported your tip income, the IRS will assess the taxes you owe based on the best available records of your employer. Tip income adds up. Underreporting could result in you owing substantial Federal Income, Social Security and Medicare penalties, and interest.

Is not claiming tips tax evasion? ›

The truth is, neglecting to declare cash tips, while it technically counts as tax fraud, is not likely to land someone in the slammer unless they're earning some seriously good tips. That being said, an IRS audit experience can wind up being extremely expensive and stressful.

Are tips or gratuities taxable income? ›

Tip income is taxable and must be reported to the Internal Revenue Service (IRS). Both employers and employees have specific reporting responsibility relating to tip income.

Do cash tips count as earned income? ›

All cash and non-cash tips an received by an employee are income and are subject to Federal income taxes.

How do you claim your tips on taxes? ›

Tally and report your tips every month

Use IRS Form 4070 to do so. You'll need to turn it in by the 10th of the month after you receive the tips. For example, if you made $100 in tips in January, you'd need to report those by Feb. 10.

Does gratuity count as income? ›

Because gratuities and service charges are both forms of wage income, employers are required to keep detailed records of both and pay their share of Social Security tax and Medicare tax based on the employee's total earnings.

What is the difference between a tip and a gratuity? ›

A gratuity (often called a tip) is a sum of money customarily given by a customer to certain service sector workers such as hospitality for the service they have performed, in addition to the basic price of the service. Leaving some change on the restaurant table is one way of giving a gratuity to the restaurant staff.

What is the difference between cash tips and paycheck tips? ›

They are given directly to the service provider, often immediately after service has been rendered. This method allows service staff to receive gratuity instantly, providing immediate access to their earnings. Paycheck tips, on the other hand, are tips that are added to an employee's regular paycheck.

Are tips exempt from FICA? ›

Do Tips Count as Wages? Yes, reported tips are considered as gross income and must be included in an employee's wages for purposes of FICA tax. In addition, they are subject to federal income tax withholding.

What does I am not subject to tax withholding? ›

Taxable income not subject to withholding - Interest income, dividends, capital gains, self employment income, IRA (including certain Roth IRA) distributions. Adjustments to income - IRA deduction, student loan interest deduction, alimony expense.

How do I submit a tip to the IRS? ›

You can submit Form 3949-A online or by mail. We don't take tax law violation referrals over the phone. We will keep your identity confidential when you file a tax fraud report. You won't receive a status or progress update due to tax return confidentiality under IRC 6103.

Is not reporting your tips illegal? ›

Cash tips include tips received directly from customers, tips from other employees under any tip-sharing arrangement, and charged tips (for example, credit and debit card charges) that you distribute to the employee. Both directly and indirectly tipped employees must report tips received to their employer.

Do servers actually report cash tips? ›

The Internal Revenue Code requires employees to report (all cash tips received except for the tips from any month that do not total at least $20) to their employer in a written statement.

Does my employer report my cash tips? ›

If you receive $20 or more per month in cash tips, report that income to your employer. Your employer will report your tip income on your W-2, Box 7 (Social Security tips).

Can you get in trouble for not reporting cash income? ›

Civil Penalties: “The penalty for negligent failure to timely file, to include all required information or to include correct information is $250 per return, not to exceed $3,000,000 per calendar year. IRC Section 6721(a)(1).

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