When you start a new job, employers typically factor in gratuity and their contribution to the Employees’ Provident Fund (EPF) in the total cost to company (CTC) mentioned in your offer letter. While figuring out the EPF contribution is pretty straightforward, many people are unsure about how HR calculates gratuity.
In India, the Payment of Gratuity Act of 1972 regulates gratuity payments. According to Saraswathi Kasturirangan, a Partner at Deloitte India, “When a new hire receives an offer letter, many companies include the gratuity benefit based on the basic salary listed in that letter.”
To calculate gratuity in the offer letter, Puneet Gupta, a Tax Partner at EY India, explains, “According to Section 4(2) of the Payment of Gratuity Act, gratuity is paid for each completed year of service, and for any part of a year if it exceeds six months. Employers are required to pay gratuity at a rate of 15 days’ wages based on the last salary drawn by the employee.” The formula for calculating gratuity is: Last drawn monthly wage X 15 / 26.
Kasturirangan adds, “An employee is entitled to gratuity after completing a minimum of five years with the organization. Companies account for this liability each year, estimating the annual incremental liability based on actuarial valuation and the last drawn basic salary (including dearness allowance if applicable). For this calculation, eligibility is determined at 15/26 of the monthly wage for each completed year of service.”
Gupta breaks this down with an example. Let’s say an employee’s annual basic salary is Rs 100. That means their monthly basic salary would be Rs 8.33 (which is Rs 100 divided by 12). The gratuity for each year of service would come to 4.81, calculated as 8.33 multiplied by 15/26.
In your offer letter, you’ll see that 4.81% of your annual basic salary is listed as gratuity.
To illustrate this further, imagine a company offers you a CTC of Rs 18.50 lakh. In this scenario, HR would figure out the gratuity as 4.81% of the employee’s basic salary, which amounts to Rs 35,594.
It’s worth mentioning that the portion of CTC set aside for gratuity gets updated whenever there’s a change in the basic salary. Typically, the basic salary is adjusted annually after an employee’s appraisal. Kasturirangan points out that “4.81% is calculated based on the current salary each year since gratuity is based on the last drawn basic salary, including any applicable Dearness Allowance. It’s an increasing liability determined by actuarial valuation, taking into account the most recent salary on a yearly basis.”