Payment of Gratuity Act Computation and Actuarial Valuation Basics

Definition of Gratuity

Gratuity is a lump-sum monetary benefit paid by an employer to an employee as a reward for long-term and continuous service. It is a statutory benefit governed by the Payment of Gratuity Act, 1972. An employee becomes legally entitled to gratuity after completing a minimum of five years of continuous service with the same employer. Gratuity is generally payable upon retirement, resignation, death, or permanent disability.

Eligibility and Application of Gratuity

Applicability of the Act

The Payment of Gratuity Act applies to factories, mines, oilfields, plantations, ports, railway companies, and to every shop or establishment employing 10 or more employees.

Eligibility Criteria

An employee is eligible for gratuity after completing at least five years of continuous service. Continuous service refers to uninterrupted service, including periods of interruption due to sickness, accident, leave, layoff, strike, or lockout.

Under Social Security Code 2020, Fixed-Term employees (FTEs) in India are eligible for gratuity after completing just one year of continuous service. Unlike permanent employees, who must wait 5 years.

To qualify as continuous service:

• An employee must have worked at least 240 days in a 12-month period

• For employees working in underground mines, the requirement is 190 days

  
  

Application Process

To claim gratuity, the employee, nominee, or legal heir must submit an application using the prescribed forms:

• Form I   – by the employee

• Form J  – by the nominee

• Form K – by the legal heir

The application should be submitted within 30 days from the date gratuity becomes payable.

Employer’s Responsibility

Once the application is received, the employer must pay the gratuity amount within 30 days. Any delay attracts simple interest at 10% per annum from the due date until the date of payment.

Gratuity Calculation

Gratuity is calculated using the following formula:

Gratuity = Last Drawn Salary × (15/26) × Number of Completed Years of Service

Where:

• Last drawn salary includes Basic Salary + Dearness Allowance (DA)

• 15/26 represents 15 days’ wages for every completed year of service

  
  
  
  

Tax Exemption on Gratuity

Under Section 10(10) of the Income Tax Act, 1961, gratuity received by employees of private sector companies is tax-exempt up to ₹20 lakh, subject to prescribed limits and conditions.

And gratuity received by Central/State Government employees, members of the civil services, or local authorities is fully exempt from tax. 

Actuarial Valuation: Basics

What is Actuarial Valuation?

Actuarial valuation is a scientific and mathematical assessment conducted by a certified actuary to estimate a company’s future liabilities toward employee benefits. These benefits include:

• Gratuity

• Leave encashment

• Pension

• Other long-term employee benefits

• Insurance obligations

  
  

The objective is to determine how much money a company should set aside today to meet future employee benefit payments.

Why is Actuarial Valuation Required?

Compliance with Accounting Standards

Actuarial valuation is mandated under:

• AS 15 (Revised) – applicable to companies following Indian GAAP

• Ind AS 19 – applicable to companies following Indian Accounting Standards

These standards require employee benefit obligations to be recognized in the financial statements based on actuarial calculations.

Other Key Reasons

Actuarial valuation helps organizations:

• Make accurate provisions in the balance sheet

• Understand future financial obligations

• Meet audit and statutory compliance requirements

• Plan and budget employee-related costs effectively

  
  

Key Inputs Used in Actuarial Valuation

Demographic Assumptions

The actuary considers employee-related factors such as:

• Age and date of joining

• Expected retirement age

• Attrition or resignation rate

• Mortality rate

• Probability of disability

  
  

Financial Assumptions

Financial parameters include:

• Discount rate (linked to Government bond yields)

• Salary escalation rate

• Inflation assumptions

• Expected return on plan assets, if a fund exists

  
  

Process of Actuarial Valuation

The actuarial valuation process typically involves the following steps:

1. The company provides employee data, including age, salary, service period, and date of joining.

2. The actuary applies appropriate demographic and financial assumptions.

3. A mathematical model is used to compute:

   • Present value of gratuity obligation

   • Current service cost

   • Interest cost

   • Actuarial gains or losses

4. A detailed actuarial valuation report is issued with calculations and disclosures.

   
   

Examples of Actuarial Valuation

1. Consider a company with:

   • 10 employees

   • Average monthly salary of ₹50,000

   • Average service of 5 years

   • Retirement age of 58

   • Discount rate of 7%

   • Salary escalation rate of 5%

The actuary estimates the future gratuity payable to each employee and discounts it to present value.

For example:

• Estimated total future gratuity: ₹25,00,000

• If the present value of the obligation today is: ₹18,50,000

Thus, the gratuity liability to be recognized in the books of accounts is ₹18,50,000.

Outputs of an Actuarial Valuation Report

A standard actuarial valuation report includes:

• Summary of employee data

• Assumptions used

• Present value of defined benefit obligations

• Current service cost

• Interest cost

• Actuarial gain or loss

• Movement of liability during the year

• Disclosures as per AS 15 or Ind AS 19

Difference Between Gratuity Calculation and Actuarial Valuation

Particulars	Gratuity Calculation	Actuarial Valuation
Focus	Individual employee payout	Total company liability
Method	Simple statutory formula	Complex actuarial model
Performed by	HR or Finance team	Certified Actuary
Timing	At employee exit	Every financial year
Basis	Actual data	Estimates and assumptions

When is Actuarial Valuation Required?

A company must carry out an actuarial valuation:

• If it employs 10 or more employees

• At the end of every financial year

• For statutory audit and accounting compliance

• When maintaining funded gratuity schemes

  
  

General Actuarial Formula for Gratuity Liability

PV = (15/26 × Salary × Years of Service at Exit) × Discount Factor × Probability of Survival/Exit

Where:

• 15/26 represents gratuity entitlement under the Act

• Salary is the last drawn basic salary plus DA

• Years of service at exit refers to service completed at retirement, resignation, or death

• Discount factor = 1 / (1 + r)ⁿ

• r is the discount rate (Government bond yield)

• n is the remaining years to retirement

• Probability is based on attrition and mortality assumptions