Gratuity: How it is Calculated as a Part of Employee’s CTC in Offer Letter?

When you receive a job offer letter, the company often mentions your CTC (Cost to Company). This is the total amount they spend on you as an employee.

Gratuity is a benefit that employers pay their employees as a token of appreciation for their service. This benefit, along with Employees' Provident Fund (EPF), is usually included in the CTC (Cost to Company) and mentioned in your offer letter when you join a new company. The Payment of Gratuity Act, 1972, ensures that employees receive gratuity as part of their benefits.

The formula to calculate gratuity is mentioned in Section 4(2) of the Payment of Gratuity Act, 1972. As per the Act, employers are required to pay gratuity for each full year of an employee's service and part thereof if the employee has completed more than six months.

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While calculating EPF is easy, understanding how gratuity is calculated can be confusing for many. The formula to calculate gratuity is:

Last-drawn monthly wages X 15/26.

The employee is eligible to receive gratuity after completing a minimum of 5 years with the company. Every year, the companies estimate the incremental liability using a method called actuarial valuation, which considers the employer's last-drawn basic salary (including dearness allowance, if applicable). For this purpose, the gratuity is calculated at 15/26 of the monthly basic salary for every completed year of service, which means that employees receive an amount equal to 15 days of salary per year worked.

Let's understand this with an example:

Suppose your annual basic salary is Rs.100.

Monthly basic salary (Rs. 100/12) = Rs.8.33

Gratuity per year (8.33 x 15/26) = 4.81

The offer letter will have the gratuity mentioned as 4.81% of your basic salary.

Now, assume that a company offers you a CTC of Rs. 18.50 lakh. Usually, the basic salary ranges between 40% and 50% of your CTC. Suppose the basic salary is 40% of your CTC.

Basic salary = 1,850,000 x 40% = Rs.740,000

The HR will calculate the gratuity as 4.81% of your basic salary, i.e., Rs. 35,594.

The amount of your CTC that is allocated towards gratuity changes when your basic salary changes. Most companies revise the basic salary once a year during the appraisal cycle. Since gratuity is calculated based on your last drawn salary (including dearness allowance, if applicable), the gratuity amount also increases as your salary increases.

Therefore, companies update their estimates yearly based on actuarial valuation.