Gratuity and leave encashment are two payroll obligations that most businesses handle reactively - when an employee resigns or retires - rather than managing proactively as ongoing payroll liabilities. In 2022, with the Code on Social Security 2020's changes to gratuity provisions still being implemented and leave policies under scrutiny in the post-pandemic return-to-office environment, understanding and provisioning these obligations correctly is an important part of complete payroll management.

Gratuity in 2022: What Employers Must Know

Current applicability

Gratuity is currently governed by the Payment of Gratuity Act, 1972, applicable to establishments with 10 or more employees. An employee becomes eligible for gratuity after completing five years of continuous service. The gratuity amount is computed as: (last drawn basic wage plus DA) multiplied by 15 days per year of service, divided by 26 (working days in a month).

The Code on Social Security change

The Social Security Code, 2020 introduces changes to gratuity eligibility. Under the Code, fixed-term employees will be eligible for pro-rata gratuity from the first year of service - they will not need to complete five years. This is a significant change for businesses that use fixed-term employment extensively.

While the Code is not yet fully notified in all states as of 2022, the preparation for this change - particularly for businesses with large fixed-term workforces - should begin now. Businesses that provision gratuity only for employees who have cleared the five-year threshold will need to revise their approach.

Gratuity limit in 2022

The tax-exempt gratuity limit was enhanced to Rs 20 lakhs in 2019, applicable to both government and private sector employees. This limit has not changed in 2022. Gratuity up to Rs 20 lakhs is tax-free in the hands of the employee. Beyond this, the excess is taxable.

  Gratuity provisions under the Social Security Code 2020 extend eligibility to fixed-term employees on a pro-rata basis from Year 1. This could significantly increase gratuity liability for businesses using extensive contract and fixed-term employment. (Source: Social Security Code, 2020; Ministry of Labour and Employment, 2022)

Leave Encashment in 2022

Annual leave with wages (also called earned leave or privilege leave) accumulates in the employee's leave account and can be encashed at separation or, in some cases, during service. The encashment amount is based on the salary components applicable as per the Payment of Wages Act and the applicable Shops Act or Factories Act.

In 2022, post-pandemic, many businesses are dealing with large accumulated leave balances. Employees who could not take leave during 2020 and 2021 have accrued leave that may be above the maximum carryforward limits under the applicable Act. Businesses need to review their leave policy and the encashment liability sitting on their balance sheet.

Tax treatment of leave encashment

For private sector employees, leave encashment during service is taxable as salary. At separation, leave encashment up to Rs 3 lakh is exempt for non-government employees under Section 10(10AA) of the Income Tax Act - a limit set in 1998 and not enhanced as of 2022. The excess is taxable. Employers must compute TDS on taxable leave encashment at the time of payment.

Why Proactive Provisioning Matters

Businesses that do not provision gratuity and leave encashment as ongoing liabilities face sudden, large payments at resignation or retirement - with no budgetary preparation. For businesses with long-tenured employees, gratuity liability can be substantial. A monthly provisioning model - setting aside gratuity and leave liability as they accrue - converts a potential cash flow shock into a managed liability.

"Gratuity and leave encashment are not obligations that arise when someone resigns. They accrue from the first day of employment and must be managed as ongoing payroll liabilities."

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