Towers Watson explained in a news brief that the Payment of Gratuity Act 1972 requires employers with more than 10 employees to pay a gratuity benefit to employees who have five or more years of service at the time they leave employment. The minimum benefit required is broadly calculated as 15/26 of basic salary (plus dearness allowance — an annual percentage addition to base salary) for each year of service, subject to the ceiling, and is tax-free to the employee. Companies can provide a benefit calculated on a different basis, but any benefit paid above the minimum required by the Act is treated as taxable income to the employee.
The ceiling applies to the total benefit payable and therefore applies to benefits that have already accrued, as well as to future accrual of benefits. Because of this, the change is likely to lead to increased costs for many employers, according to the news brief.
Towers Watson said a survey it conducted in 2008 found about 30% of companies surveyed provide the benefit without a ceiling, and therefore they will not be affected by the change, except that they will now be able to pay more of the benefit tax free. However, the survey showed that around 50% of companies provide only the statutory minimum gratuity benefit, and these companies are likely to see an immediate and significant increase in the amount of gratuity benefit liability accrued for current employees.
The firm suggested:
- Companies affected by the ceiling increase need to evaluate both the accounting and funding implications. While the increase will affect future service costs, many companies will also face a large increase in their past service benefit liabilities. The main impact will be reflected in the P&L expense and the balance sheet for the accounting period in which the ceiling is increased. However, both Indian and international GAAP may allow some spreading of the cost.
- Many employers in India currently fund their gratuity plan by ensuring that the plan is fully funded on an annual basis. However, there is no legal requirement to do so, and companies may wish to consider ways to spread the cost of this particular increase over a suitable period of time and the possible impact. It may also be necessary to reassess the liquidity of assets held under trust. Companies with unfunded gratuity promises should consider the increase in expected benefit cash flows and assess the impact on their budgeting.
- Employers should also consider how they communicate the increased benefit to their employees.