What Is Gratuity Insurance ?
Gratuity, a benefit payable under the “The payment of Gratuity Act”, is the amount paid by the employer to an employee who has been working for 5 or more years in a company/organisation.
Gratuity can also be paid before the completion of 5 years in the following cases:
How does Gratuity Payment Work ?An employer can take a group gratuity plan from an insurance provider or choose to pay the employees from his/her own pocket!
For an organisation to be covered by the payment of Gratuity Act, it has to employee at least 10 people on a single day in preceding 12 months. The organisation will remain covered thereafter even if the number of employees falls below 10 as well.
How to calculate Gratuity ?Gratuity is calculated by the formula:
(15 X last drawn salary X tenure of working) divided by 26
Here last drawn salary means basic salary including dearness allowance.
To make it simple,
• An employment for 6 years 8 months will give the gratuity amount for 8 years and
• An employment of 6 years 2 months will give the gratuity for 6 years!
That means for the number of months in last year of service, anything above 6 months is rounded off to the next number whereas anything below 6 months is rounded off to the previous lower number. Still, an employer can pay more gratuity to its employee however, the amount cannot exceed more than 20 lac, an amount restricted by the Gratuity Act! Employees need to nominate someone to receive a gratuity in case of any unforeseen event (like Demise) by filling theform “F” at the time of joining the organisation.
What is the approach a company can adopt in funding Gratuity ?
Companies need to recognise a liability in their financial statements with respect to the gratuity accrued to their employees. The liability is calculated by carrying out an actuarial valuation as per the provisions of AS 15 or Ind AS 19. Though a liability is recorded in the financial statements, currently companies are not required to set aside funds to back these liabilities. Therefore, many companies run ‘unfunded’ gratuity schemes where there are no backing assets. A scheme where funds have been set aside is referred to as a ‘funded’ scheme.
The current regulatory framework in India does not prescribe the amount to be maintained and companies can choose to maintain a level of funding that they are comfortable with. Companies are also free to choose the amount of contributions they want to make into the fund.
Funding with an insurance company (an insurer) usually involves purchasing a special insurance policy, generally referred to as ‘Group Gratuity Scheme’ or a similar name. This contract works as follows:
1. An employer needs to pay a regular premium to the insurer and in turn, the insurer agrees to pay gratuity to the employees when the need arises (When employees leave the service-Retirement / Resignation / Demise)
2. From the premium received, the insurer deducts ‘risk premium’ to ensure something called ‘future service gratuity’ (see below) and the balance is ‘contribution’, which is deposited to the employer’s gratuity fund.
3. The gratuity fund is like a mutual fund or a bank account from the employer’s perspective. The fund belongs to the employer (to the gratuity trust, to be precise), and the insurer manages the fund on behalf of the employer and administers the payments.
4. One important thing to understand is that the insurer pays gratuity from the employer’s gratuity fund. Therefore, any shortfall in the fund will need to be met by the employer, not the insurer.
Steps to transfer the liability to the insurer ?Step 1: Create a Trust to administer the gratuity scheme
The employer first creates a trust and appoints trustees to administer the gratuity scheme. However, it may be noted that the trust may or may not be created by the employer. Therefore, under the Policy, either Trustees or the employer can be a Policyholder.
Step 2: Contribution based on actuarial advice
The policyholder makes an initial and annual contribution to insurance company towards gratuity liability, which can be paid at the time of issuance of a policy or during the 1st 5 policy years in not more than five instalments.
These payments would normally be based on the actuarial advice to the Trustees by an Independent consulting actuary (who is not employed by the insurer).
Step 3: Choose the Investment Strategy
The Policyholder can invest the contributions in any of the investment funds managed by Insurer. Upon choosing the fund, a unit account is opened and managed for the policyholder in which units are allocated following the receipt of contributions and cancelled for the purpose of paying gratuity benefit and charges.
Units will be deducted from the unit account to pay out the policy charges and the gratuity benefit amount (other than the life insurance benefit) determined by the trustees.
A member on either leaving service due to retirement/ resignation or demise/disability during the service, or any other such event that may terminate the employment after five years, the Insurance company will pay the benefit by redeeming the units in the investment funds to pay the gratuity benefit.
The condition of continuous service of five years is not necessary if the termination of employment is due to death or disablement. The contributions and benefits under the product will be applicable as per scheme rules.
Please note that the maximum liability of the company shall be limited to the unit account value of the policy.
What is future service gratuity ?
By law, the gratuity amount is calculated as 15 days of salary for each year of service. however, if an employee dies in service, the gratuity is calculated as 15 days of salary for each year of ‘potential’ service till retirement. Therefore, in case of demise, gratuity amount is calculated not just on past service rendered by the employee, but also ‘future’ service that the employee could have rendered if he or she had worked till retirement. Therefore, the employer is liable to pay an extra 15 days of salary for each year of future service. The extra payout is insured by paying a risk premium and in case of death is called as future service gratuity
By ensuring future service gratuity, the employer transfers the liability to the insurer. The liability for past service gratuity stays with the employer
By getting into a contract with an insurer, an employer can avail the following benefits:
• Contributions paid to an approved gratuity fund are tax-deductible up to a certain limit
• Investment income earned in the fund is also tax-free
• By investing with an insurance company, employers can invest in certain asset classes which are otherwise restricted if the fund is managed internally, such as equity
• Benefits administration, investment advice, funding advice are provided by the insurer
Advantages to consider for funding a gratuity scheme
Deciding whether to fund gratuity liabilities is a long-term strategic decision and a lot of issues need to be considered. We list down some important ‘generic’ issues, which would be applicable to most companies contemplating funding their gratuity schemes.
From an employer’s perspective, there are three types of tax benefits on offer if the gratuity scheme is funded:
• Annually, an amount equal to 8.33% of basic salaries can be paid into a gratuity fund as a tax-deductible expense.
• If the gratuity liabilities are funded for the first time, a contribution of 8.33% for each year of past service of an employee can be paid into the gratuity fund as a tax-deductible expense.
• Interest or investment income earned within the gratuity fund is also tax-free.
A carefully planned funding strategy can significantly reduce the tax bill of a company. However, tax benefits are not the only consideration for deciding whether to fund a gratuity scheme.
For funding gratuity liabilities, companies will need to find cash from within the business and commit to a gratuity trust. Arguably, the most important consideration would be the alternative ways that cash could be put to use and the return that cash would generate and for how long.
When making such a comparison, one thing to remember is that since the interest earned within a gratuity fund is tax-free. Therefore, an expected return of 10% pa is equivalent to 14% pa pre-tax return, after grossing up for tax at 30%.
An example – if a company can invest excess cash into a project that could generate a return of 20% pa for the shareholders consistently for several years and the expected return in gratuity fund is 10% pa (14% pre-tax), then using that cash for gratuity scheme funding would not seem to be an attractive proposition. If the cash is just generating interest income at the bank rate, say 5%, then it would be better off backing gratuity.
Excess cash can be returned to shareholders as dividends, but this option will generally be less attractive than funding, given the tax benefits.
If liabilities are unfunded, companies will need to pay off the gratuities to leaving employees as and when they leave. Therefore, the amount companies would pay could vary greatly from year to year as the number of people leaving will be uncertain. This would be a concern for small or mid-size companies where the resignation of just a few senior employees, with high salary and service, could create a strain on their cash flow positions. On the other hand, if a scheme is ‘scientifically’ (or actuarially) funded, the fund will build up during the years when no major payouts are paid and then used when large payoffs are required to be paid.
For new companies, the gratuity payments to employees would be few and low. However, gratuity payouts increase nearly exponentially as employees age and work longer. By having the liabilities funded, companies can replace the rapidly increasingly gratuity payouts with a relatively stable stream of contributions into the fund.
Once funds are set aside to back the gratuity liabilities, a thoughtful investment strategy could go a long way in enhancing the returns and therefore reducing the costs for the employer. Although there is no single strategy that would suit all companies, there are a few things to consider:
• Companies can save on investment management expenses by managing the assets in-house. This is suitable for large companies who can afford to set up an investment management team in-house.
• Small and medium-sized companies would be better off by having a third-party asset manager (such as an insurance company) to manage the funds. This strategy would also help in companies get access to asset classes which they may not be allowed to invest in if managing the fund in-house (e.g. equities).
Ultimately, the decision to fund will depend on how important the above factors are for the company, for meeting their overall business objectives. Generally, new companies often overlook this issue as there are other more pressing issues to consider. However, even for small and new companies, there is a lot to gain from better liquidity and stability. Larger companies will have a lot to gain from the tax benefits on offer.
• Age of Employee
• Date of Birth of employee
• Date of Joining.
• Salary + DA.
• Age of retirement
Is Gratuity Provision required if an employee have not completed 5 years ?Gratuity Expense is recognised from the day employee joins the company because the gratuity benefits start accruing as soon as the employee starts his/her service. Gratuity provision needs to be made for each employee as on the balance sheet date, irrespective of whether the employee has completed 5 years or not. Also, there is no vesting condition on demise, hence employer is liable to pay gratuity in case of demise even if the employee has not completed 5 years of service.
Actuarial valuation considers the likelihood that gratuity benefit payment may not arise if an employee resigns or retires before the vesting date. Thus, the provision for gratuity is reduced to that extent. The cost of retirement benefits is accounted for in the period during which qualifying services are rendered as gratuity liability starts accruing.
Contribution consists of two parts:-
Past service:- The contributions to provide for the past service liability of the employees can be made based on Actuarial valuation done by Bajaj Allianz. The Past Service contribution can be paid in lump sum or in easy instalments (Maximum 5 instalments)
Annual Contribution:- The Annual contribution will be calculated actuarially every year after considering the funds and liability position on the annual renewal date.
What are the charges for transferring the fund management to the insurance company?1) For future service gratuity – Insurer will charge the mortality rate which is like life insurance policies. Usually, Rs.1 per 1000 sum insured.
2) Fund Management Charge – usually 0.5% to 1.25% per year
3) Premium allocation charge – Usually around 0% to 2%
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