Components of Salary – Understanding How Gross Salary is Broken into Components in India.

HR managers must understand some basic facts about employment laws in order to design a comprehensive salary structure. Following is usually how break up of gross salary works:

Basic Salary -This is the base income. The basic salary is used to calculate several other constituents of the salary. Basic salary is always taxable and hence ideally should not be kept more than 40% (percentage forty) percent of the cost to company (“CTC”), but then keeping it to low may also cause the reduction in other constituents of the salary. Hence a balanced basic income should be calculated.

Medical Reimbursement – This is the part of salary where the employee gets paid for the medical expenditure that they incur. It is tax free only up to INR 15,000 (Indian Rupees Fifteen Thousand Only) a year. If the employee does not produce medical bills for the amount, then the sum will be added to the income of the employee for that year.
House Rent Allowance (“HRA”) – House rent allowance is a very crucial part of the salary structure. It is usually 40% (percentage forty) to 50% (percentage fifty) of the basic salary. It’s important to note that HRA becomes taxable if you do not pay any rent. Additionally, if the HRA is lower than 40% (percentage forty) of the basic, the company may lose out on the chance to reduce tax.

Leave Travel Allowance – This amount is usually paid to the employee and his / her family for leave travel to any place in India. This amount is exempt from tax. The journey can be by rail or air, depending on what the employer offers.

Special allowance (Other allowance etc) – This is the part which makes up for the remainder part of the salary. It is usually not bigger than the basic salary. This is the part which actually cannot be treated as any other constituent of the salary. This part of the salary is usually completely taxable.

Employee Stock Options Plans (“ESOP”) – ESOP is designed in order to retain employees in the company. These are incentive programs that gives the qualifying employees the right to buy the firm’s common stock (ordinary shares) at a discount. The company gives an employee either free shares or gives an option to buy shares at a discounted price if the employee decides to stay with the company for a fixed period. If the holder of shares holds the shares for more than a year, capital gains tax will not be applicable.

Provident Fund Contribution – Provident fund contribution is governed by the Employees Provident Funds and Miscellaneous Provisions Act, 1952. It’s a form of social security that employees get in the form of monthly contribution (both employees share and employers share) for their old age, retirement or in case of some emergency. According to this legislation there is statutory rate of contribution, which is 12 %(percentage twelve) of emoluments (basic salary, dearness allowance, cash value of food concession and retaining allowances if any). This contribution is deducted from the employee’s salary and deposited in a fund called the employee provident fund account. The employer also makes a matching contribution. Here too a balance needs to be maintained, with the basic salary higher the PF contribution also increases which in turn can cause a reduction in take home salary and a subsequent increase in employer’s payout. Please note, out of 12% (percentage twelve) of the employer’s share of contribution, 8.33 %( percentage eight decimal three three) is to be remitted towards pension fund.

Bonus – Payment of bonus is governed by the Payment of Bonus Act, 1965. Bonus is a part of CTC, which is usually given once a year in lump sum based on employee’s and the company’s overall performance. It is taxable as a part of the salary. In some companies this amount is also variable depending on the employee’s performance and him/her meeting their key performance indicators. However, it is important to note that according to the Payment of Bonus Act, 1965 every employee who is drawing a salary of up to INR 10,000 (Indian Rupees Ten Thousand Only) per month and who has worked for minimum period of 30 (Thirty) days in a year is entitled to be paid bonus. The amount usually is 8.33% (percentage eight decimal three three) of the salary earned by the employee.

Gratuity – Payment of Gratuity, governed by the Payment of Gratuity Act, 1972 is a lump sum amount paid by the company, when the employee either retires or resigns from the company. However, for it to be paid the employee needs to have worked in the company for at least 5 (five) years. Gratuity can be calculated by the following formula:

Gratuity = Last drawn salary x 15/26 x No. of years of service

The above is broadly how gross salary is broken into components in order to save tax and other statutory contributions like provident fund, employee state insurance etc.

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