Like your colleagues who throw a warm farewell for you when you leave after putting in substantial years, your employer too has a small, but significant, way of singing 'he's a jolly good fellow' to reward you for your service to the organisation.

He does so by giving you a free lump sum of cash - called gratuity in financial parlance - on your exit. The amount that he gives is based on the number of years of service you have put into the organisation. Read on to know more about this little-known windfall and some ideas about what you can do with the free money that comes your way.

When are you entitled?

Gratuity in earlier days was rather arbitrary and completely hostage to the whims of the employer. A wealthy, well-established employer would reward his dedicated employees and the not so rich would refuse such generosities. This led to a lot of discord and finally the government stepped in, passing the Payment of Gratuity Act, 1972, making it mandatory for all employers with more than 10 employees to give them gratuity.

Employees, as defined here, are the ones hired on company payrolls. Trainees are not eligible and gratuity is paid on the basis of the employee's basic plus dearness allowance if any.

How much can you get?

You become entitled to a gratuity on resignation or on retirement after five years or more of service. As per the Act, the gratuity amount is 15 days' wages multiplied by the number of years put in by you. Here wage means your basic plus dearness allowance. Take the monthly salary drawn by you last (basic plus dearness allowance) on resignation or retirement and divide it by 26, assuming there are four Sundays in a month. This is your daily salary. Multiply this amount by 15 days and further with the number of years you have put into service.

For instance, if your average monthly salary is Rs 50,000, the gratuity payable to you after 10 years of service would be Rs 290,000. However your employer factors in another term: 'uninterrupted service'. The term covers the service period of the employee including leaves or breaks, except periods notified as breaks in service by the employer.

For employees who do not fall under the Gratuity Act, the amount due for them is half of the average ten months' salary multiplied by the number of years of service.

Tax treatment

As per the formula under the Act, gratuity up to Rs 350,000 is exempt from taxes. In the above example, the entire money is tax-free. However, for government employees any amount is non-taxable.

Your employer could choose voluntarily to pay you more gratuity; but any extra benefit that he pays, not coming under the formula, will be taxable. For instance, in the above example, if the employer pays you Rs 350,000, the entire money is not tax exempt; only the Rs 290,000 due under the formula is.

Says Sibranjan Patnaik, senior vice president and head, group business, Max New York Life: "Be it a lump sum above the due amount, or money that you get before the stipulated five years, the employer  is free to give you extra benefits. However, these sums are taxable if they exceed the specified limit under the Act.

In case of death of the employee, the heir is entitled to the gratuity immediately and the entire amount is tax-exempt. However, if death occurs after the gratuity is due then any amount above Rs 350,000 is taxable.

The employer could also offer you an extra gratuity by deducting a portion of your salary as the cost to the company. At the time of joining the organisation, ask your employer for all the details concerning gratuity and how to calculate it.

To meet its liabilities towards gratuity, a company either funds the money from its own pocket, or opens a trust and puts in money for the gratuity fund. This fund is then managed either by an insurer or an actuarial company.

Adds Patnaik: "Insurers also offer a life insurance in group gratuity policy which could be a standard cover or vary across employees." Ask your employer if there are any extra covers to be availed.

There are clear guidelines on how your gratuity money can be invested. Insurers, like service policyholders, have two opt-ions: traditional and unit-linked plans. While a traditional plan has little exposure to equities, a unit-linked plan can invest up to 60 per cent in equities.

Says Tarun Chugh, senior vice-president and head, group business, ICICI [Get Quote] Prudential Life Insurances: "We have four funds ranging from 100 per cent debt to 40 per cent debt. However, we advise companies to choose up to 20 per cent in equities since it is a defined benefit scheme and attritions exist."

Quick tips

Gratuity helps in strengthening your finances. Although the most tempting idea would be to splurge, a better proposition is to invest it.

Since it is a lump sum and not an income stream, using it to pay off your debts or increasing your down payment for a loan might be a good idea. Says Veer Sardesai, Pune-based financial planner, "It is not often that you get such free money. So a good idea would be to reduce the debt liability first and use the surplus to invest."

For the surplus, adds Sardesai: "You could invest in equity products such as an index ETF or Funds if you are a young individual since you can easily keep this amount away for the long term." For the risk-averse, a public provident fund (PPF) is a good option. However the minimum contribution per annum is Rs 500 and maximum is Rs 70,000. Therefore, Rs 290,000 can be invested here only over the years.

If you get this money after retirement, it could be a large sum, with salaries at their maximum and several years of service accumulated. Even if retirement plans involved investing in various pension plans, equity funds and debt instruments, you can't employ all your funds to get you a monthly income stream.

You need a cash buffer for emergencies and some investments happening so that all your investments are not exhausted. Says Sardesai, "Even after retirement, you need to plan for the next 30 years. So you also need to make your money grow. Putting your surplus cash in instruments like equity funds or debt instruments like PPF is advisable if you already have investments to fund your regular income."

However, for those who are banking on gratuity for a regular income stream, Senior Citizens' Savings Scheme, post office monthly income scheme or a fixed bank deposit are worthy options.

Free as it sounds and despite the splurge-instincts it arouses, gratuity is a significant sum of money and can be used effectively to further cushion your personal finance.