When designing the salary structure of an employee, an employer pays different types of allowances and perquisites to the employee. These allowances and perquisites are allowed for meeting the different types of expenses incurred by an employee. Moreover, these allowances and perquisites are offered in addition to the basic salary. The basic salary and the allowances and perquisites offered by the employer form the gross salary of the employee.
Among various types of allowances that employers offer, dearness allowance is the most common allowance that is paid to most employees. Let’s understand what this allowance is all about and how it is calculated.
Dearness allowance meaning – What is dearness allowance?
Dearness allowance means an allowance paid to employees in order to curb the impact of inflation. It is the cost of living index paid by the government to pensioners and public sector employees calculated as a fixed percentage of basic salary. Dearness allowance forms a part of the total salary of Central Government employees. A constant enhancement is necessary in the salary to help the employees cope up with the increasing cost of living. Dearness allowance is calculated on the basis of the impact of inflation in the location of the respective employees and therefore it varies from one employee to another based on their location in the rural, urban or semi-urban sector. According to the Income Tax Act, 1961, it is mandatory to declare tax liability in respect of dearness allowance at the time of filing an income tax return. Dearness allowance is paid both in India and Bangladesh.
Calculation of dearness allowance
Dearness allowance is calculated on the basic salary of the employee. Dearness allowance is calculated twice a year i.e in January and in July. As it is an allowance offered in order to protect the employees against the rising prices in a particular financial year, the government has ensured that the employees can take adequate benefit of the allowance by offering it twice a year. The government has changed the formula for calculating dearness allowance in the year 2006. There are two formulas to calculate dearness allowance, one is for Central Government employees and the other is for Central Public Sector employees.
Let’s have a look –
Types of Dearness Allowance
Dearness allowance is nothing but an adjustment which the government provides to its employee in order to compensate the cost of living which increases due to inflation. The Indian government offers the following types of dearness allowance to its employees:
- Industrial dearness allowance
Industrial dearness allowance is an allowance paid by the government to the employees of public sector companies. The rate of industrial dearness allowance is revised by the government on a quarterly basis and is based on the consumer price index.
- Variable dearness allowance
This dearness allowance is offered to the employees employed under the central government. Unlike industrial dearness allowance, variable dearness allowance is revised by the government on a half-yearly basis and varies on the basis of changes in the consumer price index. There are three elements in variable dearness allowance which includes consumer price index, variable dearness allowance and base index. The variable dearness allowance remains fixed until the basic minimum wages are increased or decreased by the government. Similarly, the base index which is the second component of variable dearness allowance also remains fixed. However, the consumer price index changes on a monthly basis and majorly affects the calculation of variable dearness allowance.
Tax treatment of dearness allowance
Dearness allowance is fully taxable in the hands of the salaried employeesas per the provisions of the Income Tax Act, 1961. If an employee gets a rent-free unfurnished accommodation from the employer, then the part of the dearness allowance that will form a part of the salary would be equal to the retirement benefit salary that the employee receives.
It is compulsory for the employee to state their tax liability with respect to the dearness allowance at the time of filing the return.
Changes in Dearness allowance rates
Dearness allowance is paid to curb inflation and is therefore based on the cost of living index which varies from one place to another. Hence, dearness allowance also varies from employer to employer based on their location. It is different for employees living in the semi-urban sector, rural sector and Urban Sector. The government increases the rates of dearness allowance twice a year i.e every 6 months. Usually, the changes in the rates of dearness allowance are introduced by the government on 1st of January up to the period of June and then again on 1st July until the end of December.
The government increased the dearness allowance rate with effect from January 2020. The rate became 164% of the basic pay for Central Government employees as well as for the employees of the central autonomous bodies. Furthermore, from 1st July 2021, the dearness allowance rate has been further enhanced to 189% of the basic pay.
Role of pay commissions in fixing the dearness allowance
The pay commission is tasked with the evaluation of the salary of the public sector. The pay commission evaluates the salary after considering the different components contained therein. Since dearness allowance is also a part of the salary component, it is taken into consideration by the pay commission at the time of preparing the subsequent pay commission report. The pay commission, thus, reviews and updates the dearness allowance rate on a periodic basis.
Dearness allowance for pensioners
A pensioner means a person who is retired and is receiving a pension from the employer. Pensioners are also retired Central Government employees who receive family or individual pensions after retirement from service.
Dearness allowance forms a part of the pension payable to pensioners. As such, when the pay commission hikes the allowance rates or the Central Government revises the rates, the pension amount is also affected.
Dearness allowance vis-a-vis house rent allowance – the difference
House rent allowance is different from dearness allowance and forms a separate part of the salary of the employee. Dearness allowance meaning is different and dearness allowance definition does not include House Rent Allowance. Let us have a look at what makes house rent allowance different from dearness allowance:
Basis of comparison
House rent allowance
Dearness allowance is paid only to the employees of Central Government and public sector employees
House rent allowance is available to employees of both public and private sector companies
Dearness allowance is a fixed percentage of basic salary paid to public sector employees
House rent allowance is the amount of allowance paid by the employer for the purpose of the accommodation and is not calculated on the basis of basic salary
Dearness allowance is fully taxable and no exemption is available in case of dearness allowance
House rent allowance is partially taxable and the employee can claim certain exemptions under the Income Tax Act.
The rate of dearness allowance is revised periodically
The house rent allowance, however, does not usually change unless the salary structure of the employee changes
The merger of Dearness allowance
Dearness allowance merger means merging the amount of dearness allowance with the basic salary of the employee when it exceeds 50%. After the revision in the formula for calculation of dearness allowance, the percentage of dearness allowance for the central government and public sector employees is rising consistently. This is the result of constant and consistent enhancement in dearness allowance every year in order to offset the effects of inflation for the employees. Dearness allowance merger would lead to a significant hike in the salary of the employees. Moreover, as the other components of the employee salary are calculated on basic salary, they would also increase with the increase in basic salary.
Ways of saving your tax liability
If you receive a dearness allowance as a part of your salary, the allowance would be taxed at your income tax slab rates. However, there are ways in which you can save your income tax liability. Such ways are as follows –
- Use the deduction under Section 80C
Section 80C of the Income Tax Act, 1961, you are allowed a deduction of up to INR 1.5 lakhs if you invest in eligible avenues or you incur eligible expenses. The eligible avenues for saving taxes under Section 80C are as follows –
- Life insurance premiums
- ELSS investments
- Principal repayment is done for a home loan
- Tuition fees paid for children
- 5-year fixed deposits
- PPF and EPF
- Sukanya Samridhi Yojana
- Senior Citizen Saving Scheme, etc.
- Invest in NPS
The National Pension System allows you to claim an additional deduction of up to INR 50,000 under Section 80CCD (1b). This deduction is in addition to the deduction available under Section 80C.
- Invest in health insurance
Section 80D allows deduction on the premiums paid towards a health insurance policy. The limit of deduction is INR 25,000 which becomes INR 50,000 for senior citizens. Buying a health insurance policy for parents results in an additional deduction of up to INR 50,000 if your parents are senior citizens.
- Use home loan interest tax benefits
Home loan interests are allowed as tax-exempt expenses under Section 24(b). The limit of exemption is INR 2 lakhs. Moreover, if you are a first-time home buyer and you fulfil some eligibility conditions, you can claim an additional deduction of INR 1.5 lakhs under Section 80EEA on the home loan interest that you pay.
Understand dearness allowance and how it is calculated to know what your salary is composed of.