Indexation applies to debt funds only. It is a technique used to adjust the purchase price of your debt fund for inflation. It helps to counter the erosion in the value of the investment over a period of time. The income tax department recognises that one needs to increase the purchase price of the investment so that it reflects inflation-adjusted true price in the year in which it is sold.
For example, you invested Rs. 1 lakh in a debt fund in January 2010 at a NAV of Rs. 10. You then redeemed all of it in July 2013 when the NAV is Rs. 15. Your entire investment is worth Rs. 1.5 lakh, and is considered long-term since it was held for over 3 years.
With indexation, your cost of acquisition will be adjusted upward to Rs. 1 lakh X 939/632= Rs. 1.486 lakh. As per Income Tax Act, Cost Inflation Index (CII) is a measure of inflation that is used for determining the indexed cost of acquisition. This is published every year for the financial year and is available on the website of the income tax department.
Thus, the long-term capital gain will be a meagre amount of Rs. 1,424 (Rs. 1.5 lakh investment redemption proceeds - Rs. 1.486 lakh indexed cost of acquisition). This will be taxed at 20%, which is almost negligible.This tax treatment is what makes debt funds superior to bank FDs.
Please note the income tax act provides for specific conditions and also exceptions for the use of indexation. The above example is indicative and you must consult a tax advisor for determining your tax obligations correctly.