Gratuity (India)
A statutory retirement benefit under the Payment of Gratuity Act, 1972, requiring Indian employers to pay a lump sum to employees who complete 5 or more years of continuous service.
- What Is Gratuity in India?
- How Gratuity Is Calculated
- Eligibility Criteria and Qualifying Service
- Tax Treatment of Gratuity in India
- Employer Obligations Under the Act
- When Gratuity Can Be Forfeited
- Recent Legal Developments and the Labour Codes
- Practical Tips for HR Teams
- Frequently Asked Questions About Gratuity in India
What Is Gratuity in India?
Key Takeaways
- ✓Gratuity is a statutory lump-sum payment governed by the Payment of Gratuity Act, 1972, applicable to every establishment with 10 or more employees in India.
- ✓Employees must complete 5 years of continuous service (or 4 years and 240 days in certain interpretations) to become eligible.
- ✓The formula for calculation is: (Last drawn salary x 15 x years of service) / 26 for employees covered by the Act.
- ✓The maximum tax-exempt gratuity amount for non-government employees is INR 25 lakh (raised from INR 20 lakh in March 2019).
- ✓Gratuity is payable on resignation, retirement, death, disablement, or retrenchment, but forfeited if termination is for specified misconduct involving moral turpitude.
Gratuity in India is a retirement benefit that rewards long-term service. Think of it as a thank-you payment from the employer for years of loyal work. It's governed by the Payment of Gratuity Act, 1972, one of India's oldest employment benefit statutes. The Act applies to every factory, mine, oilfield, plantation, port, and railway company, as well as every shop or establishment with 10 or more employees. Once an establishment becomes covered (crosses the 10-employee threshold), it remains covered even if the employee count drops below 10 later. This is a critical point that many small business owners miss. Unlike the Provident Fund (where both employer and employee contribute monthly), gratuity is entirely employer-funded. The employee pays nothing toward it. The liability accumulates silently on the employer's books until the employee leaves or retires, at which point it becomes payable within 30 days.
How Gratuity Is Calculated
The calculation formula differs depending on whether the employee is covered under the Payment of Gratuity Act or not.
Formula for employees covered under the Act
Gratuity = (Last drawn salary x 15 x completed years of service) / 26. Here, 'last drawn salary' means basic salary plus dearness allowance (DA). It excludes HRA, bonuses, overtime, and any other allowances. The denominator of 26 represents the working days in a month (30 minus 4 Sundays). Years of service exceeding 6 months are rounded up to the next full year. So 7 years and 8 months counts as 8 years. Example: an employee with 12 years of service and a last drawn salary of INR 50,000 (basic + DA). Gratuity = (50,000 x 15 x 12) / 26 = INR 3,46,154.
Formula for employees not covered under the Act
For employees not covered (establishments with fewer than 10 employees, or employees in non-covered establishments), the formula is: (Last drawn salary x 15 x completed years of service) / 30. The denominator changes from 26 to 30 because the calculation uses calendar days rather than working days. The 'last drawn salary' definition is the same. These employees don't have a statutory right to gratuity, but many employers pay it voluntarily or as part of company policy.
Salary components included in the calculation
Only basic salary and dearness allowance (DA) count toward the gratuity calculation for employees covered under the Act. Special allowance, house rent allowance, conveyance allowance, medical allowance, bonus, commission, and overtime are all excluded. This creates a structuring incentive: employers who set a low basic salary and high allowances reduce their gratuity liability. Several Indian court rulings have examined whether specific allowances should be classified as part of basic salary for gratuity purposes. The Supreme Court has held that if an allowance is universally paid and linked to the nature of work (not individual circumstances), it may be treated as part of basic salary.
Eligibility Criteria and Qualifying Service
The 5-year continuous service requirement is the most discussed aspect of Indian gratuity law. It creates a cliff-vesting situation where employees who leave at 4 years and 11 months receive nothing.
The 5-year rule and the 4 years 240 days interpretation
Section 4(1) of the Act states that gratuity is payable after completing 5 years of continuous service. However, Section 2A defines 'continuous service' and specifies that an employee who has worked for 240 days in each year is deemed to be in continuous service. Several High Courts have held that 4 years and 240 days should be treated as 5 years for gratuity purposes. The Supreme Court addressed this in Surinder Singh Pathania vs. Nai Duniya (2019), ruling that 4 years and 190 days was not sufficient. The legal position remains somewhat jurisdiction-dependent. HR teams should consult with labor law counsel in their specific state.
Exceptions to the 5-year rule
Two important exceptions exist. If an employee dies or becomes permanently disabled, gratuity is payable regardless of how long they worked. Even 1 day of service qualifies in these cases. The gratuity is paid to the nominee or legal heir in case of death. Fixed-term contract employees who complete the contract but don't accumulate 5 years may also have gratuity rights under recent amendments to the Industrial Relations Code, 2020, though the code's implementation timeline remains uncertain as of 2026.
What breaks continuous service
Authorized leave (paid or unpaid, if approved), layoff periods, and legally recognized strikes don't break continuity. Unauthorized absence of more than the prescribed limit, termination followed by re-employment with a gap, and resignation followed by re-joining are considered breaks. If an employee resigns and rejoins the same employer after a gap, the previous service period doesn't count. The 5-year clock restarts from the new joining date.
Tax Treatment of Gratuity in India
Gratuity taxation depends on whether the employee is a government servant or a private sector employee, and whether they're covered under the Act.
Government employees
Gratuity received by central and state government employees, defense personnel, and employees of local authorities is fully exempt from income tax under Section 10(10)(i) of the Income Tax Act. There's no cap on the exemption. This is one of the reasons government jobs remain attractive in India despite lower cash salaries.
Private sector employees covered under the Act
For non-government employees covered under the Payment of Gratuity Act, the tax-exempt amount is the least of three calculations: actual gratuity received, INR 25 lakh (the statutory cap, revised in 2019), or 15 days' salary for each completed year of service (calculated using the 26-day divisor). Any amount exceeding the lowest of these three is taxable as income in the year of receipt. For employees who receive gratuity from multiple employers over their career, the INR 25 lakh limit is a lifetime aggregate, not a per-employer limit.
Private sector employees not covered under the Act
For employees not covered by the Act, the calculation changes slightly. The exempt amount is the least of: actual gratuity, INR 25 lakh, or half month's salary for each completed year (using the last 10 months' average salary, with a 30-day divisor). The key difference is 'half month's salary' versus '15 days' salary' and the use of the 10-month average rather than last drawn salary. This formula typically produces a smaller exempt amount.
Employer Obligations Under the Act
The Payment of Gratuity Act imposes several procedural and financial obligations on employers beyond simply paying the gratuity amount.
Payment timeline
Gratuity must be paid within 30 days of it becoming due. If the employer delays beyond 30 days, they must pay simple interest at the rate notified by the central government (currently 10% per annum) from the due date to the payment date. The 'due date' is the date of termination, resignation, retirement, or death. This means the 30-day clock starts ticking immediately, not from when the employee submits a claim.
Compulsory insurance or trust fund
Under Section 4A of the Act, every employer must obtain gratuity insurance from the Life Insurance Corporation of India (LIC) or an approved insurer, or establish a gratuity trust fund. The purpose is to ensure funds are available when gratuity becomes payable. In practice, many employers, especially large ones, set up gratuity trusts and fund them based on actuarial valuations. Smaller employers often purchase group gratuity policies from LIC. Companies that neither insure nor establish a trust face penalties and, more importantly, risk being unable to pay when long-tenure employees exit.
Nomination requirements
Every employee must submit a nomination form (Form F) specifying who should receive the gratuity in case of death. If the employee has a family, the nominee must be a family member. Employees without families can nominate anyone. The employer must maintain these nomination records and ensure they're updated when employees' circumstances change (marriage, divorce, birth of children). If no valid nomination exists at the time of death, the gratuity is distributed among the legal heirs according to succession laws.
When Gratuity Can Be Forfeited
The Act allows gratuity to be forfeited only in very specific circumstances. Employers can't withhold gratuity simply because they're unhappy with an employee's performance or behavior.
Grounds for forfeiture under Section 4(6)
Gratuity can be forfeited wholly or partially if the employee's service was terminated for riotous or disorderly conduct, or any act of violence against the employer, manager, or other employee. Also for any act that constitutes an offense involving moral turpitude, provided the employee was convicted by a court for that offense. The key phrase is 'moral turpitude,' which Indian courts have interpreted as conduct that is contrary to accepted moral standards: theft, fraud, sexual harassment, forgery, bribery, etc. Simple performance issues, insubordination, or policy violations don't qualify.
Partial forfeiture
If the employee caused damage or loss to the employer's property during their service, the employer can forfeit gratuity to the extent of the damage. This must be documented with evidence of the damage and its monetary value. The forfeiture amount can't exceed the actual damage caused. This provision is rarely used in practice because documenting and quantifying damage is difficult, and labor courts tend to scrutinize forfeiture claims closely.
Recent Legal Developments and the Labour Codes
India's labor law framework is undergoing a major overhaul with four new Labour Codes that consolidate 29 existing labor laws. The Code on Social Security, 2020, will subsume the Payment of Gratuity Act when implemented.
Changes under the Code on Social Security, 2020
The Code extends gratuity eligibility to fixed-term employees: an employee on a 1-year fixed-term contract will receive proportional gratuity without needing to complete 5 years. This is a significant change for industries that rely heavily on contract labor. The Code also brings gig workers and platform workers into the social security framework, though gratuity specifically may not apply to them (the Code creates a separate Social Security Fund for gig workers). As of early 2026, the Labour Codes haven't been fully implemented. Several state governments have drafted rules, but nationwide implementation requires all states to notify their rules, which hasn't happened yet. Companies should monitor developments and prepare for compliance.
Impact of the wage code on gratuity calculations
The Code on Wages, 2019, redefines 'wages' to mean at least 50% of total remuneration. If allowances exceed 50% of the total CTC, the excess is deemed part of wages. This means employers can't structure salary with a 20% basic and 80% allowances anymore, at least not without the allowances being reclassified as wages for statutory purposes. When implemented, this will increase gratuity liability for companies that currently use low basic salary structures. The impact could be substantial: a company with 1,000 employees might see its gratuity liability increase by 30% to 50% if basic salary definitions change.
Practical Tips for HR Teams
Managing gratuity well requires a combination of financial planning, legal compliance, and clear communication.
- Get a gratuity trust or insurance policy in place: this is legally required and protects the company from cash flow shocks when long-tenure employees leave.
- Conduct actuarial valuations annually: required under Indian Accounting Standards (Ind AS 19 / AS 15) for financial reporting. Use a qualified actuary registered with the Institute of Actuaries of India.
- Monitor salary restructuring carefully: if you restructure compensation to reduce basic salary, model the impact on gratuity liability. Courts are increasingly willing to look through artificial structures.
- Include gratuity in total compensation communications: many Indian employees don't realize gratuity is a significant benefit until they receive it. Showing it in annual compensation statements improves perceived value.
- Track the 5-year cliff: employees approaching 5 years are in a critical retention window. Losing an employee at 4 years 10 months means they get nothing and may feel cheated. Consider proactive retention discussions.
- Prepare for Labour Code implementation: model the financial impact of the expanded wage definition on your gratuity liability. The change could be significant.
- Process gratuity payments within 30 days: delays trigger interest at 10% per annum and damage the employer brand. Automate through payroll software where possible.
Frequently Asked Questions
Can an employer pay more than the statutory gratuity amount?
Is gratuity applicable to contract employees and consultants?
What if the employer refuses to pay gratuity?
Does gratuity apply if the company shuts down?
Is gratuity deducted from the employee's salary?
Can gratuity be claimed for service with multiple employers?
Written by Adithyan RK