What is gratuity and who is eligible?
Gratuity is a statutory benefit paid by an employer to an employee as a gesture of gratitude for the services rendered during the period of employment. Governed by the Payment of Gratuity Act, 1972, it applies to every establishment employing ten or more persons. The key eligibility criterion is completion of five continuous years of service with the same employer. "Continuous service" has a specific legal meaning — an employee who has worked for 240 days in a year (or 190 days in the case of establishments working below ground, such as mines) is deemed to have completed a year of continuous service. This means an employee who joins on 1 January 2021 becomes eligible for gratuity on 1 January 2026, assuming continuous employment without breaks exceeding the prescribed limits.
There are important exceptions to the five-year rule. If an employee's service is terminated due to death or disablement (physical or mental), gratuity is payable regardless of the length of service. In such cases, the gratuity is paid to the nominee or legal heir. Additionally, the Supreme Court of India has clarified in several judgments that service of four years and 240 days can be rounded up to five years for the purpose of gratuity eligibility. This interpretation is significant for employees whose service is terminated shortly before completing five full years. Gratuity is applicable to all types of employees — permanent, temporary, or contractual — as long as the establishment falls under the Act and the service condition is met. Under the new labour codes, fixed-term employees are also entitled to gratuity on a proportionate basis, even if their contract tenure is less than five years, which is a significant expansion of coverage.
The gratuity calculation formula
For employees covered under the Payment of Gratuity Act (which includes most private sector employees), the formula is: Gratuity = (Last drawn salary x 15 x Number of years of service) / 26. Here, "last drawn salary" means the basic salary plus dearness allowance (DA) as on the date of cessation of employment. The number 15 represents 15 days' wages for each completed year of service, and 26 represents the working days in a month. Years of service exceeding six months are rounded up to the next full year — so an employee with 7 years and 8 months of service is treated as having 8 years for the calculation. For example, an employee with a last drawn basic salary plus DA of ₹50,000 per month and 10 years of service would receive: (50,000 x 15 x 10) / 26 = ₹2,88,461.
For employees not covered under the Act (such as those in establishments with fewer than ten employees, or certain categories of employees excluded by notification), the formula is slightly different: Gratuity = (Last drawn salary x 15 x Number of years of service) / 30. The denominator is 30 (calendar days in a month) instead of 26 (working days), resulting in a slightly lower gratuity amount. For piece-rated employees (those paid per unit of output rather than a fixed monthly salary), the calculation uses the average of the last three months' total wages as the base salary. Seasonal establishment employees receive gratuity at the rate of seven days' wages for each season. The maximum gratuity payable under the Act is ₹20,00,000 (twenty lakh rupees), as enhanced by a government notification in 2019 — any amount above this is paid at the employer's discretion and is fully taxable.
Tax exemption rules on gratuity
The tax treatment of gratuity depends on whether the employee is a government employee, a private sector employee covered under the Act, or a private sector employee not covered under the Act. For government employees (central, state, and local authority), gratuity received is fully exempt from income tax without any monetary ceiling. For private sector employees covered under the Payment of Gratuity Act, the least of the following three amounts is exempt from tax: (a) the actual gratuity received, (b) ₹20,00,000, or (c) 15 days' salary for each completed year of service calculated at the last drawn salary (using 26 as the divisor). Any amount exceeding the exempt portion is taxable as "income from salary."
For private sector employees not covered under the Act, the exemption is calculated differently: the least of (a) actual gratuity, (b) ₹20,00,000, or (c) half month's average salary for each completed year of service, where "salary" is the average of the last ten months' basic salary. The ₹20 lakh ceiling applies as a cumulative lifetime limit — if an employee receives gratuity from multiple employers over their career, the total exemption across all gratuity receipts cannot exceed ₹20 lakh. HR teams should maintain records of any gratuity previously received by employees (disclosed in the joining declaration form) to correctly compute the taxable portion. Workro's gratuity calculator automates this computation, allowing HR professionals to input the employee's last drawn salary, years of service, and any prior gratuity received to instantly determine the exempt and taxable portions.
Forfeiture conditions and employer obligations
An employer can forfeit the gratuity of an employee, wholly or partially, under specific conditions defined in Section 4(6) of the Act. Gratuity can be forfeited to the extent of damage or loss caused to the employer's property due to the employee's wilful omission or negligence. Additionally, if the employee's services are terminated for riotous or disorderly conduct, or for any act of violence, or for any act that constitutes an offence involving moral turpitude (provided the employee is convicted for such offence), the gratuity can be forfeited wholly or partially. However, courts have interpreted these forfeiture provisions strictly — the employer bears the burden of proving the specific grounds, and routine misconduct or poor performance is generally not sufficient for forfeiture.
Employers are obligated to pay gratuity within 30 days of it becoming payable. If the employer fails to pay within this period, simple interest at the rate notified by the central government (currently 10% per annum) is payable on the outstanding amount. The employee can file a complaint with the Controlling Authority (usually the Assistant Labour Commissioner) if gratuity is not paid or is paid at a lower amount than entitled. The employer must also display an abstract of the Act and the rules in English and the local language at a conspicuous place in the establishment, and must obtain insurance for their gratuity liability or establish an approved gratuity fund (many companies create a gratuity trust for this purpose). Under the new labour codes, the gratuity framework remains largely intact but with streamlined compliance procedures and the notable addition of proportionate gratuity for fixed-term employees — a change that HR teams need to factor into contract structuring and exit settlement processes.
New labour code changes affecting gratuity
The Social Security Code, 2020 introduces several changes relevant to gratuity. The most impactful is the provision for gratuity to fixed-term employees on a proportionate basis. Under the existing Act, fixed-term contract employees were often excluded because they did not complete the five-year threshold. The new code ensures that if an employee is hired on a one-year fixed-term contract, they receive proportionate gratuity for that year of service — calculated as (last drawn salary x 15 x 1) / 26. This is a significant cost addition for companies that rely heavily on fixed-term or project-based hiring, particularly in IT services, manufacturing, and construction sectors.
The revised wage definition under the Code on Wages also affects gratuity calculations. Since "wages" must now constitute at least 50% of total remuneration, and gratuity is calculated on last drawn wages (basic plus DA), the base for gratuity computation increases for companies that previously structured a lower basic component. For an employee with ₹12 lakh CTC, the shift from 40% basic (₹4,80,000) to 50% basic (₹6,00,000) increases the annual gratuity provision by approximately ₹3,460 per year of service. Over a 10-year employment tenure, this adds up to a ₹34,600 increase in gratuity liability per employee. Companies should re-evaluate their gratuity fund contributions and insurance coverage in light of these combined changes. Using compliance tools with built-in calculators — like those available on the Workro platform — ensures that these updated calculations are applied consistently across your workforce rather than being manually computed for each employee, reducing errors and audit risks.