Gratuity rules for employers: eligibility, formula, tax

Gratuity is the one statutory payment most small companies get wrong at the exact moment it matters: the last working day of a long-serving employee. The rules are not complicated, but they changed in two places when the Code on Social Security 2020 came into force on 21 November 2025, and the old habits have not caught up. This is the employer's view: who is owed what, when, and how to compute it.

Who the law covers

The Payment of Gratuity Act 1972 now lives inside Chapter V of the Code on Social Security. It applies to every factory, mine, oilfield, plantation, port and railway company, and to every shop or establishment with ten or more employees on any day in the preceding twelve months. Once covered, an establishment stays covered even if headcount later falls below ten.

Every employee is covered, with no wage ceiling. The idea that gratuity applies only to people below a certain salary is a hangover from the pre-1994 law and is wrong.

Who qualifies

Regular employees: five years of continuous service with the same employer, counted to the date of leaving. Resignation, retirement, superannuation and termination all qualify. Death or disablement waives the five-year condition entirely.
Fixed-term employees: this is the first change. Under Section 53 of the Code, an employee on a fixed-term contract is entitled to gratuity on a pro-rata basis after one year of service under that contract, when the contract ends. The Ministry of Labour's FAQ of 16 March 2026 confirms it. If you use fixed-term contracts to avoid gratuity, that no longer works.
The "4 years and 240 days" argument: several High Courts, starting with the Madras High Court in Mettur Beardsell (1998), have held that four years plus 240 worked days in the fifth year counts as five years. The Supreme Court has not settled it. Treat it as a live risk if you refuse gratuity to someone at four years and nine months; many employers simply pay.

Continuous service survives leave with wages, maternity leave, sickness, accident and lay-off. It does not require the employee to have been physically present every day.

The formula

Gratuity = 15 ÷ 26 × last drawn monthly wages × completed years of service.

Three things decide the number:

Element	Rule
Wages	Basic plus dearness allowance under the old Act. Under the Code's definition of "wages", if the excluded allowances exceed half of total remuneration, the excess is added back. For a structure with a 40 percent basic, the gratuity base rises.
Years	Completed years, plus one more if the final partial year exceeds six months. Seven years and seven months counts as eight.
15/26	Fifteen days' wages for every year, with a month taken as 26 working days. For monthly-paid staff this is the standard divisor.

Worked example. An employee leaves after 7 years and 8 months. Last drawn basic plus DA is ₹40,000. Years count as 8. Gratuity = 15 ÷ 26 × 40,000 × 8 = ₹1,84,615. If the same person's gross is ₹80,000 and the structure fails the 50 percent test, the base becomes ₹40,000 plus the excess, and the figure rises accordingly. A gratuity calculator does this arithmetic, but it cannot tell you what the correct wage base is; that comes from your salary structure.

There is no statutory ceiling on the amount the employer must pay. The ₹20 lakh figure is a tax limit, not a payment cap, and the employer may pay more under contract or policy.

When and how to pay

Section 56 of the Code requires the employer to arrange payment within 30 days of the date gratuity becomes payable, which is the last working day. If payment is late, simple interest runs from the due date at a rate the central government notifies, unless the delay was the employee's fault. Gratuity is paid in full on exit, not spread across months.

Practically, the employee applies in the prescribed form, the employer determines the amount and gives written notice of it, and payment goes with the full and final settlement. Compute it before the F&F sheet is shared, and show the working on the sheet. Most disputes come from a figure appearing without a basis.

Nomination is required: every covered employee should file a nomination within 30 days of completing a year of service. Collect it at onboarding and store it with the employee's statutory documents; it decides who is paid if the employee dies in service.

Tax

Gratuity received by a private-sector employee covered by the Act is exempt from income tax up to ₹20 lakh. The limit is a lifetime aggregate across all employers, not a per-job figure. Anything above it is taxed as salary in the year of receipt. The exemption applies only on exit or retirement; an advance against gratuity paid during service does not get it. Deduct TDS on the taxable excess before paying.

Funding and provisioning

Gratuity is a liability that builds silently from day one. Companies with more than a handful of long-serving employees should provision for it annually in the accounts, and the Act permits compulsory insurance through a group gratuity scheme in states that notify it. A 50-person company with average tenure of four years has a six-figure liability it has probably never computed.

Common employer mistakes

Treating the five years as calendar years from the offer letter rather than from the date of joining.
Using basic alone as the base when the structure fails the 50 percent test under the Code.
Refusing gratuity to fixed-term staff who have crossed one year.
Paying "with the next payroll" and missing the 30-day deadline.
Forfeiting gratuity for misconduct without the written order the law requires; forfeiture is allowed only for specified misconduct and only to the extent of the loss caused.

Sources

This article describes general legal provisions and common practice, not legal advice. Gratuity eligibility, the wage base and tax treatment depend on the statutes, rules and state notifications applicable to your establishment; confirm specifics with a professional.