Gratuity Calculation in India — Formula, Eligibility, Tax Rules & 2025 Labour Code Changes

Gratuity is one of those things every employer knows they have to pay — but many get the calculation wrong, miss the eligibility rules, or are unaware of the significant changes that came into effect in late 2025.

This guide covers everything: the formula, eligibility, what counts as salary, tax rules, and the new Labour Code updates that affect fixed-term and contract employees.

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What Is Gratuity?

Gratuity is a statutory lump-sum payment made by an employer to an employee as a token of appreciation for long-term service. It is governed by the Payment of Gratuity Act, 1972.

It is payable when an employee:

• Retires or superannuates
• Resigns after completing the minimum service period
• Is terminated (other than for misconduct)
• Becomes disabled due to accident or disease
• Dies (paid to the nominee/legal heir — no minimum service required)

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Who Must Pay Gratuity?

The Act applies to any establishment with 10 or more employees. Once an establishment crosses this threshold, it remains covered even if the headcount later drops below 10.

Covered sectors include: factories, mines, oil fields, plantations, ports, railways, motor transport, shops, and all other establishments.

If you have 10 or more employees — you are covered. No exceptions.

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Eligibility: The 5-Year Rule

An employee must have completed at least 5 years of continuous service with the same employer to be eligible for gratuity.

Important exceptions (no minimum service required):

• Death of the employee — gratuity paid to the nominee
• Permanent disability due to accident or disease

What counts as "continuous service"?

An employee is considered to be in continuous service even during periods of:

• Paid leave (CL, SL, EL)
• Maternity or paternity leave
• Lay-off periods
• Temporary disablement from work injury

The 4 years + 240 days rule

For the fifth year, courts have interpreted "5 years" to mean 4 years and 240 days of actual working. This is especially relevant for employees who resign just before completing exactly 5 years. If they have worked 240+ days in the fifth year, gratuity is payable.

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The Gratuity Formula

Gratuity = (Last Drawn Salary × 15 × Years of Service) ÷ 26

Where:

• Last Drawn Salary = Basic Pay + Dearness Allowance (DA)
• 15 = 15 days of salary per year of service
• 26 = 26 working days in a month (4 weeks × 6.5 days, excluding Sundays)
• Years of Service = completed years only (6 months and above rounds up — see below)

Rounding years of service

• Less than 6 months in the last year → round down
• 6 months or more in the last year → round up to the next full year

Example: An employee with 7 years and 8 months of service → treated as 8 years.

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Worked Examples

Example 1 — Standard employee

Gratuity = (45,000 × 15 × 9) ÷ 26 = ₹2,33,654

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Example 2 — Senior employee at maximum limit

Calculated gratuity = (1,20,000 × 15 × 25) ÷ 26 = ₹17,30,769

This is below the ₹20 lakh ceiling, so the full amount is paid.

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Example 3 — Gratuity capped at ₹20 lakh

Calculated gratuity = (1,50,000 × 15 × 30) ÷ 26 = ₹25,96,154

This exceeds ₹20 lakh. Under the Act, the maximum gratuity payable is ₹20 lakh. The employer is required to pay only ₹20 lakh, unless they voluntarily choose to pay more (which many large companies do).

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What Counts as "Salary" for Gratuity?

Only Basic Pay + Dearness Allowance is used in the formula. Everything else is excluded.

For most private companies that don't pay DA, only the Basic Pay is used. This is why keeping Basic Pay low (a common CTC structuring trick) directly reduces gratuity liability — something the new Labour Codes are addressing.

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New Labour Code Changes — Effective November 2025

India's four Labour Codes came into effect on November 21, 2025, bringing significant changes to gratuity rules:

1. Wages must be at least 50% of total CTC

Under the Code on Social Security, 2020, the definition of "wages" for gratuity (and PF) calculation now requires that Basic + DA must be at least 50% of total remuneration.

If you currently structure CTC with Basic at 30–35% of CTC to reduce PF and gratuity liability, you need to revise this. Allowances exceeding 50% of total remuneration are deemed wages for calculation purposes.

Impact: Higher gratuity payouts for employees with inflated allowance structures.

2. Fixed-term employees eligible after 1 year

Previously, only permanent employees with 5+ years of service were eligible. Under the new codes:

• Fixed-term contract employees qualify for gratuity on a pro-rata basis after completing 1 year of service
• This closes a loophole where employers hired on rolling short-term contracts to avoid gratuity liability

3. Faster payment timeline

The new codes tighten the payment window. Gratuity must be paid within 30 days of it becoming due. Delays attract interest.

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Tax Rules on Gratuity

For employees covered under the Payment of Gratuity Act

The least of the following three amounts is tax-exempt:

1. Actual gratuity received
2. ₹20,00,000 (₹20 lakh — the statutory ceiling)
3. Calculated gratuity = (Last drawn salary × 15 × years of service) ÷ 26

Any gratuity received above ₹20 lakh is fully taxable as income in the year of receipt.

For government employees

Gratuity received by Central or State government employees is fully exempt from income tax with no upper limit.

Key point: ₹20 lakh is a lifetime limit

The ₹20 lakh exemption applies across your entire career — not per employer. If you received ₹12 lakh as gratuity from a previous employer, only ₹8 lakh is exempt from your next employer's gratuity.

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What Employers Must Do

1. Check your CTC structure

If Basic Pay is below 50% of CTC, revise salary structures in line with the new Labour Codes. Consult your CA or payroll provider.

2. Create a gratuity provision

Accounting standards require companies to provision for gratuity liability in their books. Many SMBs skip this and get hit with a large cash outflow when a senior employee exits. Options:

• Internal provisioning (add to P&L each year)
• Group Gratuity Scheme via LIC or private insurers (most tax-efficient)

3. Revise contracts for fixed-term employees

If you use fixed-term contracts and haven't updated them since November 2025, review with a labour law consultant. Gratuity eligibility now kicks in after 1 year for these employees.

4. Pay on time

Gratuity must be paid within 30 days of the employee's last working day (or date of application, whichever is later). Late payment attracts simple interest at the rate notified by the government.

5. Maintain a nomination record

Every employee should submit Form F (nomination form) so gratuity can be paid to the correct person in case of death. This is a legal requirement under the Act — and often missed by smaller companies.

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Quick Reference Cheat Sheet

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Common Mistakes to Avoid

1. Using gross salary instead of Basic + DA — the formula only uses Basic + DA. Using CTC or gross will give a wrong (higher) number.
2. Ignoring the 240-day rule — employees who resign just under 5 years may still be eligible if they've worked 240+ days in the fifth year.
3. Not provisioning — gratuity is a long-term liability. Treating it as a one-time expense when someone leaves is bad accounting.
4. Delaying payment — 30 days is the limit. Interest starts accruing from day 31.
5. Forgetting nomination forms — Form F is mandatory. Without it, disputes arise when an employee passes away.

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Gratuity is non-negotiable once an employee clears the eligibility threshold. Get the formula right, provision for it annually, and stay updated on the Labour Code changes — your future self (and your exiting employees) will thank you.