FinTech Glossary

What is Gratuity

Gratuity is a lump-sum benefit linked to an employee’s completed service period. It may become payable when employment ends through resignation, retirement, superannuation, death, disablement, or another event covered under the applicable rules.

When discussing Gratuity in salary, it is important to distinguish it from monthly take-home pay. Employers may account for gratuity within the cost to company, although employees do not receive that provision with their regular salary. Unlike provident fund, gratuity does not require an employee contribution.

Why is Gratuity Important

Gratuity becomes particularly useful when regular salary ends or an employee leaves a job held for several years. Someone retiring after 20 years, for example, may use the lump sum for household expenses, medical needs, loan repayment, or additional retirement savings. It can provide useful financial support during a major change in income.

The protection also extends to the employee’s family. If an employee dies, gratuity can become payable to the nominee or legal heirs without the normal five-year service requirement. The present framework has also widened access for qualifying fixed-term employees, who can become eligible after one year of service. 

Understanding the Gratuity formula, eligible service period, and wage base also helps employees review their final settlement. A worker who knows how the amount should be determined is in a better position to spot a missing service year, an incorrect salary base, or another calculation error.

Eligibility Criteria for Gratuity (Old Rule)

Under the earlier Payment of Gratuity Act, 1972, five years of continuous service was the standard requirement. The Act generally applied to factories, mines, oilfields, plantations, ports, railway companies, and shops or establishments employing 10 or more people during the prescribed period. Once an establishment came under the Act, coverage continued even if its workforce later fell below the threshold. 

Under the old rules, Gratuity applicability generally required:

• At least five years of continuous service with the same employer.
• Retirement, superannuation, or resignation after satisfying the service requirement.
• No five-year minimum where employment ended because of death or disablement.
• Payment to the nominee or legal heirs when an eligible employee died.
• A part of a year exceeding six months to be treated as another completed year while calculating gratuity. 

These were the main eligibility conditions before November 21, 2025. Current gratuity cases must now be considered under the Code on Social Security, 2020. 

Payment of Gratuity Act, 1972 – Key Provisions (Old Rules)

Fifteen Days’ Wages for Each Eligible Year

The old Act provided gratuity equal to 15 days’ wages for every completed year of service or part of a year exceeding six months. For a monthly rated employee, the law divided monthly wages by 26 and multiplied the result by 15.

Payment Within 30 Days

Once gratuity became payable, the employer had to determine the amount and arrange payment within 30 days. Delay could attract simple interest, subject to the limited exceptions provided under the law. The current Code retains a 30-day payment requirement after gratuity becomes payable. 

Nomination After One Year

An employee who completed one year of service was required to make a nomination in the prescribed manner. The nomination identified who could receive the gratuity if the employee died before collecting the amount. The current Code also contains a nomination requirement after one year of service. 

Forfeiture in Specific Cases

Gratuity could be forfeited partly or fully only in specified situations. These included loss or damage caused by misconduct, riotous or violent behavior, and an offense involving moral turpitude committed during employment. Termination itself did not automatically remove an employee’s gratuity entitlement. 

Gratuity Calculation Formula (Under the Act)

Under the old Act, the standard Gratuity calculation for a monthly rated covered employee was: 

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

Last drawn wages for this traditional calculation generally included basic salary and dearness allowance. 

Suppose an employee’s eligible last drawn wages were ₹50,000 and the person worked for 10 years and seven months. The service period would be taken as 11 years because the additional period exceeded six months. The amount would therefore be about ₹3,17,308, calculated as ₹50,000 × 15 ÷ 26 × 11. This is the basic answer to how to calculate Gratuity under the earlier statutory framework. 

Current calculations retain the 26-day approach for monthly rated employees, but the definition of wages now comes from the new labor code framework. 

New Gratuity Rules under the Code on Social Security, 2020

The Code on Social Security, 2020 became operative on November 21, 2025. The Ministry of Labour and Employment has since clarified that gratuity calculations under the new regime apply from that date.

Five Years Remains the General Rule

For regular employees, five years of continuous service remains the normal requirement for gratuity on superannuation, retirement, or resignation. The five-year condition does not apply in cases such as death, disablement, or the expiry of qualifying fixed-term employment. 

Fixed-Term Employees Get Separate Treatment

A significant change affects employees hired directly for a fixed term. Ministry guidance issued in March 2026 states that a fixed-term employee becomes eligible for gratuity after completing one year of service from the beginning of the contract. An 11-month contract does not meet this threshold. The Code provides for gratuity to such employees on a pro rata basis. 

Contract Labor is Different From Fixed-Term Employment

A worker hired through a contractor should not automatically be treated as a fixed-term employee. The Ministry distinguishes direct fixed-term employment from contract labor. Its 2026 guidance states that the contractor, as employer, bears the gratuity liability for contract labor after five years of continuous service, subject to the applicable conditions. 

The Definition of Wages Has Changed

The current wage definition includes basic pay, dearness allowance, and retaining allowance. Several other salary components are excluded. However, where specified excluded components cross 50% of total remuneration, the excess is added back to wages. This can increase the base used for gratuity where a salary structure places a large share of compensation under allowances. The revised wage definition applies to gratuity calculations from November 21, 2025. 

Current Cases Are Not Split Into Two Service Periods

An employee leaving on or after November 21, 2025 does not have gratuity calculated once for service under the old Act and again for service under the new Code. The Ministry has clarified that gratuity is based on the last drawn wages at the time of separation under the current framework. 

Maximum Amount is Set by Notification

The Code provides that gratuity cannot exceed the amount notified by the Central Government. This statutory Gratuity limit should not be confused with the tax exemption ceiling. Current Income Tax Department guidance separately uses ₹20 lakh as the exemption benchmark for qualifying non-government gratuity. 

Gratuity in Private vs Public Sector

The public sector is not one uniform category for gratuity. Government employees holding posts covered by separate gratuity or pension rules are excluded from the relevant gratuity chapter of the Social Security Code. Public sector undertakings and statutory corporations may have different employment rules, so employees should check the provisions applicable to their own organization. 

Taxation of Gratuity in India

The tax on Gratuity depends on who receives it, when it is received, and how much qualifies for exemption. The tax exemption threshold should not be treated as the amount every employee is automatically entitled to receive. Current Income Tax Department guidance, updated in April 2026, continues to prescribe different treatments for government employees and other employees. 

Government Employees

Qualifying gratuity received by government employees at retirement is fully exempt from income tax. The Income Tax Department distinguishes government employees from employees of statutory corporations for this purpose. 

Non-Government Employees Covered by the Gratuity Framework

For qualifying non-government employees, the exempt amount is the lowest of:

• Gratuity actually received.
• The amount arrived at through the prescribed statutory calculation.
• ₹20 lakh.

Any portion that does not qualify for exemption is taxable according to the applicable income-tax provisions.

Non-Government Employees Outside Statutory Coverage

For employees outside the statutory gratuity framework, the exemption is generally the lowest of the actual gratuity received, ₹20 lakh, or half a month’s average salary for each completed year of service. The Income Tax Department uses the average salary of the 10 months immediately preceding retirement for this calculation. 

Gratuity Received During Employment

A gratuity payment received while an employee is still in service is fully taxable under current Income Tax Department guidance. The retirement exemption applies when the relevant conditions for exempt gratuity are satisfied. 

For tax purposes, the correct approach is to identify the employee category first, work out the eligible gratuity, and then calculate the available exemption. Looking only at the ₹20 lakh figure can give an incorrect result because the exempt amount may be lower based on the prescribed formula or the amount actually received.