India's Gratuity Law: When It Applies, How to Calculate, and What Foreign Employers Need to Know

What Is Gratuity?

Gratuity is a lump-sum payment made by an employer to an employee as a reward for long-term service. Under the Payment of Gratuity Act, 1972, gratuity is a statutory right for employees who have completed at least 5 years of continuous service with the same employer.

It applies to every establishment employing 10 or more persons on any day in the preceding 12 months, as defined in the Payment of Gratuity Act. Once the Act applies to an establishment, it continues to apply even if the number of employees falls below 10.

When Is Gratuity Payable?

Gratuity becomes payable on:

1. Resignation after completing 5 years of continuous service
2. Retirement (superannuation)
3. Death of the employee (payable to nominee/legal heir — no minimum service requirement)
4. Disablement due to accident or disease (no minimum service requirement)
5. Termination by the employer after the employee has completed 5 years

Important exception: In case of death or disablement, there is no minimum service requirement. Gratuity is payable even if the employee worked for less than 5 years.

The 4 Years and 240 Days Rule

Courts have interpreted “5 years of continuous service” to include cases where an employee has worked for 4 years and 240 days (or 4 years and 190 days in establishments working below ground in mines). This means an employee who resigns after 4 years and 8 months may still be entitled to gratuity.

How to Calculate Gratuity

The Formula

For employees covered under the Payment of Gratuity Act:

Gratuity = (Last drawn basic salary + DA) × 15 × Years of service / 26

Where:

• Last drawn basic salary + DA = The basic salary and dearness allowance at the time of separation
• 15 = Represents 15 days of wages for each year of service
• 26 = Working days in a month (excluding 4 Sundays)
• Years of service = Completed years (service of 6 months or more in the last year is rounded up)

Worked Examples

Example 1: Employee with ₹50,000 monthly basic, 5 years of service

Gratuity = (50,000 × 15 × 5) / 26 = ₹1,44,231

Example 2: Employee with ₹80,000 monthly basic, 8 years of service

Gratuity = (80,000 × 15 × 8) / 26 = ₹3,69,231

Example 3: Employee with ₹1,00,000 monthly basic, 12 years of service

Gratuity = (1,00,000 × 15 × 12) / 26 = ₹6,92,308

Maximum Gratuity Cap

The Payment of Gratuity Act sets a maximum gratuity limit of ₹20,00,000 (₹20 lakh). Any amount above this cap is subject to income tax, even though the employer may choose to pay more.

Note: The government has revised this cap periodically. It was raised from ₹10 lakh to ₹20 lakh by the Payment of Gratuity (Amendment) Act 2018. Central government employees have a separate ₹25 lakh ceiling under DoPT rules, but the private-sector Income Tax exemption under Section 10(10) remains ₹20 lakh. Under the Social Security Code 2020, the limit can be revised by government notification without amending the Act itself.

Tax Treatment of Gratuity

For Employees Covered by the Gratuity Act

Gratuity received is exempt from income tax up to the following limits:

• ₹20,00,000 (the statutory ceiling), OR
• The gratuity amount calculated using the formula, OR
• The actual gratuity received

Whichever is the least is exempt. Any excess is taxable as salary income.

For Employees NOT Covered by the Gratuity Act

For employees of organizations not covered by the Act (fewer than 10 employees), the tax exemption calculation is different:

• Exempt up to the least of:
  • ₹20,00,000
  • Half month’s average salary for each completed year of service (average of last 10 months)
  • Actual gratuity received

How Basic Salary Affects Gratuity

Since gratuity is calculated on the last drawn basic salary + DA, the basic salary percentage in the CTC structure directly impacts gratuity liability.

This is one reason companies carefully calibrate the basic salary percentage — it’s not just about PF, it also affects long-term gratuity liability.

Gratuity Provisioning: How Employers Budget

Since gratuity is payable after 5 years, employers must provision for this liability from year one. There are two approaches:

1. Internal Provisioning (Book Reserve)

The employer sets aside a calculated amount each month as a liability on the books. This is typically 4.81% of basic salary per month (which is the annual gratuity entitlement of 15/26 of basic salary, spread across 12 months).

How it appears in CTC:

This amount is included in CTC but is not paid to the employee monthly — it’s set aside for future payment.

2. Gratuity Insurance (Group Gratuity Scheme)

Some employers purchase a group gratuity insurance policy from LIC (Life Insurance Corporation of India) or private insurers. The employer pays an annual premium, and the insurer pays the gratuity directly to the employee when it becomes due.

Advantages:

• Gratuity liability is funded externally, not on the employer’s balance sheet
• Premium payments are tax-deductible for the employer
• Employees receive payment from the insurer, reducing administrative burden

How EOR Providers Handle Gratuity

When you use an EOR, gratuity handling is typically managed as follows:

1. Monthly provisioning is included as part of the CTC structure. The EOR tracks the accrued gratuity liability for each employee.

2. When an employee completes 5 years, the EOR calculates the gratuity amount based on the last drawn basic salary and total service period.

3. Payment is made as part of the full-and-final settlement process, either from the EOR’s provisioned funds or through a group gratuity insurance policy.

4. For employees who leave before 5 years, the provisioned amount is typically released (it’s not payable to the employee, except in cases of death or disablement).

Key question for your EOR: Ask whether gratuity provisioning is segregated per employee or pooled. Segregated provisioning ensures funds are available when individual employees become eligible.

Gratuity Under the New Social Security Code

The Social Security Code, 2020 (one of the four new labour codes) includes several changes to gratuity:

• Fixed-term employees will be eligible for gratuity on a pro-rata basis, even for contracts shorter than 5 years. This is a significant change from the current law.
• Gratuity ceiling may be periodically revised by the government through notification (without requiring an amendment to the Act)
• The definition of “wages” is being standardized, which may affect basic salary calculations and consequently gratuity amounts

As of 2026, full implementation of the new code is still in progress across states. However, the direction is clear: gratuity will become more broadly applicable.

Common Gratuity Questions

What if the employee is on a fixed-term contract?

Under the current law, fixed-term employees are eligible for gratuity on a pro-rata basis regardless of contract duration — this provision was introduced in 2018. Under the new Social Security Code, this is further reinforced.

Can gratuity be forfeited?

Yes, partially or wholly, if the employee’s services were terminated for:

• Riotous or disorderly conduct
• Any act of violence
• Any act that constitutes an offence involving moral turpitude (if convicted by a court)

Forfeiture cannot exceed the amount of damage caused to the employer’s property.

Is gratuity applicable to contract workers?

Contract workers employed through a contractor are typically not eligible for gratuity from the principal employer. However, they may be eligible from the contractor if the contractor’s establishment meets the 10-employee threshold.

Can the employer pay more than the formula amount?

Yes. The formula provides the minimum gratuity payable. Employers can pay more, but amounts exceeding the statutory formula and the ₹20 lakh cap attract income tax.

Key Takeaways

• Gratuity is mandatory after 5 years of continuous service (or 4 years and 240 days)
• The formula: (Last basic salary × 15 × years of service) / 26
• Maximum tax-exempt gratuity is ₹20 lakh
• Basic salary percentage directly impacts gratuity liability — higher basic = higher gratuity
• Employers should provision 4.81% of basic salary monthly for gratuity
• Death and disablement trigger gratuity regardless of service length
• Ask your EOR how they handle gratuity provisioning and ensure funds are tracked per employee