Gratuity Calculation, Tax Exemption, and Compliance 2026

Understanding Gratuity: A Complete Guide for Indian Employers and Employees

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Key Takeaways

Gratuity is a statutory benefit under the Payment of Gratuity Act, 1972, applicable to every establishment with 10 or more employees on any day in the preceding 12 months.
Eligible employees must complete 5 years of continuous service (reduced to 1 year for fixed-term contract workers under the new labour codes).
The standard formula is (Last Drawn Salary x 15 x Years of Service) / 26, where salary means basic pay plus dearness allowance.
Tax exemption under Section 10(10) of the Income Tax Act: Rs 20 lakh for private-sector employees covered by the Act, Rs 25 lakh for government employees (central, state, local authority).
Employers cannot claim a tax deduction for gratuity provisions under Section 40A(7). Contributions to an approved gratuity fund under Section 36(1)(v) are deductible.
Service exceeding 6 months in the final year is rounded up to a full year for calculation purposes.

Every employer in India with 10 or more employees must pay gratuity when an eligible employee exits. It is not discretionary. It is not a bonus. It is a statutory liability under the Payment of Gratuity Act, 1972, and failure to pay it invites prosecution. For the employee, it is a lump-sum payout that is partially or fully tax-exempt. For the employer, it is a long-term liability that requires provisioning, correct calculation, and timely payment within 30 days of it becoming due.

This guide covers the calculation formula, tax treatment for both employer and employee, the new labour code changes, and the compliance steps every SME owner needs to follow.

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Who Is Covered Under the Payment of Gratuity Act

The Payment of Gratuity Act, 1972, applies to:

Every factory, mine, oilfield, plantation, port, and railway company
Every shop or establishment in which 10 or more persons are employed, or were employed, on any day of the preceding 12 months

Once the Act becomes applicable to an establishment, it continues to apply even if the number of employees later drops below 10. This is a point many SME owners miss. If you had 10 employees in January 2026 and reduced to 8 by March, the Act still applies.

Every employee (regardless of designation, whether permanent, temporary, or contractual) who has rendered 5 years of continuous service is eligible for gratuity upon:

Superannuation (retirement)
Resignation
Death (payable to nominee/legal heir; the 5-year requirement is waived)
Disablement due to accident or disease (5-year requirement is waived)

The 15/26 Calculation Formula

For employees covered under the Payment of Gratuity Act, the formula is:

Gratuity = (Last Drawn Salary x 15 x Completed Years of Service) / 26

Component	What It Means
Last Drawn Salary	Basic pay + dearness allowance (DA) as on the date of exit. Does not include HRA, bonus, overtime, or any other allowance
15	Represents 15 days of salary for each year of service. This is the rate fixed by the Act
Years of Service	Completed years. Service exceeding 6 months in the final year is rounded up to the next full year. Service of 6 months or less is ignored
26	The number of working days in a month (excluding Sundays). This divisor converts the monthly salary into a daily rate

Worked Example 1: Employee Covered Under the Act

An employee resigns after 12 years and 8 months of continuous service. Their last drawn salary (basic + DA) is Rs 45,000 per month.

Years of service: 12 years and 8 months. Since 8 months exceeds 6, it rounds up to 13 years.
Gratuity = (Rs 45,000 x 15 x 13) / 26
Gratuity = Rs 87,75,000 / 26
Gratuity = Rs 3,37,500

This amount is fully within the Rs 20 lakh exemption ceiling, so no tax is payable on it.

Worked Example 2: Higher Salary, Exemption Limit Applies

A senior manager retires after 25 years of service. Last drawn salary (basic + DA) is Rs 1,20,000 per month.

Gratuity = (Rs 1,20,000 x 15 x 25) / 26
Gratuity = Rs 4,50,00,000 / 26
Gratuity = Rs 17,30,769

This is within the Rs 20 lakh exemption limit. The full amount is tax-exempt.

If the same employee had 30 years of service:

Gratuity = (Rs 1,20,000 x 15 x 30) / 26 = Rs 20,76,923
Exempt amount: Rs 20,00,000 (the statutory cap)
Taxable gratuity: Rs 76,923

Formula for Employees NOT Covered Under the Act

For employees of establishments that are not covered by the Payment of Gratuity Act (typically establishments with fewer than 10 employees where the employer voluntarily pays gratuity), the tax exemption calculation uses a different formula:

Exempt Gratuity = (Average Salary of Last 10 Months x 15 x Completed Years of Service) / 30

Difference	Covered Under Act	Not Covered Under Act
Salary base	Last drawn salary (basic + DA)	Average of basic + DA over the last 10 months
Divisor	26 (working days in a month)	30 (calendar days in a month)
Rounding of service	Yes, 6+ months rounds up	No rounding; only completed years count

The exemption for non-covered employees is the least of:

Actual gratuity received
Half-month average salary for each completed year of service (the formula above)
Rs 20,00,000

Tax Exemption Rules by Employee Category

Category	Exemption Limit	Governing Provision
Government employees (central, state, local authority, defence)	Fully exempt up to Rs 25,00,000	Section 10(10)(i) of Income Tax Act
Private employees covered under the Act	Exempt up to the least of: actual gratuity, formula amount (15/26), or Rs 20,00,000	Section 10(10)(ii)
Private employees NOT covered under the Act	Exempt up to the least of: actual gratuity, formula amount (15/30 of 10-month average), or Rs 20,00,000	Section 10(10)(iii)

The Rs 20 lakh ceiling (raised from Rs 10 lakh by notification dated March 29, 2018) applies per employee across their entire career. If an employee receives gratuity from multiple employers at different points in time, the cumulative exempt amount cannot exceed Rs 20 lakh. Any amount above that is taxable as "Income from Salary" in the year of receipt.

The Rs 25 lakh ceiling for government employees was notified separately and reflects the 7th Central Pay Commission recommendations.

Maximum Gratuity Payable Under the Act

The Payment of Gratuity Act caps the maximum gratuity an employer is statutorily required to pay at Rs 20,00,000. If the formula yields a higher amount, the employer is only legally obligated to pay Rs 20 lakh under the Act. However, an employer may voluntarily pay more than this cap. The tax exemption on the excess would still be limited by the income tax exemption ceiling.

New Labour Code Changes: Fixed-Term Workers

The Code on Social Security, 2020 (with rules notified effective from November 21, 2025) introduced two significant changes to gratuity eligibility:

Fixed-term contract workers are eligible for pro-rata gratuity after 1 year of continuous service, instead of the standard 5-year requirement. If a worker on a 2-year fixed-term contract completes 1 year, they are entitled to gratuity calculated proportionally.
Wages definition broadened. Under the new labour codes, at least 50% of CTC must be treated as "wages" for the purpose of gratuity (and PF/ESI) calculations. Employers who structured CTC with a low basic and high allowances to minimize gratuity liability may need to restructure.

These changes apply prospectively to contracts entered into after the effective date. Permanent employees on open-ended employment continue to require 5 years of continuous service.

Employer's Tax Treatment of Gratuity

The tax treatment of gratuity on the employer's books has two distinct paths:

Path 1: Direct Payment (Unfunded)

If your business pays gratuity directly from company funds when an employee exits:

Section 40A(7) of the Income Tax Act disallows provisions (accruals) made for gratuity in the profit and loss account. You can book the provision for accounting purposes under AS-15 / Ind-AS 19, but you cannot claim it as a tax deduction.
The actual gratuity paid in a financial year is deductible as a business expense under Section 37 in the year of payment. The deduction is available only when payment is actually made, not when provisioned.

Path 2: Approved Gratuity Fund (Funded)

If you set up an approved gratuity fund (an irrevocable trust registered under the Income Tax Act for the exclusive benefit of employees):

Contributions to the approved gratuity fund are deductible under Section 36(1)(v) of the Income Tax Act, subject to limits prescribed by Rule 103.
The fund is managed by an insurer (LIC, private insurers) or the trust itself. The employer contributes periodically, and the fund pays gratuity to employees when due.
This route is better from a tax planning perspective because the employer gets an annual deduction for contributions, rather than a lump-sum deduction only when an employee exits.

Most SMEs with fewer than 50 employees use Path 1 (direct payment). Businesses with larger teams and higher gratuity exposure increasingly set up approved gratuity funds through LIC or private insurers.

Accounting Requirements: AS-15 and Ind-AS 19

Regardless of whether your gratuity is funded or unfunded, Indian accounting standards require you to recognize the gratuity liability in your financial statements:

AS-15 (Revised 2005) for companies following Indian GAAP
Ind-AS 19 for companies following Ind-AS

Both standards require an actuarial valuation of the gratuity liability. This involves estimating the present value of the expected future payout based on employee demographics (age, salary growth, attrition, mortality). An actuary provides this valuation annually, and the resulting liability is disclosed in the balance sheet.

For SMEs, getting an actuarial valuation done is typically straightforward. Actuaries and insurers like LIC provide standardized gratuity valuation reports at modest fees. Your statutory auditor will require this report as part of the annual audit.

Forfeiture of Gratuity

The Act allows an employer to forfeit gratuity (wholly or partly) only in specific situations:

Termination for moral turpitude. If the employee's services are terminated for any act, willful omission, or negligence causing damage or loss to the employer's property, gratuity can be forfeited to the extent of the damage.
Termination for riotous or disorderly conduct, or violence. If the employee is terminated for conduct involving an offence involving moral turpitude, committed during the course of employment, the gratuity may be wholly or partly forfeited.

The forfeiture must be supported by a formal termination order specifying the grounds. Blanket forfeiture clauses in employment contracts that go beyond these statutory grounds are unenforceable.

Compliance Timeline for Employers

Step	Requirement	Timeline
Employee files Form I (application for gratuity)	Employee or nominee submits the claim	Within 30 days of gratuity becoming payable (exit date)
Employer issues Form L (notice of determination)	Employer determines the gratuity amount and communicates to the employee	Within 15 days of receiving Form I
Employer pays gratuity	Actual disbursement	Within 30 days of it becoming due
Interest on delayed payment	If not paid within 30 days, employer must pay simple interest at the rate notified by the government (currently 10% per annum)	From the date it becomes payable to the date of actual payment

Non-payment of gratuity within the prescribed time without sufficient cause can lead to prosecution under Section 9 of the Act, with imprisonment up to 2 years and/or a fine.

Nomination

Every employee who has completed 1 year of service must file a nomination in Form F with the employer, specifying who should receive the gratuity in case of the employee's death. If the employee has a family, the nomination must be in favor of one or more family members. An employee without a family can nominate any person.

The employer must maintain a record of all nominations. When an employee's family circumstances change (marriage, birth of a child), the employee should update the nomination.

Practical Steps for SME Employers

Count your headcount. If you had 10 or more employees on any day in the past 12 months, the Payment of Gratuity Act applies to your establishment.
Maintain service records. Record each employee's date of joining, salary history (basic + DA), and any breaks in service.
Get an actuarial valuation. Your statutory auditor will require it for annual accounts under AS-15 or Ind-AS 19. Engage an actuary or use the insurer's valuation service.
Decide on funding. For teams above 20 to 25 employees, consider setting up an approved gratuity fund (through LIC or a private insurer) for tax-efficient funding and to avoid large cash outflows when senior employees exit.
Collect nominations. Ensure all employees with 1+ year of service have filed Form F. Keep copies on file.
Budget for exits. Gratuity for a 10-year employee earning Rs 30,000 basic + DA is Rs 1,73,077. For a 20-year employee, it doubles. Build this into your annual cash flow plan.
Review CTC structures. Under the new labour codes, at least 50% of CTC must be treated as wages. If your basic pay is currently below 50% of CTC, gratuity (and PF) liabilities will increase.

Tax Garden Keeps Your Payroll and Gratuity Compliant

Tax Garden's payroll compliance plans handle PF, ESI, professional tax, TDS on salary, and gratuity provisioning end to end. We calculate gratuity liabilities, maintain service records, and ensure Form 16 / Form 12BA reflect the correct exemptions. For gratuity fund setup, we coordinate with insurers and actuaries on your behalf.

Frequently Asked Questions

Is gratuity applicable to contract employees and interns?

Under the Payment of Gratuity Act, any employee who has completed 5 years of continuous service is eligible, regardless of designation. Contract employees on open-ended contracts who complete 5 years qualify. Under the new labour codes (Code on Social Security 2020), fixed-term contract workers are eligible for pro-rata gratuity after just 1 year. Interns are generally not considered employees under the Act unless they have a formal employment relationship with the establishment.

What if the employer refuses to pay gratuity?

The employee or nominee can file an application to the Controlling Authority (usually the Deputy Labour Commissioner) under Section 7 of the Payment of Gratuity Act. The authority will conduct a hearing and issue an order directing payment. Non-compliance with the order can lead to prosecution, with imprisonment up to 2 years and a fine. The employee can also approach the labour court or civil court for recovery.

Is gratuity included in CTC?

Many employers include the estimated annual gratuity cost (approximately 4.81% of basic + DA) as a component of CTC. This is an accounting representation. Gratuity is payable only on exit after completing the qualifying service period, not monthly. It reduces the in-hand salary calculation only on paper, not as an actual monthly deduction from the employee.

What happens to gratuity if the company shuts down?

Gratuity is a statutory liability and has priority over unsecured creditors during winding up. Employees are entitled to gratuity even if the company closes. If the company has an approved gratuity fund, the fund pays out. If unfunded, the liability is settled from the company's assets during liquidation. Under the Insolvency and Bankruptcy Code, employee dues (including gratuity) are treated as workmen's dues with priority in the resolution plan.

Can an employer deduct provident fund contributions from gratuity?

No. Gratuity is an independent statutory benefit under the Payment of Gratuity Act. The employer cannot set off PF contributions, bonus payments, or any other dues against the gratuity payable. Each benefit is calculated and paid separately.

Is gratuity taxable under the new income tax regime (Section 115BAC / Section 202)?

The gratuity exemption under Section 10(10) is available under both the old and the new tax regime. Switching to the new tax regime does not affect the Rs 20 lakh (or Rs 25 lakh for government employees) exemption on gratuity. This is unlike deductions under Chapter VI-A (80C, 80D, etc.), which are not available under the new regime.

How is continuous service of 5 years calculated?

Under Section 2A of the Payment of Gratuity Act, continuous service includes periods of sickness, accident, authorised leave, layoff, and legal strike. An employee who has worked for 240 days in a year (190 days for underground mine workers or seasonal establishments) in each year of the 5-year period is treated as in continuous service. For the final year, service beyond 6 months is rounded up to a full year for gratuity calculation.

My business has 8 employees now but had 12 last year. Does the Act still apply?

Yes. Once the Payment of Gratuity Act becomes applicable to an establishment (10+ employees on any day in the preceding 12 months), it continues to apply even if the employee count drops below 10 later. The applicability is a one-way trigger. You remain covered until the establishment ceases to exist.

Sources

This guide is verified against the Payment of Gratuity Act, 1972 (Sections 2, 2A, 4, 4A, 7, and 9 covering eligibility, calculation, employer obligation, nomination, and penalties); Section 10(10) of the Income Tax Act, 1961 (gratuity exemption for government employees, Act-covered employees, and non-covered employees); the Central Government notification dated March 29, 2018 raising the exemption ceiling to Rs 20 lakh; Section 40A(7) (disallowance of gratuity provision) and Section 36(1)(v) (deduction for approved gratuity fund contributions); AS-15 (Revised 2005) and Ind-AS 19 (employee benefit accounting standards); the Code on Social Security, 2020 (Section 53 on fixed-term worker gratuity after 1 year, Section 142 on wages definition); and the Rs 25 lakh government employee ceiling per the 7th Central Pay Commission notification. Cross-checked against ClearTax, Tax2win, BajajFinserv, and TaxGuru coverage as of May 2026. All amounts, thresholds, and section references should be confirmed against the latest notifications on incometax.gov.in and labour.gov.in before applying to specific situations.