How to Calculate Gratuity and Claim Tax Exemption in 2026

Understanding Gratuity: A Complete Guide for Indian Employers and Employees

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. If you are the employee receiving gratuity and only need the tax side, see our gratuity tax exemption guide for AY 2026-27.

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

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

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

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

Tax Exemption Rules by Employee Category

Tax Rate Chart

Gratuity Tax Exemption Limits by Employee Category

Maximum tax-exempt gratuity under Section 10(10) of the Income Tax Act, 1961

Government Employees

Central, state, local authority, defence : fully exempt; Section 10(10)(i)

Fully exempt

Private Employees (Act Covered)

Least of actual gratuity, 15/26 formula amount, or Rs. 20 lakh; Section 10(10)(ii)

Rs. 20 lakh

Private Employees (Not Act Covered)

Least of actual gratuity, 15/30 of 10-month average, or Rs. 20 lakh; Section 10(10)(iii)

Rs. 20 lakh

Source: Section 10(10) of the Income Tax Act, 1961; CBDT Notification No. 16/2019 (S.O. 1213(E)) dated March 8, 2019

The Rs 20 lakh ceiling (raised from Rs 10 lakh by CBDT Notification No. 16/2019 dated March 8, 2019, for employees who retired, died, resigned or became disabled on or after 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.

Government Employees and the "Rs 25 Lakh" Confusion

Gratuity received by Central Government, State Government and local authority employees is fully exempt with no upper limit under Section 10(10)(i). Employees of PSUs, public sector banks and statutory corporations do not count as government employees here. They fall under Section 10(10)(ii) or (iii) and the Rs 20 lakh ceiling.

You will often see "Rs 25 lakh" quoted as the new gratuity limit. That figure is the maximum gratuity the Central Government pays its own employees under the CCS (Pension) Rules and NPS gratuity rules. It went up from Rs 20 lakh to Rs 25 lakh from January 1, 2024, when DA reached 50%. It is a payout cap, not a tax exemption limit, and it changes nothing for private or PSU employees.

Worked Example 3: Private Employee Above the Ceiling

An employee covered by the Act retires after 25 years with last drawn basic + DA of Rs 1,50,000 per month and receives Rs 28,00,000 as gratuity.

The Rs 8 lakh is added to salary and taxed at slab rates. Because it relates to 25 years of past service, the employee can claim relief under Section 89 by filing Form 10E before filing the return.

Gratuity on Death or Disablement

The 5-year service condition is waived on death or disablement, but the tax treatment of the two is different.

There is no special unlimited exemption for disablement gratuity paid to a private-sector employee. Only the eligibility rule is relaxed.

Gratuity Under the New Tax Regime

The Section 10(10) exemption is available under both regimes. Section 115BAC removes deductions such as 80C, 80D and HRA, but it does not touch gratuity, leave encashment at retirement (Section 10(10AA)) or VRS compensation (Section 10(10C)). A private employee gets the same Rs 20 lakh ceiling whichever regime they choose.

The "Rs 5 lakh limit" some articles mention is the VRS compensation exemption under Section 10(10C), a separate benefit. It is not a gratuity limit under the new regime.

From tax year 2026-27, the Income-tax Act, 2025 replaces the 1961 Act, and the salary exemptions in Section 10(10) move to Section 19 of the new Act. Gratuity received in FY 2025-26 (AY 2026-27) is still governed by Section 10(10) of the 1961 Act.

Gratuity vs Leave Encashment

How to Report Gratuity in Your ITR

1. Pick the form. Gratuity does not by itself stop you from using ITR-1. Use ITR-2 if you also have capital gains beyond what ITR-1 allows, more than one house property, or foreign assets, and ITR-3 if you have business income.
2. Show the full amount in salary. Include the total gratuity in salary under Section 17(1), matching Form 16.
3. Claim the exempt part. Under "Allowances to the extent exempt under Section 10", select Section 10(10) gratuity and enter the exempt amount.
4. Check AIS and Form 16. Your employer reports the payment, so the ITR must show it even if the whole amount is exempt.
5. File Form 10E first if you are claiming Section 89 relief on a taxable portion.

Common Gratuity Tax Mistakes

• Treating Rs 20 lakh as a per-employer limit. It is a lifetime ceiling, reduced by exemptions claimed from earlier employers.
• Assuming PSU or bank employees are "government". They get the Rs 20 lakh ceiling, not full exemption.
• Using CTC or gross salary in the formula. Only basic pay plus DA (and, for non-covered employees, commission fixed as a percentage of turnover) counts.
• Rounding up service for non-covered employees. The 6-month round-up applies only under the Payment of Gratuity Act. For non-covered employees, only completed years count.
• Leaving exempt gratuity out of the ITR. Report it and claim the exemption so the return matches AIS and Form 16.

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:

1. 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.

2. 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:

1. Damage or loss to the employer. 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.

2. Riotous or disorderly conduct, violence, or moral turpitude. If the employee is terminated for riotous or disorderly conduct or any other act of violence, or for 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

• Nomination: collect Form F from every employee after 1 year of service.
• Application: the employee (or nominee) applies in Form I once gratuity becomes payable, usually at exit.
• Determination: the employer determines the amount and gives written notice to the employee (Form L).
• Payment: within 30 days of the date gratuity becomes payable (Section 7(3)). Late payment carries simple interest at the rate notified by the Central Government (Section 7(3A)).

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. For how employees are taxed when they later withdraw PF, see EPF withdrawal tax rules.

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.

For related topics, see our guides on PF and ESI employer contribution rates, professional tax state-wise rates, HRA exemption and Section 10(13A), Section 89 relief on salary arrears, TDS return filing for Form 24Q and 140, and our old vs new tax regime comparison.

Frequently Asked Questions

Is the gratuity exemption available under the new tax regime?

Yes. The Section 10(10) exemption on gratuity is not withdrawn under the new regime in Section 115BAC. A private-sector employee covered by the Payment of Gratuity Act gets the least of actual gratuity, the 15/26 formula amount or Rs 20 lakh tax-free in either regime. Only the excess is taxed as salary.

Within how many days must an employer pay gratuity?

Under the Payment of Gratuity Act, the employer must pay gratuity within 30 days of it becoming payable, usually the date of exit. If it is paid late, simple interest is due from the due date to the payment date at the rate notified by the government. Continued non-payment can lead to recovery proceedings and prosecution.

How is gratuity reported in the employee's ITR?

The exempt part of gratuity is shown under exempt income, and any amount above the exemption limit is included in salary income for the year of receipt. Check that your Form 16 shows the correct split. If a large taxable gratuity pushes you into a higher slab, you can claim relief under Section 89 by filing Form 10E before the ITR.

Can an employer pay gratuity to someone with less than five years of service?

Yes, an employer can pay it voluntarily, and fixed-term employees are now statutorily entitled after one year under the Code on Social Security. But for a permanent employee who leaves before five years without death or disablement, a voluntary payment is not gratuity under the Act and is generally fully taxable as salary.

Can an employer claim the gratuity provision as a tax deduction every year?

No. Section 40A(7) disallows a mere provision for gratuity. The employer can deduct gratuity only when it is actually paid to the employee, or when contributions are made to an approved gratuity fund, which are deductible under Section 36(1)(v). The provision still has to be booked in the accounts under AS-15 or Ind AS 19.

Do government employees pay any tax on gratuity?

No. Gratuity received by Central Government, State Government and local authority employees is fully exempt under Section 10(10)(i), with no monetary cap. Employees of PSUs, public sector banks and statutory corporations are not government employees for this purpose and get the Rs 20 lakh limit instead.

Is the tax-free gratuity limit now Rs 25 lakh?

Not for income tax. The Rs 25 lakh figure is the maximum gratuity the Central Government pays its own employees, raised from Rs 20 lakh from 1 January 2024 when DA reached 50%. Their gratuity was already fully tax-exempt. For private and PSU employees, the Section 10(10) exemption ceiling is still Rs 20 lakh.

Is gratuity paid to the family after an employee's death taxable?

No. Under CBDT Circular No. 573 dated 21 August 1990, gratuity paid to the widow or other legal heirs of an employee who dies in service is not taxable in their hands. Gratuity received by a living employee on disablement is different: for a private employee it is exempt only up to the normal Section 10(10) limit.

Is the Rs 20 lakh gratuity exemption per employer or lifetime?

Lifetime. The Rs 20 lakh ceiling is reduced by any gratuity exemption you already claimed from earlier employers. If you claimed Rs 6 lakh exempt on leaving one job, only Rs 14 lakh of exemption is left for all future gratuity receipts.

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); CBDT Notification No. 16/2019 dated March 8, 2019 raising the exemption ceiling to Rs 20 lakh; CBDT Circular No. 573 dated August 21, 1990 (gratuity paid to legal heirs); Section 10(10AA) and Notification No. 31/2023 (leave encashment ceiling); 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 Department of Pension and Pensioners' Welfare order raising the maximum Central Government retirement and death gratuity to Rs 25 lakh from January 1, 2024. 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/iec/foportal/ and labour.gov.in before applying to specific situations.