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Gratuity is a lump-sum payment made by an employer to an employee as a token of gratitude for their long years of service upon retirement, resignation, layoff, or death/disability. It is governed by the Payment of Gratuity Act, 1972, which applies to establishments employing 10 or more persons in factories, mines, oilfields, plantations, ports, railways, motor transport undertakings, companies, and other establishments. Once an establishment is covered under the Act, it continues to be covered even if the employee count falls below 10. The minimum qualifying service for gratuity is 5 continuous years (except in cases of death or disability, where gratuity is payable regardless of tenure). The calculation formula for employees covered under the Payment of Gratuity Act is: Gratuity = (Last Drawn Salary × 15/26) × Number of Years of Service, where 'last drawn salary' includes basic pay plus Dearness Allowance (DA), and 15 represents 15 working days in a month out of 26 working days (excluding Sundays). For employees NOT covered under the Act (establishments with fewer than 10 employees or those in certain categories), the formula is: Gratuity = (Last Drawn Salary × 15/30) × Years of Service. The maximum tax-free gratuity is ₹20 lakh (increased from ₹10 lakh by the Payment of Gratuity Amendment Act, 2018). Any gratuity amount above ₹20 lakh is taxable as 'Income from Salary' in the hands of the employee. Government employees are entitled to unlimited tax-free gratuity.
Gratuity (Covered under Act) = (Last Basic + DA) × 15/26 × Completed Years of Service; Gratuity (Not covered under Act) = (Last Basic + DA) × 15/30 × Completed Years of Service; Max Tax-Free: ₹20,00,000
- 1Determine if the employer is covered under the Payment of Gratuity Act, 1972 — applicable to establishments with 10+ employees; once covered, always covered regardless of current strength.
- 2Confirm the employee has completed at least 5 continuous years of service with the same employer (exception: death or permanent disability — payable regardless of tenure).
- 3Identify the last drawn salary for gratuity purposes: Basic Salary + Dearness Allowance only. HRA, bonus, commissions, overtime, and other allowances are excluded from the gratuity calculation base.
- 4Count the years of service: a period of service exceeding 6 months is rounded up to the next year; a period of 6 months or less is rounded down. For example, 7 years and 8 months = 8 years; 7 years and 4 months = 7 years.
- 5Apply the formula: (Basic + DA) × 15/26 × rounded years of service (for Act-covered establishments); or (Basic + DA) × 15/30 × years (for non-covered establishments).
- 6Check if the calculated amount exceeds ₹20 lakh — the statutory maximum under the Act; if employer offers more ex-gratia, the excess over ₹20 lakh is taxable.
- 7Tax treatment: for private sector employees, the minimum of (actual gratuity, 15 days × average salary × years, or ₹20 lakh) is tax-exempt; for government employees, the entire gratuity is tax-free.
10 years 7 months rounds to 11 years; tax-free as ₹3.81L < ₹20L limit
Service of 10 years and 7 months rounds up to 11 years (since 7 months > 6 months). Formula: 60,000 × (15/26) × 11 = 60,000 × 0.5769 × 11 = ₹3,80,769. Fully tax-free.
Excess ₹8,84,615 above ₹20L limit is taxable if paid by employer
The Payment of Gratuity Act caps gratuity at ₹20 lakh. The employer is legally obligated to pay ₹20 lakh. Any amount above ₹20 lakh (ex-gratia) is at the employer's discretion and is taxable in the employee's hands.
Non-Act formula uses 30 as denominator instead of 26; still tax-free within ₹20L
For non-Act establishments, the formula uses 15/30 instead of 15/26. 8 years 4 months rounds to 8 years (4 months < 6). Gratuity = 40,000 × 0.5 × 8 = ₹1,60,000. This is entirely at employer discretion (not legally mandated).
5-year minimum does not apply for death or permanent disability — gratuity is paid from day one
In cases of death or permanent disablement, the 5-year minimum service requirement is waived. Gratuity is calculated on actual years served and paid to the nominee (for death) or employee (for disability). Fully tax-free in the nominee's hands.
Employees calculating their gratuity entitlement before resigning to decide the optimal time to leave (just before or after 5-year anniversary).
HR departments computing gratuity provisions in company accounts and estimating the gratuity liability for actuarial purposes.
Employees in mergers/acquisitions verifying that their past service continuity is preserved for gratuity calculation.
Financial planning — incorporating expected gratuity into retirement corpus projections alongside EPF, NPS, and personal savings.
Legal disputes — employees or their nominees filing gratuity claims with the Controlling Authority when employers fail to pay or underpay.
Gratuity Under New Labour Codes
The Code on Social Security, 2020 (part of the four new labour codes) proposes to extend gratuity benefits to fixed-term contract workers, gig workers, and platform workers. Under the proposed code, fixed-term employees would be eligible for gratuity proportional to their service (even less than 5 years) — but as of FY 2024-25, the old Payment of Gratuity Act, 1972 remains in force pending full implementation of the labour codes.
Rounding of Service Period
The Payment of Gratuity Act specifies that a fraction of a year greater than six months shall be considered a full year. For example: 12 years 7 months → 13 years; 12 years 6 months → 12 years; 12 years 5 months → 12 years. This rounding applies specifically to the years of service in the formula, not to the 5-year eligibility threshold.
Gratuity After Voluntary Retirement
Employees who opt for Voluntary Retirement Scheme (VRS) are entitled to gratuity as normal (if they have completed 5+ years). The gratuity is calculated on the last drawn salary at the time of VRS. VRS compensation itself may have separate tax treatment under Section 10(10C) of the Income Tax Act — up to ₹5 lakh of VRS compensation is exempt from tax.
Transfer of Gratuity on Company Acquisition
When a company is acquired or merged, the service of employees generally continues for gratuity purposes — past service with the predecessor company counts toward the 5-year threshold and total years of service calculation. However, this depends on the terms of the merger/acquisition agreement. Employees must ensure continuity of service is formally recognised in writing during corporate transactions.
| Category | Tax-Free Limit | Formula Used |
|---|---|---|
| Govt employees (central/state) | Entire gratuity — no cap | Different formula per service rules |
| Act-covered private employees | Minimum of: actual gratuity, 15/26 × average salary × years, ₹20L | 15/26 × last basic+DA × years |
| Non-Act private employees | Minimum of: actual gratuity, ½ month salary × years, ₹20L | 15/30 × last basic+DA × years |
| In case of death (nominee) | Entire gratuity tax-free in nominee's hands | Regardless of tenure |
| Statutory maximum | ₹20,00,000 (since March 2018) | Amended by Payment of Gratuity Amendment Act 2018 |
Is gratuity compulsory for all employers?
Gratuity under the Payment of Gratuity Act, 1972 is mandatory for establishments employing 10 or more persons. Once an establishment crosses the 10-employee threshold, it is covered permanently — even if headcount later falls below 10. Establishments with fewer than 10 employees are not legally obligated under the Act, but can voluntarily pay gratuity. Some states have extended coverage to smaller establishments through state government notifications.
Does the 5-year rule apply strictly to the day?
Courts have interpreted 'five years of continuous service' to include cases where an employee has served for 4 years and 240 days (considering that the working year has 240 working days, not 365). The Supreme Court in 1991 (Surendra Kumar Verma vs. CGAT) held that 240 days of work in the 5th year constitutes continuous service. However, this interpretation is not universally applied — it is safer to complete 5 calendar years to avoid disputes.
What salary components are included in the gratuity calculation?
For establishments covered under the Payment of Gratuity Act, only the last drawn Basic Salary + Dearness Allowance (DA) is considered for gratuity calculation. House Rent Allowance (HRA), transport allowance, bonus, overtime, commission, incentives, medical allowance, and other perquisites are expressly excluded. This is a common point of confusion — employers cannot include allowances to inflate gratuity, nor can employees claim them.
Can gratuity be forfeited by the employer?
Yes, under Section 4(6) of the Payment of Gratuity Act, an employer can forfeit gratuity (wholly or partially) if the employee is dismissed for misconduct causing financial loss to the employer (forfeiture limited to the loss caused) or for acts of violence, riotous behaviour, or moral turpitude. Simple resignation, termination without cause, or poor performance does not justify forfeiture. Any forfeiture beyond these grounds is legally challengeable.
Is gratuity received during service (not at exit) taxable?
Gratuity received during the course of employment (for example, from a previous employer after leaving) follows the same tax rules. The minimum of actual gratuity received, 15 days' average salary per year of service, or ₹20 lakh is tax-exempt. In practical terms, gratuity is always received at termination/retirement, not during active service with the same employer.
What is the deadline for the employer to pay gratuity?
Under the Payment of Gratuity Act, gratuity must be paid within 30 days from the date it becomes payable. If the employer fails to pay within 30 days, simple interest at the rate specified by the appropriate government (typically 10% per annum) is payable for the delayed period. The employee can file a complaint with the Controlling Authority (typically the Labour Commissioner) in case of non-payment.
Can I claim gratuity from multiple employers?
Yes. Gratuity from each employer is independent. If you worked at Company A for 7 years and then at Company B for 10 years, you are entitled to gratuity from both (assuming 5+ years at each). Each gratuity amount is subject to the ₹20 lakh tax-free limit independently. There is no aggregation across employers for the tax exemption — each lump sum from each employer gets its own ₹20 lakh limit.
What is a Gratuity Trust and how does it work?
Some large employers create an approved Gratuity Trust Fund — a dedicated fund managed by trustees to accumulate money for future gratuity payments. The employer makes annual contributions to the trust, and the trust pays gratuity when due. Employers with approved gratuity trusts get income tax deduction on their contributions. Alternatively, employers can purchase a Group Gratuity policy from LIC or other insurers as a managed option.
Proffstips
Even if your employer is not legally covered under the Payment of Gratuity Act (fewer than 10 employees), you can negotiate gratuity as part of your employment contract. Getting it documented in writing protects you — without a formal agreement, uncovered establishments have no obligation to pay gratuity even after 5+ years of service.
Visste du?
India's Payment of Gratuity Act has an interesting 'grandfather clause' — once an establishment is covered after crossing 10 employees, it remains covered forever. There are factories and small establishments in India that closed down to 3-4 employees but still technically owe gratuity to their remaining staff from the years when they were covered. The ₹20 lakh tax-free limit, set in 2018, has not been indexed for inflation — at 6% annual inflation, its real purchasing power erodes by ₹1.2 lakh every year.
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