Gratuity (Payment of Gratuity Act, 1972)

By Priya Sharma | Updated March 2026

What Is Gratuity?

Gratuity is a statutory lump-sum payment made by an employer to an employee upon termination of employment — whether through resignation, retirement, superannuation, or death/disability. It is governed by the Payment of Gratuity Act, 1972, which applies to every factory, mine, oilfield, plantation, port, railway, and every establishment employing 10 or more persons. The formula is straightforward: 15 days' wages for every completed year of service, with a statutory cap of INR 20 lakh.

For foreign companies operating in India through a wholly owned subsidiary, branch office, or liaison office, gratuity is a mandatory labour cost that must be budgeted from day one. Unlike severance pay in the US or UK — which is typically negotiable and tied to termination — Indian gratuity is a vested right that accrues automatically and cannot be waived by contract. Failing to pay gratuity on time exposes the employer to penalties of up to 6 months' imprisonment and fines.

The Code on Social Security, 2020, which came into effect on November 21, 2025, has consolidated and updated the Payment of Gratuity Act. The most significant change: fixed-term employees are now eligible for gratuity after just 1 year of continuous service (down from 5 years), and the definition of "wages" has been restructured so that basic pay plus dearness allowance must constitute at least 50% of total remuneration.

Legal Basis

The statutory framework for gratuity in India rests on these provisions:

• Section 4 of the Payment of Gratuity Act, 1972 — Establishes the right to gratuity for employees who have completed 5 years of continuous service (waived in cases of death or disablement). Prescribes the calculation formula: 15 days' wages per completed year of service, based on the last drawn wages.
• Section 4(2) and (3) — Sets the statutory maximum at INR 20 lakh (increased from INR 10 lakh by Notification S.O. 1420(E) dated March 29, 2018). For central government employees, the ceiling was raised to INR 25 lakh effective January 1, 2024.
• Section 4(6) — Permits forfeiture of gratuity (wholly or partially) only in cases of termination for moral turpitude or riotous/disorderly conduct, or to the extent of damage caused by wilful negligence.
• Section 4A — Mandates compulsory gratuity insurance with LIC or an approved insurer, or establishment of an approved gratuity fund. Non-compliance is an offence.
• Section 10(10) of the Income Tax Act, 1961 — Exempts gratuity from income tax up to INR 20 lakh for employees covered under the Act, and fully for government employees.
• Section 53 of the Code on Social Security, 2020 — Effective November 21, 2025, extends gratuity eligibility to fixed-term employees after 1 year of service on a pro-rata basis and redefines "wages" for calculation purposes.

How Gratuity Is Calculated

The Standard Formula

For employees covered under the Payment of Gratuity Act:

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

Where:

• Last Drawn Wages = Basic Pay + Dearness Allowance (DA) + Retaining Allowance (if any). Under the new labour codes, wages must be at least 50% of total CTC.
• 15 = 15 days' wages (half a month)
• 26 = Working days in a month (excludes 4 Sundays)
• Completed Years = Full years of service. If the employee has served more than 6 months in the final year, it rounds up to the next full year.

Calculation Examples

For Employees NOT Covered Under the Act

Establishments with fewer than 10 employees are not covered under the Act, but employers may still offer gratuity contractually. In such cases, the formula is typically: Last Drawn Wages x 15 x Completed Years / 30 (using 30 days instead of 26), which yields a lower amount. The tax exemption under Section 10(10)(iii) still applies, subject to the INR 20 lakh ceiling.

Tax Treatment of Gratuity

The income tax treatment of gratuity depends on the employee category:

The INR 20 lakh exemption is a lifetime limit — if an employee receives gratuity from multiple employers over their career, the total exemption across all receipts cannot exceed INR 20 lakh. Any amount exceeding this limit is added to "Income from Salaries" and taxed at the applicable slab rate. TDS is deducted on the taxable portion at the time of payment.

Eligibility and Applicability

Who Must Pay Gratuity?

Every employer running an establishment that employs 10 or more persons on any day in the preceding 12 months is covered under the Act. Once an establishment is covered, it remains covered even if the employee count later falls below 10. This includes:

• Factories, mines, oilfields, plantations, ports, and railways
• Shops and commercial establishments (as notified by state governments)
• Foreign companies operating through subsidiaries, branch offices, or project offices in India

Who Is Eligible?

Any employee (including managerial and supervisory staff, with no salary ceiling for coverage) who has completed 5 years of continuous service. The 5-year requirement is waived in cases of death or total permanent disablement. Under the Code on Social Security, 2020 (effective November 2025), fixed-term employees qualify after just 1 year of continuous service.

"Continuous service" includes periods of sickness, accident, authorised leave, layoff, and strikes that are not illegal — these are not treated as breaks in service under Section 2A of the Act.

Forfeiture of Gratuity

Under Section 4(6) of the Act, an employer can forfeit gratuity only in two narrow circumstances:

• Wilful damage to employer property — Gratuity can be forfeited to the extent of the damage caused. The employer must quantify the loss.
• Termination for moral turpitude or riotous/violent conduct — Gratuity can be wholly or partially forfeited, but only if the offence was committed during the course of employment and the employee was terminated for that specific conduct.

The employer must follow procedural fairness: issue a show-cause notice, conduct a domestic inquiry, and provide the employee an opportunity to be heard before forfeiting gratuity. Courts have consistently held that mere termination for poor performance, retrenchment, or voluntary resignation does not permit forfeiture. The burden of proof rests on the employer.

Gratuity Insurance and Funding

Under Section 4A, every employer (other than government establishments) must either:

• Obtain a gratuity insurance policy from LIC of India or another approved insurer, or
• Establish an approved gratuity fund (commonly through a trust managed by LIC or an insurance company)

Employers with 500 or more employees who have already set up an approved gratuity fund are exempt from the compulsory insurance requirement. Contributions to an approved gratuity fund are tax-deductible under Section 36(1)(v) of the Income Tax Act, making the trust/fund route financially attractive for larger establishments.

For foreign subsidiaries in India, the gratuity provision creates a significant actuarial liability that must be disclosed under Ind AS 19 (Employee Benefits) — equivalent to IAS 19 under IFRS. Actuaries calculate the present value of the defined benefit obligation using the projected unit credit method, and the liability appears on the balance sheet from year one.

How This Affects Foreign Investors in India

Gratuity is one of the most significant employment cost differences between India and Western markets. Here is how it compares globally:

Key implications for foreign companies setting up operations in India:

• Budget from day one: Unlike US-style at-will employment, gratuity is a non-negotiable cost. For a team of 50 employees with an average monthly wage of INR 75,000, the annual gratuity accrual is approximately INR 25.96 lakh (75,000 x 15 x 50 / 26 / annual provision factor).
• Actuarial valuation required: Under Ind AS 19, the gratuity liability must be valued by a certified actuary and disclosed in financial statements. This applies to private limited companies, LLPs, and branch offices alike.
• Cannot be contracted out: You cannot ask employees to waive gratuity rights. Any agreement to that effect is void under Section 14 of the Act.
• Applies to expat employees too: Foreign nationals employed by an Indian entity are entitled to gratuity on the same terms as Indian employees, provided they complete the qualifying service period.
• Cross-border transfers: When an employee transfers from the parent company abroad to the Indian subsidiary, the gratuity clock starts from the date of joining the Indian entity, not from the original overseas hire date.

Common Mistakes

• Treating gratuity as discretionary or tying it to performance. Gratuity is a statutory right, not a bonus. Once an employee completes 5 years of continuous service, the employer must pay — regardless of the employee's performance rating, reason for leaving, or the company's financial health. Withholding gratuity exposes the company to penalties under Section 9 (up to INR 10,000 fine and/or 6 months' imprisonment).
• Using CTC (cost-to-company) instead of "last drawn wages" for the calculation. The formula uses basic pay + DA + retaining allowance only — not HRA, bonuses, commissions, or allowances. Under the new labour codes, if your salary structure has basic pay below 50% of CTC, the wage component is deemed to be 50%, which increases the gratuity liability. Many foreign companies structure salaries with low basic pay (30-35% of CTC) and are caught off guard.
• Ignoring the rounding-up rule for partial years. If an employee has served 4 years and 7 months, the service rounds up to 5 years (since the last year exceeds 6 months), making them eligible. Employers who terminate employees just before the 5-year mark to avoid gratuity face legal challenges — courts have held that service of 4 years and 240 days constitutes "continuous service" for gratuity eligibility.
• Not setting up gratuity insurance or an approved fund. Section 4A makes this compulsory. Many foreign subsidiaries, especially in the first few years, treat gratuity as a balance-sheet provision without purchasing insurance or creating a trust. This is a compliance violation, and in the event of the company's closure, unfunded gratuity liabilities become personal liabilities of the directors.
• Assuming gratuity is a "India-only" accounting issue that doesn't affect global reporting. The gratuity defined benefit obligation flows through to consolidated IFRS financial statements of the parent company. For a 200-person Indian subsidiary with average tenure of 6 years, the gratuity liability can exceed INR 2 crore — material enough to require disclosure and actuarial certification at the group level.

Practical Example

NovaBridge Technologies Inc., a US-based SaaS company, set up a wholly owned subsidiary in Bengaluru in 2019 with 30 employees. By March 2026, the team has grown to 85 employees.

Scenario 1: Standard resignation

Rajesh, a senior developer, resigns after 7 years and 8 months of service (rounds up to 8 years). His last drawn wages: Basic Pay INR 1,20,000 + DA INR 15,000 = INR 1,35,000 per month.

• Gratuity = (1,35,000 x 15 x 8) / 26 = INR 6,23,077
• Tax exemption: INR 6,23,077 (fully exempt, within INR 20 lakh limit)
• NovaBridge must pay within 30 days of Rajesh's last working day. If delayed, simple interest at 10% per annum accrues from the due date.

Scenario 2: Early termination of a fixed-term contract (post-November 2025)

Maria, a German UX designer, is hired on a 2-year fixed-term contract starting January 2026. She completes 14 months before the project ends. Under the Code on Social Security, 2020, she qualifies for pro-rata gratuity after 1 year. Her monthly wages: INR 1,80,000.

• Gratuity = (1,80,000 x 15 x 1) / 26 = INR 1,03,846 (for 1 completed year; 2 months do not round up as they are below 6 months)

Scenario 3: The costly mistake

NovaBridge did not purchase gratuity insurance or set up a trust for the first 5 years. In 2024, a labour inspector flagged the violation under Section 4A. The company had to:

• Purchase a group gratuity policy from LIC retroactively, paying a lump-sum premium of INR 38 lakh to fund the accrued liability for all eligible employees
• Pay a penalty of INR 50,000 for the Section 4A violation
• Restate its Ind AS 19 liability in the statutory audit, which flowed through to the US parent's IFRS consolidation and required an AOC-4 filing amendment

Key Takeaways

• Gratuity is a mandatory statutory benefit under the Payment of Gratuity Act, 1972 — it cannot be waived, negotiated away, or made conditional on performance
• The formula is (Last Drawn Wages x 15 x Years of Service) / 26, capped at INR 20 lakh (INR 25 lakh for central government employees)
• Employees covered under the Act need 5 years of continuous service; fixed-term employees qualify after 1 year under the Code on Social Security, 2020 (effective November 2025)
• Tax exemption under Section 10(10) is capped at INR 20 lakh as a lifetime limit; government employees get full exemption
• Employers must either purchase gratuity insurance (Section 4A) or establish an approved gratuity fund — non-compliance is a criminal offence
• Forfeiture is permitted only for moral turpitude, violent conduct, or wilful property damage — not for poor performance or voluntary resignation
• The gratuity liability must be actuarially valued under Ind AS 19 and flows through to the parent company's consolidated IFRS financial statements

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