Most Indian HR managers handle gratuity in one of two ways — they wing it on a calculator at the time of full and final, or they treat it as a once-a-year actuarial line item that the auditor sorts out. Both approaches quietly create problems: an employee who completed 4 years and 8 months gets denied her dues, a fixed-term contractor walks out after 14 months expecting a pro-rata payout, or a CFO gets blindsided in March because the gratuity provision was understated all year.
Gratuity calculation in India 2026 is not complicated — but the rules have shifted under the new Labour Code, and most payroll teams have not caught up. Here is the formula, the 5-year rule and its exceptions, the tax treatment, and the six mistakes HR managers keep making.
TL;DR: Gratuity in India 2026 at a Glance
- Formula: (Last Drawn Basic + DA) × 15 ÷ 26 × Completed Years of Service
- Minimum service: 5 years continuous service — waived in death or permanent disablement
- Tax-free ceiling: ₹20 lakh for private sector, ₹25 lakh for central government employees
- New under Code on Social Security: Fixed-term employees now get pro-rata gratuity after just 1 year of service (effective 21 November 2025)
What is Gratuity Under Indian Law?
Gratuity is a lump-sum payment an employer makes to an employee as a thank-you for long service, governed in India by the Payment of Gratuity Act, 1972. It applies to any factory, shop, or establishment employing 10 or more persons on any day in the preceding 12 months. Once the Act applies to your business, it continues to apply even if headcount later drops below 10.
From 21 November 2025, the Code on Social Security, 2020 became operative and now reads alongside the 1972 Act. The Code keeps the core framework intact but adds one big change: fixed-term employees become eligible for gratuity after one year of continuous service, instead of waiting five.
The Gratuity Formula — With Worked Examples
For establishments covered under the Payment of Gratuity Act, the formula is:
Gratuity = (Last Drawn Basic + DA) × 15 ÷ 26 × Completed Years of Service
The 15 represents 15 days’ wages for every completed year. The 26 represents the average working days in a month, excluding weekly off. That ratio (15/26) is roughly 0.577 — handy to remember when you’re sanity-checking a payslip.
Example 1: Standard payout
Priya is a project manager in Pune. She resigns after 8 years and 7 months. Her last drawn Basic is ₹45,000 and DA is ₹5,000.
- Completed years: 9 (since 7 months > 6, it rounds up)
- Gratuity = 50,000 × 15 ÷ 26 × 9 = ₹2,59,615
Example 2: Seasonal worker
For seasonal employees (think sugar mills, ice factories), the formula uses 7 days per season instead of 15:
Gratuity = (Basic + DA) × 7 ÷ 26 × Completed Seasons
Example 3: Establishment not covered by the Act
If your business has fewer than 10 employees and gratuity is paid voluntarily under a contract, the denominator changes from 26 to 30: (Basic + DA) × 15 ÷ 30 × Completed Years. The payout is lower, and the tax treatment differs (covered below).
The 5-Year Rule — and the 4-Year-240-Days Exception
The Act says gratuity is payable only on completion of 5 years of continuous service. Most HR teams stop reading there. But Section 2A defines “continuous service” — and the Madras High Court (Mettur Beardsell Ltd. v. RLC, 1998) and several other High Courts have held that an employee who has worked 240 days in the fifth year is deemed to have completed one full year of service.
Translation for your payroll team: an employee with 4 years and 240 days (roughly 4 years 8 months) of service is eligible for gratuity. Refusing it leads to a controlling-authority case you will almost certainly lose.
The 5-year rule is fully waived in two situations:
- Death — gratuity is paid to the nominee even if service was less than 5 years
- Permanent disablement due to accident or disease
Tax Treatment of Gratuity in 2026
Gratuity tax exemption falls under Section 10(10) of the Income Tax Act, and it survives in both the old and new tax regime. The exemption depends on which category the employee falls into:
| Employee Category | Tax-Free Limit (FY 2025-26) | Excess Treatment |
|---|---|---|
| Central / State Government employees | Entire amount tax-free (₹25 lakh ceiling for Central staff after 50% DA hike, 1 Jan 2024) | N/A |
| Private sector — covered under Gratuity Act | Least of: ₹20 lakh, actual gratuity, or (Basic+DA × 15/26 × years) | Taxed as “Salary” at slab rate |
| Private sector — not covered under Gratuity Act | Least of: ₹20 lakh, actual gratuity, or (Avg salary of last 10 months × ½ × years) | Taxed as “Salary” at slab rate |
Two payroll team gotchas: the ₹20 lakh is a lifetime cap across all employers — if Priya already used ₹15 lakh of her exemption at her previous job, she only gets ₹5 lakh free with you. And the exemption applies only when gratuity is paid on retirement, resignation, death, or disablement — not as an ex-gratia bonus during employment.
When Must You Pay Gratuity?
Under Section 7 of the Act, gratuity must be paid within 30 days of it becoming payable (typically the last working day). If you delay, simple interest at the rate notified by the central government becomes payable from the due date until actual payment.
Practical timeline most Indian SMEs run: HR computes gratuity within 15 days of last working day, issues Form L (notice of payment), and releases payment within 30 days along with leave encashment and notice pay. For a fuller walkthrough of how gratuity sits inside FnF, see our Full and Final Settlement in India 2026 guide.
Forfeiture: When You Can Refuse to Pay
Section 4(6) allows forfeiture only in narrow situations: partial forfeiture if the employee’s services were terminated for wilful omission or negligence causing damage to the company (limited to the extent of damage), and full forfeiture if dismissed for riotous conduct involving violence or for an offence involving moral turpitude during employment. You cannot forfeit gratuity just because the employee did not serve notice period — the grounds are narrow and the burden of proof sits with the employer.
What Changed Under the Code on Social Security, 2020
The Code consolidates nine social security laws including the Payment of Gratuity Act. Effective 21 November 2025, here is what HR managers should track:
- Fixed-term employees: Pro-rata gratuity after just 1 year of service — a massive shift for IT services, project-based manufacturing, and contractual staffing models
- Wage definition: “Wages” must now be at least 50% of total CTC. If your salary structures are top-heavy with allowances, your gratuity base goes up — and so does the liability
- Inter-state migrant workers: Specifically brought under gratuity coverage
- Working journalists: Eligible after 3 years of service (unchanged from earlier)
If you have not yet re-modelled your CTC structures for the 50% wage rule, you should — the gratuity provision on your balance sheet is probably understated. The same wage definition affects PF, ESI, leave encashment, and bonus calculations, so it is worth doing properly once. See the EPFO portal for related PF wage clarifications.
6 Mistakes Indian HR Managers Keep Making
- Denying gratuity at 4 years 8 months. If 240 days were worked in the 5th year, the employee is eligible. Period.
- Calculating on gross salary instead of Basic + DA. HRA, conveyance, special allowance, LTA — none of them are part of the gratuity wage. Including them inflates payouts; excluding DA underpays.
- Rounding service down. 8 years 7 months is 9 years for gratuity. 8 years 5 months is 8 years. The cutoff is 6 months — anything above rounds up.
- Forgetting to provision for fixed-term staff. Under the Code on Social Security, your project contractor with 14 months of service is owed gratuity. If you are not provisioning monthly, you will get a surprise.
- Treating notice-period non-service as grounds for forfeiture. It is not. Notice pay recovery is separate from gratuity. They cannot be netted off without a written agreement.
- Missing the 30-day payment window. Interest accrues automatically. Most HR teams only discover this when an employee files Form N with the controlling authority.
Gratuity Provisioning: What Finance Needs From You
Ind AS 19 and AS 15 require employers to recognise gratuity as a defined benefit obligation on the balance sheet. For SMEs with more than 50 employees, an annual actuarial valuation is the norm. Three things go to the actuary every year — full employee master with date of joining, current Basic + DA, and the company’s gratuity policy. If you are running payroll in a proper HRMS, this report is a 2-click export. If you are still on Excel, expect a 3-day cleanup before the actuary will even look at it.
Frequently Asked Questions
Is gratuity payable if an employee is terminated for misconduct?
Yes, in most cases. Gratuity can only be forfeited fully if the termination was for riotous conduct involving violence or for an offence involving moral turpitude committed during employment. Standard performance-related termination does not justify forfeiture.
Is gratuity calculated on CTC or only on Basic + DA?
Only Basic + DA, not CTC. However, under the Code on Social Security, “wages” must constitute at least 50% of total CTC. So if your Basic was earlier 30% of CTC, restructuring it to 50% will raise your gratuity liability proportionally.
What happens to gratuity if my company shuts down before I complete 5 years?
If the company is sold, merged, or transferred as a going concern, your continuous service carries over to the new entity. If the company is liquidated, gratuity dues are treated as preferential debt under the Insolvency and Bankruptcy Code, ahead of most unsecured creditors.
Can my employer pay more than the formula amount?
Yes. The Act sets a minimum. Many companies pay enhanced gratuity through a contract or policy. The tax exemption is still capped at ₹20 lakh, so anything above that is taxable as salary income in the year of receipt.
How long does an employer have to pay gratuity after resignation?
30 days from the date gratuity becomes payable, which is usually the last working day. Beyond that, simple interest applies. Most SMEs build it into their standard 45-day FnF cycle.
Do contract employees and apprentices get gratuity?
Apprentices under the Apprentices Act, 1961 are excluded from gratuity. But contract employees on a fixed-term contract are now eligible for pro-rata gratuity after 1 year of service under the Code on Social Security, 2020, effective 21 November 2025.
The Bottom Line
Gratuity is one of the highest-stakes payouts in the Indian payroll cycle — get the formula right, respect the 4-years-240-days reality, provision for fixed-term staff, and pay within 30 days. If you would rather not chase this every month in spreadsheets, EZHRM’s compliance module auto-calculates gratuity provisioning, tracks 240-day milestones, and generates the statutory forms at FnF time. Start a free trial.