Gratuity is a lump-sum benefit paid by employers to employees as a reward for long-term service. It’s a statutory right in India, governed by labour laws. In this comprehensive guide, we’ll explain what gratuity is, who is eligible, how it’s calculated, the old rules under the Payment of Gratuity Act 1972, and the new provisions under the Code on Social Security 2020. We’ll also cover sector-specific notes (private, public, teachers, etc.), tax implications, and answer common FAQs.
What is Gratuity?
Gratuity is essentially a financial “thank you” given to employees for their loyalty and years of service. It’s not a regular monthly component of salary, but rather paid out in a lump sum when you leave the company (due to resignation, retirement, or other reasons) after a long period of employment.
The Payment of Gratuity Act, 1972 makes gratuity a legal obligation for employers meeting certain criteria, ensuring employees receive this benefit for dedicated long-term work. In simple terms, gratuity is money paid by the employer to appreciate an employee’s continuous service, typically paid at the time of separation or retirement.
Key point: Gratuity is entirely funded by the employer. There are no contributions from the employee’s salary towards gratuity (unlike provident fund or NPS). Some employers may include a notional gratuity amount in your CTC (Cost to Company) package for accounting, but it isn’t deducted from your take-home pay. The employer bears the cost and pays the amount when it falls due.
Why is Gratuity Important?
Gratuity serves multiple purposes for employees:
- Reward for Loyalty: It recognizes and rewards employees who have stayed with an organisation for a significant period. It’s a token of appreciation for loyalty.
- Retirement Corpus: Gratuity provides a financial cushion at retirement or when leaving a job, helping employees in their post-employment life. Along with provident fund and pensions, it forms an important part of an employee’s retirement benefits.
- Security for Families: In case of the employee’s untimely death or disability, gratuity provides immediate support to the family or nominee. The law even ensures that if an employee passes away, gratuity is paid out regardless of length of service (we’ll discuss this in eligibility).
- Legal Entitlement: Unlike discretionary bonuses, gratuity is backed by law. This means employees have clarity and assurance of this benefit as long as they meet the eligibility criteria. It’s a predictable part of long-term compensation planning.
Overall, gratuity is a significant part of employee benefits in India, encouraging retention and providing social security. Next, let’s see who qualifies for gratuity and under what conditions.
Eligibility Criteria for Gratuity (Old Rule)
Under the Payment of Gratuity Act, 1972, the primary eligibility condition for gratuity is continuous employment of at least 5 years with the same employer. Once an employee has completed five years, gratuity becomes payable when they leave the job (either due to resignation, retirement/superannuation, or layoff). However, there are important nuances and exceptions:
- 5-Year Rule: In general, you must have 5 years of continuous service to be eligible for gratuity on resignation or retirement. “Continuous service” typically means unbroken service, but certain types of leave or layoffs are not counted as breaks as per the Act’s definition. Notably, some courts have interpreted 4 years and 240 days in the fifth year as fulfilling the “5 years” in specific cases, but the safest rule is 5 full years for eligibility.
- Death or Disability Exception: The five-year rule is waived if the employment terminates due to the employee’s death or a permanent disability due to accident or illness. In such unfortunate cases, gratuity is payable to the employee’s nominee or legal heirs regardless of tenure. This ensures the family gets some support even if the employee hadn’t served 5 years.
- Retirement/Superannuation: If an employee reaches the retirement age (superannuation) defined by the company, gratuity is due at that point (provided the 5-year service condition is met).
- Resignation: If an employee resigns after five or more years of service with the organization, they are entitled to gratuity. One must typically apply for the gratuity to claim it (more on the process later).
- Termination for Misconduct: If an employee is terminated for certain severe misconduct, the employer may have the right to forfeit gratuity (fully or partially) as per the Act’s provisions. This is only in cases of grave misconduct – for example, if the employee’s actions caused financial loss to the company or involved moral turpitude (more on this in a later section). Aside from such cases, an eligible employee cannot be denied gratuity; the Act protects gratuity from forfeiture except in cases of serious misconduct.
It’s also important to note that the employer must fall under the Act’s applicability for these rules to mandatorily apply. Let’s see what that means.
Payment of Gratuity Act, 1972 – Key Provisions (Old Rules)
The Payment of Gratuity Act, 1972 is the law that governs gratuity for most employees in India. Here are the key provisions and rules under this Act:
- Coverage (Applicability): The Act applies to establishments with 10 or more employees. This includes factories, mines, oilfields, plantations, ports, railways, shops and business establishments, and also educational institutions. (Notably, a 2009 amendment brought teachers in private schools/colleges under the Act’s ambit as “employees,” so teachers are entitled to gratuity now just like other employees.) Once an organization comes under the Act, it remains covered even if headcount falls below 10. Most public sector undertakings (PSUs) and private companies with 10+ staff are covered; central and state government departments have their own gratuity rules but broadly similar benefits.
- Benefit Amount: The gratuity amount is 15 days of wages for every completed year of service, subject to a cap. For this calculation, the “last drawn salary” (basic pay plus dearness allowance) is considered. We will detail the formula in the next section. Partial years beyond 6 months are counted as a full year for calculating gratuity. For example, 10 years and 7 months of service is counted as 11 years, whereas 10 years and 4 months is counted as 10 years for gratuity purposes.
- Maximum Limit (Ceiling): The Act (and subsequent government notifications) impose a ceiling on the maximum gratuity payable. Currently, the maximum gratuity amount mandated (and tax-free) for private sector employees is ₹20 lakh. Originally the limit was ₹10 lakh, which was increased to ₹20 lakh in 2018. For central government employees, the ceiling is even higher – ₹25 lakh as of 2024 (following a Dearness Allowance hike). This means even if the formula calculation yields a higher amount, the employer’s statutory liability is capped at these limits.
- Payment Timeline and Interest: Employers are required to pay the gratuity within 30 days from the date it becomes due (date of leaving/retirement). Failing this, they can be liable to pay interest on the amount due and may incur penalties. The Act sets penalties for employers who delay or refuse payment without valid justification. In practice, one should apply for gratuity as soon as possible after leaving to initiate the process (though even if you apply late, you don’t lose the right – the claim remains valid with reasonable cause for delay).
- Forfeiture Conditions: The Act protects employees’ gratuity from attachment or forfeiture, except in cases of severe misconduct. Under Section 4(6) of the Act, an employer can forfeit gratuity only if: (a) the employee is terminated for an act that caused willful loss or damage to the employer’s property – then forfeiture is to the extent of the damage; or (b) the employee is terminated for an offense involving moral turpitude (serious wrongdoing) or riotous/violent misconduct – then gratuity can be wholly or partially forfeited. Even in these cases, proper procedure must be followed (e.g. a domestic inquiry). For minor misconduct or if the employee resigns, gratuity cannot be withheld.
- Nomination: Employees should nominate a beneficiary for gratuity (usually a family member) so that if the employee passes away, the gratuity is paid to the nominee. The Act allows such nomination and prescribes that in case of death, the gratuity is paid to the nominee or legal heir. If the nominee is a minor, the amount is deposited with a bank or authority until the minor comes of age.
In summary, the 1972 Act ensures that any employee who serves a company long enough (5+ years) gets a parting benefit as gratitude. Now, let’s look at how gratuity is calculated under these rules.
Gratuity Calculation Formula (Under the Act)
For employees covered by the Gratuity Act (1972), the calculation formula is quite straightforward. The law effectively gives 15 days’ worth of salary for each year of service. The formula is:
Gratuity = (Last Drawn Salary × 15 × Number of years of service) ÷ 26.
Here, Last Drawn Salary means your basic salary plus dearness allowance (DA) at the time of leaving. The number 15 represents 15 days of wages per year, and 26 represents the number of working days in a month (the Act assumes a month has 26 working days, excluding Sundays).
So essentially, gratuity ≈ half a month’s salary for every year worked (15/26 is roughly 0.577, which is about half). If you worked, say, 10 years and your last basic + DA was ₹50,000, then gratuity = (50,000 × 15 × 10) / 26 ≈ ₹2.88 lakh.
- Rounding of Service: Only full years of service are counted. However, if you have a part-year more than 6 months, it is rounded up to a full year. Example: 10 years 7 months becomes 11 years (so you’d get 11 * 15 days salary). But 10 years 4 months stays 10 years. This rule ensures those who crossed half-year get benefit of a full year.
- Employees Not Covered by Act: If an organization has <10 employees or is not under the Act, some employers still choose to pay gratuity as a goodwill gesture. In such cases, they may use a slightly different formula: (Last Salary × 15 × years of service) ÷ 30. Here 30 is used as the divisor (total days in a month) instead of 26, which yields a slightly smaller amount. However, since it’s not mandated by law, these terms can vary by company policy. The majority of formal sector employees are covered by the Act, so the 26 divisor formula is standard.
- Gratuity in Case of Death: In case of death, gratuity is payable regardless of tenure and is calculated as per the standard formula under the Act, subject to applicable minimums and statutory caps
In most scenarios, calculating gratuity is not something employees have to do manually – employers will do it, and many online calculators are available. The main thing to remember is that your basic salary/DA and tenure are the determinants, and there’s an upper limit as discussed.
New Gratuity Rules under the Code on Social Security, 2020 (Proposed/Upcoming)
India’s labour laws are undergoing reforms with new labour codes. The Code on Social Security, 2020 consolidates and amends provisions of the Gratuity Act (among other laws). The Code on Social Security, 2020 has been passed but is yet to be fully implemented. Until notified by the Centre and respective States, the Payment of Gratuity Act, 1972 continues to govern gratuity. Here are the new gratuity rules and changes under the code, in comparison to the old rules:
- Gratuity for Fixed-Term Employees (Contract workers): Under the new code, the government has proposed to reduce the minimum service requirement for gratuity from 5 years to 1 year for Fixed Term Employees (FTEs). This means if you are on a fixed-term contract (say a 2-year contract), you will be eligible for gratuity after just one year of continuous service with the company, paid on a pro-rata basis for your tenure. This is a significant change, as earlier contract workers often missed out due to the 5-year rule. Now, one-year stints will earn gratuity, making benefits more portable for short-term employments. According to news reports, as the new labour codes take effect, fixed-term staff get the same benefits as permanent staff, including gratuity after 1 year. (Note: Permanent employees still need 5 years for gratuity; this 1-year rule applies to those on fixed-term contracts.)
- Working Journalists: As proposed, the Code on Social Security also specifically lowered the service requirement for working journalists to 3 years (down from 5) for gratuity eligibility. This acknowledges the shorter job tenures common in media.
- No Change for Others: For most other regular employees, the 5-year rule remains under the code (the proposal to reduce it universally to 3 or 1 was not adopted except for the above cases). So, if you’re a permanent employee, you still look at 5 years for gratuity as before.
- Expanded Coverage & Sectors: The code aims for more universal coverage. It doesn’t change the basic threshold of 10 employees for gratuity, but it brings more types of workers under social security. For example, it formally recognizes gig and platform workers, though gratuity is not directly extended to gig workers (instead, other benefits via a social security fund are planned). Most establishments that were covered by the 1972 Act will continue to be covered under the code. Government schemes for unorganized sectors are separate, but the principle of gratuity remains focused on employer-employee relationships.
- Uniform Definition of Wages: One indirect but crucial change is the standardisation of “wages” definition across all labour laws. The code defines wages to include basic pay, dearness allowance, and retaining allowance, and stipulates that certain allowances are capped at 50% of total remuneration. If allowances (like HRA, commissions, etc.) exceed 50% of total, the excess is counted back into wages.
Gratuity in Private vs Public Sector (and Other Sectors)
Gratuity is prevalent across all sectors in India – private, public (government), and even non-profit or educational sectors – with some differences:
Private Sector Employees
Most medium to large private companies come under the Payment of Gratuity Act and thus must pay gratuity. The rules we discussed (5-year eligibility, formula 15/26, ₹20 lakh cap) apply. Private sector employees do not contribute to gratuity; it’s paid from the employer’s funds or an insurer.
If a company has fewer than 10 employees, it’s not legally bound to pay gratuity, but some may still do so voluntarily or as per employment contract. Under the new codes, private sector fixed-term contract workers benefit from the reduced service requirement (1 year) for gratuity. Also, any establishment with 10+ employees in private sector, including shops, IT firms, factories, etc., is covered.
Public Sector Undertakings (PSUs)
PSUs (like government-owned companies, banks, etc.) generally follow the Payment of Gratuity Act as well (or sometimes superior company policies). So, their employees are eligible under the same terms or better. For instance, many PSU banks and enterprises honour the ₹20 lakh cap (some had raised it even before the law mandated). Essentially, if you work for a PSU, gratuity is part of your service benefits, similar to a private company of equivalent size.
Central/State Government Employees
Government employees have gratuity provisions under their service rules (Central Civil Services Pension Rules for central government, for example). The concept is the same – government staff get gratuity on retirement, death, etc. – but the calculation and limits can differ.
As of January 2024, the central government has increased the gratuity limit to ₹25 lakh for its employees, and government employee gratuity is fully tax-free under income tax law (being “death-cum-retirement” gratuity). Central government gratuity is calculated as 1/4th of last drawn salary (including DA) for each completed six-month period of service, subject to the limit (this roughly equals half-month’s pay per year, similar to the Act’s formula). State government rules are usually analogous. In short, government employees have guaranteed gratuity as a retirement benefit, with higher caps and complete tax exemption.
Teachers and Educational Sector
For a long time, teachers in private schools/colleges weren’t covered under the Gratuity Act (due to a technical definition of “employee”). This changed with the Amendment Act of 2009 which included teachers, made retrospective from 1997. In 2022, the Supreme Court upheld that teachers are entitled to gratuity just like other staff. So, if you’re a teacher in an institution with 10+ employees, you qualify after 5 years of service. Even many government school teachers (state government employees) get gratuity as per state rules.
Seasonal, Casual, Part-time Workers
The Act has special provisions for seasonal establishments (gratuity is calculated at the rate of 7 days’ wages per season year). Part-time employees in a covered establishment are generally considered eligible if they meet continuity criteria. Under the new code, there is an intent to include all kinds of workers; however, gratuity for truly gig or platform workers is not directly applicable since they don’t have a single employer for 5 years. Instead, other benefits are planned for them.
Railways and Defense
Indian Railways staff are central government employees, so they get gratuity per government rules (often along with pension or National Pension System). Armed Forces have their own gratuity rules under military regulations, often receiving gratuity on retirement or disability in addition to defense pension, with amounts usually aligned to central government scales.
Taxation of Gratuity in India
One common question is: Is gratuity amount taxable? The answer is gratuity is partly or fully tax-exempt, subject to certain limits and conditions:
Government Employees
For central and state government employees (including defense personnel), any gratuity received on retirement or death is fully exempt from income tax. There is no monetary ceiling for tax purposes – although practically they have a service rule cap (₹25 lakh for central govt as of 2024), whatever amount is paid is not taxed as per Section 10(10)(i) of the Income Tax Act. In short, government servants enjoy tax-free gratuity.
Private Sector Employees (Covered by Gratuity Act)
For non-government employees, gratuity is tax-exempt under Section 10(10)(ii) up to a limit. Currently, the maximum tax-free gratuity is ₹20 lakh for private sector folks. Any amount above ₹20 lakh received is taxable as “Income from Salaries”. The ₹20 lakh is a cumulative limit for your whole career (it considers past gratuity if any). When you retire or resign, the tax-exempt portion will be the least of: (a) the actual gratuity received, (b) ₹20,00,000, (c) gratuity as per the formula (15/26 * last salary * years). In most cases, ₹20 lakh is the cap. For example, if your calculated gratuity is ₹15 lakh, it’s fully tax-free. If it’s ₹30 lakh, ₹20 lakh is exempt and ₹10 lakh is added to your taxable salary income.
Private Employees (Not Covered by Act)
If you happen to work in an establishment not under the Act (rare for formal sectors), the tax exemption is still capped at ₹20 lakh (Section 10(10)(iii)). The calculation for eligible amount in that case uses a formula of half-month’s salary for each year of service, but again ₹20 lakh cap holds. So effectively, whether covered by the Act or not, the tax-free limit is ₹20 lakh for private sector gratuity.
Recent Update on Limits
As mentioned, in March 2018 the government raised the limit from ₹10 lakh to ₹20 lakh for private sector, bringing parity with government at the time. Now government has a ₹25 lakh ceiling (due to DA indexation) but private remains ₹20 lakh. There is speculation that the limit might be revisited in the future for private sector too, but as of now it remains ₹20 lakh.
Tax on Excess
If you do receive gratuity beyond the exempt amount, the surplus is taxed as part of your salary in the year of receipt. This can potentially push you into a higher tax bracket, so some people do tax planning around it (like spreading retirement benefits across financial years if possible). However, many employees won’t exceed the limit unless they have very high salaries or extremely long tenures.
