How to Calculate Gratuity in India 2026: Complete Employer Guide

How to Calculate Gratuity in India 2026: Complete Employer Guide

Gratuity is one of the most frequently miscalculated statutory payments in Indian payroll. The formula appears simple, but the edge cases — employees completing exactly five years, employees who resign versus those who are terminated or retired, employees who die in service, and the new wage code implications — create errors that can cost employers significant amounts at the time of separation.

This guide covers the complete gratuity calculation methodology for Indian employers in 2026, including the correct formula, eligibility rules, the tax treatment for employees, and the employer's accounting obligation.

Who Is Entitled to Gratuity

The Five-Year Rule

Gratuity under the Payment of Gratuity Act 1972 is payable to an employee who has completed five years of continuous service with the same employer. This applies at the time of:

• Superannuation (retirement)
• Resignation
• Termination (except for proven misconduct)
• Death or disablement due to accident or disease

The five-year rule has one important exception: if an employee dies or becomes disabled before completing five years, gratuity is payable regardless of tenure — calculated for the actual period of service.

What Counts as Five Years

Continuous service of five years means 4 years and 240 days of actual service in the fifth year (for establishments working 6 days a week) or 4 years and 190 days (for establishments working 5 days a week). This matters for employees who resign shortly before completing exactly five years — check whether the partial fifth year meets the 240-day or 190-day threshold before denying gratuity.

Employees Not Covered

Employees in managerial or administrative roles earning above ₹1 lakh per month are NOT automatically excluded from gratuity — the Payment of Gratuity Act covers all employees regardless of wage level in most establishments. The Act covers establishments with 10 or more employees. Once covered, coverage continues even if headcount drops below 10.

The Gratuity Calculation Formula

For Employees Covered Under the Payment of Gratuity Act

Gratuity = (Last drawn monthly salary × 15/26) × Number of years of service

Where:

• Last drawn monthly salary = Basic salary + Dearness Allowance (DA). Not gross salary. Not CTC. Not HRA.
• 15/26 = 15 days of salary (numerator) ÷ 26 working days in a month (denominator)
• Number of years of service = Completed years, with any partial year of 6 months or more rounded up to the next full year

Example 1: Employee with 8 years 3 months of service, last drawn basic + DA = ₹40,000/month

• Service years = 8 (3 months is less than 6 months, so not rounded up)
• Gratuity = (40,000 × 15/26) × 8 = ₹1,84,615

Example 2: Employee with 8 years 7 months of service, last drawn basic + DA = ₹40,000/month

• Service years = 9 (7 months exceeds 6 months, rounded up to 9)
• Gratuity = (40,000 × 15/26) × 9 = ₹2,07,692

Example 3: Employee with 5 years 0 months of service (exactly 5 years), basic + DA = ₹30,000/month

• Service years = 5
• Gratuity = (30,000 × 15/26) × 5 = ₹86,538

For Seasonal Establishments

For seasonal establishments, the formula uses 7 days instead of 15: Gratuity = (Last drawn monthly salary × 7/26) × Number of years of service

For Establishments Not Covered Under the Act (Voluntary Gratuity)

Some companies pay gratuity as an ex-gratia for employees not covered under the Payment of Gratuity Act, or pay more than the statutory amount. In these cases, the formula and eligibility are set by company policy, not by statute. The tax treatment for amounts above the statutory gratuity limit is different (see tax section below).

The Maximum Gratuity Limit

The maximum gratuity payable under the Payment of Gratuity Act was last revised to ₹20 lakh. This cap applies to the statutory gratuity amount — amounts above ₹20 lakh paid voluntarily are treated differently for tax purposes.

For an employee with 30 years of service and a high salary, the formula may yield a gratuity amount above ₹20 lakh. In such cases, the statutory obligation is ₹20 lakh, and any additional amount paid is voluntary and taxable as ex-gratia.

Example: Employee with 30 years service, basic + DA = ₹1,00,000/month

• Formula: (1,00,000 × 15/26) × 30 = ₹17,30,769 — within the ₹20 lakh cap
• Formula: (1,50,000 × 15/26) × 30 = ₹25,96,154 — exceeds cap; statutory payment = ₹20,00,000

Tax Treatment of Gratuity

For Government Employees

Gratuity received by central or state government employees is fully exempt from income tax under Section 10(10)(i).

For Non-Government Employees Covered Under the Act

For employees in establishments covered under the Payment of Gratuity Act, the tax exemption under Section 10(10)(ii) is the least of:

• Actual gratuity received
• ₹20 lakh (statutory maximum)
• 15/26 × last drawn salary × completed years of service

In practice, since the formula and the statutory cap are the same, the amount calculated under the Act is typically fully exempt for employees whose gratuity does not exceed ₹20 lakh.

For Non-Government Employees NOT Covered Under the Act

For employees in non-covered establishments receiving ex-gratia or voluntary gratuity, the exemption under Section 10(10)(iii) is the least of:

• Actual gratuity received
• ₹20 lakh
• Half of average salary × completed years of service (where average salary = average of last 10 months)

Any amount received above the exempt limit is taxable as salary income in the year of receipt.

Gratuity Accounting: Provisioning for the Liability

Why Gratuity Provisioning Matters

Gratuity is a contingent liability — it accrues over the employee's tenure and becomes payable at separation. Companies that do not provision for gratuity create a balance sheet risk: when a senior employee with 15 years of service resigns, the gratuity payment can be ₹8–15 lakh or more, appearing as an unexpected cash outflow.

Actuarial Valuation Under AS 15 / Ind AS 19

Under Indian Accounting Standards (Ind AS 19 for listed companies, AS 15 for others), defined benefit obligations like gratuity must be measured using the Projected Unit Credit method with actuarial assumptions — discount rate, salary escalation rate, employee turnover, and mortality. The resulting liability and service cost must be recognised in the financial statements.

For small companies that are not required to follow Ind AS or AS 15, a simple provision based on the formula method — calculating the gratuity payable for each employee if they were to leave today and summing across the workforce — is an acceptable approximation for internal management accounts.

Gratuity Fund vs Unfunded Obligation

Companies can fund their gratuity obligation through a Gratuity Trust or through an LIC Group Gratuity policy. Funded gratuity has the advantage of tax deductibility for contributions to the fund (up to the actuarially determined amount). Unfunded gratuity means the company pays from operating cash flow when the obligation arises. Most SMBs operate on an unfunded basis — which is legally permissible but creates cash flow risk for long-tenure employees.

Gratuity in the New Wage Code

The Code on Social Security 2020 — which subsumes the Payment of Gratuity Act — has been notified but the implementation rules are pending as of 2026. The new code proposes to reduce the eligibility threshold from five years to one year for fixed-term contract employees, and to align the gratuity base with the new definition of "wages" under the wage code (which includes Basic + DA and must be at least 50% of CTC).

Until the implementation rules are notified and a specific implementation date is announced, the Payment of Gratuity Act 1972 continues to apply. Monitor ESIC and Ministry of Labour notifications for the implementation date.

Gratuity in Your HRMS

Your HRMS should track gratuity eligibility and calculate the contingent liability automatically. Features to look for:

• Eligibility tracking: The system flags employees who have crossed five years of service and are therefore eligible for gratuity on separation.
• Automatic calculation: When an employee's separation is processed, the HRMS calculates gratuity based on last drawn basic + DA and completed service years, including the rounding rule for partial years.
• Gratuity provision report: A monthly or quarterly report showing the total gratuity liability if all employees were to leave today — useful for Finance team provisioning.
• New wage code readiness: Confirmation from the vendor that the system will update gratuity calculation methodology when the new wage code implementation is notified.

Frequently Asked Questions

Does gratuity apply if an employee is terminated for misconduct?

No. An employee terminated for proven misconduct under the company's disciplinary policy, following due process, is not entitled to gratuity under Section 4(6) of the Payment of Gratuity Act. This exception requires that the misconduct be established through a proper domestic inquiry — summary termination without an inquiry does not qualify for this exception. When in doubt, consult a labour law attorney before withholding gratuity on misconduct grounds.

Is gratuity calculated on gross salary or basic salary?

Under the Payment of Gratuity Act, gratuity is calculated on basic salary plus dearness allowance only — not HRA, not special allowance, not other components. The formula uses last drawn salary meaning the salary in the last completed month of service.

When must gratuity be paid?

Gratuity must be paid within 30 days of the date it becomes payable. If payment is delayed beyond 30 days, the employer must pay simple interest at the rate of 10% per annum from the due date to the date of payment.

Can an employer deduct from gratuity for damage caused by the employee?

Yes, under Section 4(6), if an employee has caused damage or loss to the employer through wilful omission or negligence, the employer may deduct the amount of damage from the gratuity — but only after providing a notice and an opportunity to respond. The deduction cannot exceed the amount of damage proved.

Is gratuity payable for the notice period if the employee serves it?

Yes. The notice period served is part of the employee's continuous service and counts toward gratuity calculation. An employee on three months' notice, if they serve the notice, will have those three months counted in their total service for gratuity purposes.

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