Gratuity Calculation Explained (With the Labour Code Formula)

Gratuity is a lump-sum payment an employer owes an employee for long service, calculated using a fixed statutory formula rather than negotiated terms. Here is exactly how the number is worked out, who qualifies, and what has changed under the Labour Codes.

Key facts at a glance

• The standard gratuity formula is (15 x last drawn basic + DA x completed years of service) / 26.
• Employees must complete 5 years of continuous service to qualify, except in cases of death or disablement.
• Gratuity received is tax-free up to Rs 20 lakh under the Payment of Gratuity Act.
• Fixed-term employees are entitled to pro-rata gratuity even before completing 5 years, under the Code on Social Security, 2020.
• Gratuity is calculated only on basic pay plus dearness allowance, not full CTC.
• The Code on Wages' 50% rule on basic pay can significantly increase the gratuity a company owes.
• All four Labour Codes came into force on 21 November 2025, though state-level rules are still being notified as of mid-2026.

How the Gratuity Formula Works

The Payment of Gratuity Act, 1972 sets out a single formula for most establishments:

Gratuity = (15 x Last drawn basic salary + DA x Number of completed years of service) / 26

Here, 26 represents the assumed number of working days in a month, and 15 represents half a month's wages for each year of service. If an employee's last drawn basic plus DA is Rs 30,000 and they have completed 8 years of service, the calculation is (15 x 30,000 x 8) / 26, which works out to roughly Rs 1,38,462.

Any service period beyond 6 months in the final year is rounded up to a full year for this calculation. A slightly different formula applies to seasonal establishments, where gratuity is calculated at 7 days' wages for each season worked.

Who Is Eligible for Gratuity

The core eligibility rule is 5 years of continuous service with the same employer. Continuous service includes periods of authorised leave, and brief interruptions like strikes or lockouts generally do not break continuity as long as the employee was not at fault.

There are two important exceptions where the 5-year requirement is waived entirely:

• Death of the employee - gratuity is paid to nominees or legal heirs regardless of how long the employee had worked.
• Disablement due to accident or disease that ends the employee's ability to work.

The 50% Wages Rule and Your Gratuity Liability

Under the Code on Wages, the definition of "wages" now requires that basic pay plus dearness allowance make up at least 50% of an employee's total remuneration. If a company's current salary structure has basic pay below that threshold, the balance previously classified as other allowances gets reclassified as wages.

Because gratuity is calculated only on basic plus DA, a higher mandated basic component directly means a higher gratuity accrual for every employee, even if their total CTC does not change. Employers who have not yet restructured their salary breakups should model this impact before it hits their books, since state-level notification of the Labour Codes is still uneven as of mid-2026 and the exact compliance timeline can vary by state.

Fixed-Term Employees and Pro-Rata Gratuity

Historically, only employees with 5 years of continuous service could claim gratuity. The Code on Social Security, 2020 changed this specifically for fixed-term employees - those hired on a defined contract for a specific project or period. They are now entitled to gratuity on a pro-rata basis for whatever period they actually worked, without needing to cross the 5-year mark.

This matters for companies that rely heavily on fixed-term or project-based hiring, since it removes what was previously a way to avoid gratuity liability for shorter-tenure staff.

Tax Treatment of Gratuity Payouts

Gratuity received by an employee covered under the Payment of Gratuity Act is exempt from income tax up to Rs 20 lakh over their lifetime, across all employers. Any amount received above this ceiling is added to the employee's taxable salary income for that year. Government employees receive gratuity entirely tax-free with no ceiling.

For employers, gratuity is typically funded either through an approved gratuity trust with an insurer, or paid directly from the company's books when it falls due. Funding it through an approved scheme is generally treated as an allowable business expense.

If you are not sure how your current salary structure and headcount affect your statutory gratuity, PF, ESI and bonus obligations, ComplianceCheck's Statutory Health Check gives you a clear picture in a few minutes.

Sources

• Payment of Gratuity Act, 1972 and Code on Social Security, 2020 - labour.gov.in
• Ministry of Labour and Employment - labour.gov.in
• Income Tax Department, for gratuity tax exemption rules - incometax.gov.in

This guide is general information, not legal advice. Requirements vary by state, sector and headcount - confirm specifics with a compliance professional or the relevant authority.