Gratuity is a statutory retirement benefit payable by employers to employees who have completed at least 5 years of continuous service — on resignation, retirement, death, or disability. Governed by the Payment of Gratuity Act, 1972, it is not optional for eligible employers. Mismanaging gratuity — not paying it, computing it incorrectly, or missing nomination formalities — can result in labour court proceedings and heavy penalties. This guide explains gratuity applicability, computation, payment rules, and tax treatment.
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1. Applicability of Gratuity
- Mandatory for all establishments employing 10 or more employees on any day during the preceding 12 months
- Once applicable, the Gratuity Act continues to apply even if headcount falls below 10
- Applies to all industries — factories, mines, oil fields, plantations, ports, railways, shops, and establishments
- Covers all employees — permanent, contractual, temporary — who have completed 5 years of continuous service
2. Employee Eligibility for Gratuity
- Minimum 5 years of continuous service — the fundamental condition
- On death or disability: Gratuity is payable even if 5 years have NOT been completed — payable to the nominee or legal heir
- "Continuous service" includes authorised leave, lay-off, strike not deemed illegal, and absence due to accident/illness
- The 5-year rule: if an employee has worked 4 years and 240 days in the 5th year — it is counted as 5 years of service (240 days = one year of continuous service for non-mining establishments)
Many employers are unaware of the 240-day rule — that 4 years and 240 days qualifies as 5 years. Don't underpay gratuity and face labour court action.
Check Gratuity Eligibility →3. Gratuity Calculation Formula
Gratuity = (Last Drawn Basic + DA) × 15/26 × Number of Years of Service
- 15/26 = 15 working days' wages per year of service (26 = working days in a month)
- Number of years: Each completed year of service + fraction of a year above 6 months counts as a full year
- Maximum gratuity payable: ₹20 lakh (for private sector employees covered under the Act). Employers can pay more voluntarily.
- Government employees have a different, more beneficial formula
Example: Last drawn Basic = ₹30,000/month; Service = 8 years 8 months (rounds to 9 years)
Gratuity = ₹30,000 × 15/26 × 9 = ₹1,55,769
4. Tax Treatment of Gratuity
| Category | Tax Exemption |
|---|---|
| Government Employees | Fully exempt — entire gratuity is tax-free |
| Private Sector (covered under Gratuity Act) | Exempt up to the least of: actual gratuity, ₹20 lakh, or formula amount. Excess taxable. |
| Private Sector (not covered under Act) | Exempt up to ½ month salary per year of service, subject to ₹20 lakh overall limit |
| On death of employee | Fully exempt in hands of nominee/legal heir |
5. Gratuity Provision and Accounting
Prudent businesses make a gratuity provision in their accounts every year — even though the actual payment happens only on separation. AS 15 / Ind AS 19 (Employee Benefits) requires companies to account for gratuity as a defined benefit obligation — typically using an actuarial valuation for larger organisations. For smaller businesses, an annual provision of approximately 4.81% of basic salary per employee is a standard rule of thumb. This provision reduces taxable income when made through an approved gratuity trust.
Gratuity Computation, Compliance and Accounting — For All Employers
From checking employee eligibility and computing gratuity payouts to making annual accounting provisions and advising on gratuity trust setup — our CA team helps businesses manage gratuity compliance correctly across India.
Get Gratuity Compliance Help →Disclaimer: This article is for general informational and educational purposes only, representing our professional views as Chartered Accountants. It does not constitute legal or tax advice. Laws are subject to change. Please consult our team for situation-specific guidance.