Gratuity is a lump-sum payment an employer makes to an employee as a reward for long service, and for most employees it is one of the more significant amounts they receive when they leave a company. For employers, it is a statutory obligation with a clear formula and clear eligibility rules — but it is also one of the most commonly misunderstood components of Indian payroll, with frequent confusion about who qualifies and how the amount is worked out.
This guide lays out the rules, the formula, the recent changes brought by the Labour Codes, and how the calculation actually works in practice.
What gratuity is and who pays it
Gratuity is governed by the Payment of Gratuity Act. It applies to establishments employing ten or more persons, and it obliges the employer to pay a gratuity amount to employees who leave after putting in a qualifying period of continuous service. The idea is straightforward: the longer an employee stays, the larger the reward when they eventually move on, retire, or in unfortunate circumstances, in the event of death or disablement.
Gratuity is paid by the employer. It is not deducted from the employee's salary like PF — it is an additional cost the employer bears, though many companies provision for it within the CTC framework.
Eligibility — the five-year rule and its exceptions
The headline eligibility condition is five years of continuous service with the same employer. An employee who completes five years and then leaves — by resignation, retirement, or termination other than for misconduct — is entitled to gratuity. An employee who leaves before completing five years generally is not.
This five-year threshold is the single biggest source of confusion at exit. An employee who leaves at four years and ten months is, in the usual case, not entitled to gratuity, which can come as an unwelcome surprise if it was never clearly communicated. There is some nuance around what counts as a completed year near the boundary, and continuous service has its own definition that accounts for certain absences, but the broad rule stands: five years is the qualifying line.
There are important exceptions to the five-year rule. Where service ends due to death or disablement, the five-year condition is relaxed, and gratuity becomes payable even if the employee had not completed five years. In the case of death, the gratuity is paid to the nominee or legal heir.
The Labour Codes change for fixed-term employees
Here is a significant recent development. Under the new Labour Codes, which came into force on 21 November 2025, fixed-term employees become eligible for gratuity after completing just one year of service, rather than the usual five. This is a meaningful shift — it extends gratuity to a category of workers who previously would rarely have qualified, and employers using fixed-term contracts need to account for this new one-year eligibility in their cost planning and their FnF processes.
The gratuity formula
For employees covered under the Payment of Gratuity Act, the standard formula is:
Gratuity = (Last drawn basic salary + dearness allowance) × 15/26 × Number of completed years of service
Let us unpack the pieces. The "15/26" represents fifteen days of wages for each completed year of service, with 26 taken as the number of working days in a month (the month being treated as having 26 working days after excluding Sundays). The "last drawn basic plus DA" is the monthly figure at the time of leaving. And the number of completed years of service is rounded in a specific way — a part of a year beyond six months is generally treated as a full year, while a part of six months or less is dropped.
The ceiling and the tax exemption
There is a statutory maximum on the gratuity payable under the Act, and gratuity received up to a certain limit is exempt from income tax, with the specifics governed by the prevailing law. The tax exemption is a real benefit to the employee — within the exempt limit, the gratuity lands tax-free, which is part of what makes long service financially rewarding.
The new wage definition under the Labour Codes also matters here. Because gratuity is calculated on basic plus DA, and the Labour Codes push the wage base up to at least 50% of total remuneration, gratuity entitlements rise for employees whose structures previously had a low basic. A higher basic means a larger gratuity, which is good for employees and an increased provision for employers to plan for.
A worked example
Take an employee, Anjali, who leaves after 8 years and 7 months of continuous service. Her last drawn basic plus DA is ₹40,000 per month.
First, the years of service. She has completed 8 full years, and the additional 7 months — being more than six months — rounds up to a full year. So her years of service for the formula are 9.
Now apply the formula: ₹40,000 × 15/26 × 9.
₹40,000 × 15 = ₹6,00,000. Divided by 26 = ₹23,077 (approximately) per year of service. Multiplied by 9 years = ₹2,07,692.
So Anjali's gratuity works out to approximately ₹2,07,692, subject to the statutory ceiling and the tax exemption on the eligible portion.
Now consider how the Labour Codes affect this. If Anjali's structure previously had a basic plus DA of only ₹30,000 because the rest was loaded into allowances, the new 50% wage rule lifting her wage base would increase the basic plus DA used in the formula, and therefore her gratuity. The redefinition directly enlarges the gratuity entitlement for basic-light structures.
When gratuity is paid
Gratuity is part of the full and final settlement when an employee leaves. The expectation is that it is paid promptly after the employee's last working day, along with the rest of the FnF dues. Delaying gratuity payment is both a compliance risk and a source of disputes, and the trend in labour regulation has been towards tighter timelines for clearing final dues. We cover the broader exit process in detail in our separate full and final settlement guide; gratuity is one of the larger components of that settlement for long-tenured employees.
Common mistakes with gratuity
A few errors recur.
Denying gratuity to an employee who has actually crossed the five-year line, or paying it to someone who has not — both happen when the years of continuous service are calculated loosely rather than precisely.
Forgetting the rounding rule, so that an employee at, say, 6 years and 8 months is credited with 6 years instead of the correct 7.
Overlooking the new one-year eligibility for fixed-term employees under the Labour Codes, and under-providing for that category.
Calculating gratuity on a stale or incorrect basic figure, especially after the wage redefinition raised the wage base.
Missing the death and disablement exceptions to the five-year rule, and incorrectly denying gratuity in those circumstances.
Letting gratuity payment drag well past the employee's last day as part of a delayed FnF.
Why accurate gratuity depends on connected records
Gratuity sits at the intersection of three things: the employee's exact continuous service period, their current basic plus DA, and the eligibility rules including the recent fixed-term change. When these inputs live in different places — service dates in an HR system, salary structure in payroll, employment type in yet another record — calculating gratuity accurately for every exit becomes a manual cross-checking exercise, and that is where the rounding errors and eligibility mistakes creep in.
When the employee's joining date, employment type, salary structure, and exit date all sit on a single database, gratuity is computed directly from the real service period and the real current basic plus DA, with the correct eligibility rule applied automatically — including the one-year rule for fixed-term employees. Nothing has to be reconciled across systems, so the figure is accurate by construction. This is part of how Helion handles the employee lifecycle: because a hire, a salary revision, and an exit are all events on the same underlying record, the gratuity calculation pulls from the true history rather than a manually maintained summary.
For a company with a maturing workforce where more employees are crossing the five-year line each year, getting gratuity right consistently is both a compliance necessity and a matter of fairness to long-serving people.
This guide reflects the position as of 2026, including the four Labour Codes effective from 21 November 2025. Gratuity eligibility, the statutory ceiling, the tax exemption limit, and the treatment of fixed-term employees are governed by the applicable statutes and continue to settle in detail. This is general information for employers, not a substitute for advice from a qualified professional on a specific case.