What is Gratuity?

Definition

Gratuity is a statutory retirement benefit governed by the Payment of Gratuity Act, 1972. It is a one-time lump-sum payment the employer makes to an employee in recognition of long, continuous service. The Act applies to every factory, mine, oilfield, plantation, port, railway, shop and establishment in India that employs 10 or more persons on any day in the preceding twelve months.

An employee becomes eligible for gratuity after completing five years of continuous service with the same employer. The five-year condition is waived if the employee's service ends due to death or disablement caused by accident or disease. In the case of death, gratuity is paid to the nominee or legal heir.

Gratuity is part of the employee's total compensation and is often shown as a line item in the CTC, even though it is paid only at the time of exit and is not accessible during regular employment.

How gratuity is calculated

For employees covered under the Payment of Gratuity Act, gratuity is computed using a fixed formula:

Gratuity = (Last drawn Basic + Dearness Allowance) × 15 / 26 × Number of years of service

The factor 15/26 represents 15 days of wages for every completed year of service, treating 26 as the number of working days in a month. Service beyond six months in the final year is rounded up to a full year; less than six months is ignored.

For example, an employee with:

• Last drawn Basic + DA: ₹50,000
• Years of service: 8 years 7 months (rounded up to 9 years)

Gratuity = 50,000 × 15 / 26 × 9 = ₹2,59,615 (approximately).

The maximum gratuity that is exempt from income tax is ₹20 lakh — anything above this limit is taxable as salary income. For employees not covered under the Act (typically those in establishments with fewer than 10 employees), the formula uses 15/30 instead of 15/26.

Why it matters for Indian businesses

Gratuity is a meaningful long-term liability on the employer's books. Indian accounting standards (Ind AS 19 / AS 15) require companies to recognise gratuity as a defined benefit obligation, with periodic actuarial valuation. Many employers fund this liability through an approved gratuity trust or a group gratuity scheme with LIC or another insurer.

Operationally, employers must compute and disburse gratuity within 30 days of it becoming payable, failing which simple interest is payable. Accurate tracking of date of joining, last drawn Basic + DA and nomination details in the HRMS is essential to avoid disputes and statutory penalties at the time of separation.

Related terms

Gratuity vs PF: The Provident Fund is a monthly contribution by both employer and employee that accumulates with interest and is available at retirement or earlier withdrawal. Gratuity is a one-time, employer-funded payment based on service length, payable only after five years.

Gratuity vs Leave Encashment: Leave encashment is payment for unused earned leave at the time of exit, separate from gratuity. Both are part of full-and-final settlement.

Gratuity vs Superannuation: Superannuation is an optional pension scheme funded by the employer. Gratuity is mandatory under the Payment of Gratuity Act once the eligibility conditions are met.

Frequently asked questions

What is the minimum service required for gratuity?

Five years of continuous service with the same employer. This requirement is waived if service ends due to death or disablement caused by accident or disease.

What is the maximum tax-free gratuity in India?

₹20 lakh is the current tax-exempt cap under Section 10(10) of the Income Tax Act. Any gratuity received above this amount is taxable as salary.

Is gratuity part of CTC?

Many employers include the annual gratuity accrual (Basic × 15/26 × 1/12 per month, roughly 4.81% of Basic per year) as a line item in the CTC. It is, however, payable only at the time of exit and only if the employee completes five years.

Within how many days must gratuity be paid?

The employer must pay gratuity within 30 days from the date it becomes payable. Delay attracts simple interest at the rate notified by the Central Government.

Is gratuity payable if the employee resigns before 5 years?

Generally no, except in the case of death or disablement. Some employers offer ex-gratia gratuity-like payments as a goodwill gesture, but this is not a statutory right.

How is gratuity calculated for employees not covered by the Act?

For uncovered employees, the formula is (Last drawn Basic + DA) × 15 / 30 × years of service, and the tax exemption is the least of the actual gratuity, ₹20 lakh, or half-month average salary for each year of completed service.