Gratuity in India: eligibility, formula, tax and worked examples

Gratuity is a lump-sum reward for long service, and one of the larger numbers in any full and final settlement. It is governed by the Payment of Gratuity Act, 1972. Because it is paid at exit and taxed with its own exemption rules, both HR and finance need to understand exactly how it is computed.

What gratuity is and who must pay it

Gratuity is a statutory benefit an employer pays an employee for continuous service. The Payment of Gratuity Act applies to factories, mines, plantations, shops and establishments employing 10 or more people. Once the Act applies to an establishment, it continues to apply even if the headcount later falls.

Who is eligible

An employee becomes eligible for gratuity after completing five years of continuous service with the same employer. The five-year condition is waived where employment ends because of death or disablement, in which case gratuity is payable regardless of tenure.

"Continuous service" has a specific meaning and includes periods of authorised leave, so it is not simply days physically present.

The formula for covered establishments

For an establishment covered by the Act, gratuity is:

Gratuity = (15 × last drawn salary × years of service) ÷ 26

Where:

• "Last drawn salary" means Basic salary plus Dearness Allowance.
• 26 represents the number of working days in a month.
• 15 represents 15 days of wages for each completed year.

A key rounding rule: any part of a year beyond six months counts as a full year. So 7 years and 8 months is treated as 8 years, while 7 years and 4 months is treated as 7 years.

Worked example

Take an employee with a last drawn Basic + DA of ₹60,000 and 8 completed years of service.

Step	Calculation	Value
Numerator	15 × 60,000 × 8	72,00,000
Divide by 26	72,00,000 ÷ 26	₹2,76,923

So the gratuity payable is ₹2,76,923.

Now take the same salary but 12 years and 7 months of service. The service rounds up to 13 years:

Step	Calculation	Value
Numerator	15 × 60,000 × 13	1,17,00,000
Divide by 26	1,17,00,000 ÷ 26	₹4,50,000

The statutory cap

The maximum gratuity payable under the Act is ₹20,00,000. Even if the formula produces more, the amount payable under the Act is capped at this figure. Employers may pay more voluntarily, but anything above the exemption limit is taxable.

How gratuity is taxed

Gratuity enjoys an exemption under Section 10(10) of the Income Tax Act. For employees covered by the Payment of Gratuity Act, the exempt amount is the least of:

1. The actual gratuity received.
2. ₹20,00,000.
3. The formula amount (15 × last drawn salary × years ÷ 26).

Any gratuity above the exempt amount is added to income and taxed. Government employees have a fuller exemption.

Common mistakes to avoid

• Using gross salary instead of Basic + DA in the formula.
• Ignoring the six-month rounding rule for the final part-year.
• Forgetting the ₹20 lakh cap for a very long-service, high-salary employee.
• Applying the wrong exemption when computing TDS on the settlement.

Frequently asked questions

Is gratuity payable if someone resigns before five years? Generally no, unless service ended due to death or disablement.

Does notice period count toward service? Yes, service continues until the last working day, including served notice.

Can an employer forfeit gratuity? Only in limited circumstances involving misconduct, under the Act's specific provisions.

Key takeaways

• Gratuity is payable after five years of continuous service (waived for death or disablement).
• The formula is 15 × last salary × years ÷ 26, with the final part-year rounded at six months.
• The statutory maximum is ₹20,00,000.
• Exemption under Section 10(10) is the least of the actual amount, ₹20 lakh, and the formula amount.

NeevHR accrues gratuity over the employment and computes it in the full and final settlement, applies the Section 10(10) exemption, and shows the net amount in words for the relieving documents.