Gratuity Rules Explained: Eligibility, Calculation, and Tax Treatment

Gratuity often sits quietly in a payslip's CTC breakup for years without anyone thinking much about it — until an employee actually resigns or retires, and HR has to work out exactly how much is owed, whether the person even qualifies, and how much of it is taxable. Unlike PF or ESI, nothing is deducted from the employee's salary each month to fund it; gratuity is entirely employer-funded, and it runs on its own eligibility rule, its own formula, and its own tax exemption — getting any one of the three wrong is a common and expensive mistake.

Who Is Covered, and the Five-Year Rule

The Payment of Gratuity Act, 1972 applies to factories, shops, establishments, and a range of other notified workplaces once they employ 10 or more people on any day in the preceding twelve months — and, much like PF, coverage continues even if headcount later falls below that number. Within a covered establishment, the standard eligibility rule is five years of continuous service: an employee who resigns, retires, or is terminated for reasons other than misconduct before completing five years generally has no statutory claim to gratuity at all. 'Continuous service' has a specific meaning under the Act rather than a plain-English one — an employee who has worked 240 days in a year (190 days for certain below-ground or less-than-six-day-a-week roles) is typically treated as having completed a full year of continuous service for that year, which matters most for employees approaching the five-year mark.

• Death of the employee — gratuity is payable to the nominee or legal heir regardless of how long the employee had served
• Disablement due to accident or disease that ends the employee's ability to continue working — the five-year requirement is waived on the same basis as death
• Beyond these two situations, the five-year rule is applied strictly, including in most resignation cases

How Gratuity Is Calculated

For employees covered under the Act, the formula is: (15 ÷ 26) × last drawn monthly salary (basic pay plus dearness allowance) × number of completed years of service, with any period beyond six months in the final year rounded up to a full year. The 26 represents assumed working days in a month and the 15 represents 15 days' wages for each completed year — so, for example, an employee who exits after 12 years and 8 months of service (rounded up to 13 years) with a last-drawn basic-plus-DA of ₹60,000 a month would work out to (15/26) × 60,000 × 13, which comes to exactly ₹4.5 lakh. Employees at establishments not covered under the Act are typically paid gratuity under a different, employer-defined formula — commonly using 30 days instead of 26 as the divisor, and completed years without the six-month rounding benefit — so identical tenure and salary can produce a meaningfully different number depending on which formula applies. Seasonal establishments follow their own rule again: seven days' wages for each season worked, rather than a per-year calculation.

Tax Treatment Under Section 10(10)

Gratuity received by a government employee is fully exempt from income tax, with no upper limit. For employees in the private sector covered under the Payment of Gratuity Act, the exemption under Section 10(10) is the least of three amounts: the gratuity actually received, the amount worked out under the Act's (15/26) formula, and the statutory exemption ceiling — currently ₹20 lakh, counted cumulatively across an employee's entire working life, not per employer. For private-sector employees not covered under the Act, the same 'least of three' logic applies, but the middle figure is computed using a half-month-average-salary formula instead of the Act's formula. Anything received above the exempt amount is taxed as salary income in the year of receipt. Because this ceiling is revised by the government from time to time — it was last raised from ₹10 lakh a few years ago — employers and employees should confirm the prevailing limit at the time of payout rather than assume an older figure still holds. Gratuity paid to a nominee or legal heir on an employee's death is treated as fully exempt, independent of these limits.

Resignation vs Retirement vs Death: What Actually Changes

It's easy to assume that how an employee leaves changes how gratuity is taxed — in reality, it mostly changes whether gratuity is payable at all. Resignation and retirement are treated identically for tax purposes once eligibility is met: the same Section 10(10) exemption formula applies either way. What resignation actually risks is eligibility, not taxation — resign at four years and eleven months, short of the 240-day rule pushing it to a full fifth year, and the statutory entitlement is typically nil; whatever the employer chooses to pay instead would usually be treated as an ex-gratia payment taxed differently, not as exempt gratuity. Death removes the eligibility condition entirely, as does qualifying disablement. Termination is its own separate track: the Act allows an employer to forfeit gratuity, in whole or in part, if the termination follows an employee's act of willful damage or loss to company property, or riotous or disorderly conduct, or an offence involving moral turpitude committed during employment — forfeiture on an ordinary performance-related termination is not permitted. For employers, the practical discipline is the same regardless of exit type: confirm completed years of continuous service accurately, apply the correct formula for whether the establishment is covered under the Act, and check the current exemption ceiling before treating any part of the payout as tax-free.