Gratuity is one of those statutory benefits that looks simple on paper until an employee actually questions it. Most HR professionals know the five-year rule. Fewer know what happens at four years and eight months. The answer has real consequences – get it wrong and you either deny someone a legal entitlement or walk into an unplanned liability. This guide covers the gratuity calculation formula in India, who qualifies, what the Payment of Gratuity Act 1972 says about continuous service, and the operational mistakes that trip up HR and payroll teams most often.
What Is Gratuity?
Gratuity is a statutory lump-sum payment made by an employer to an employee in recognition of long-term service. It is governed by the Payment of Gratuity Act, 1972, which applies to all establishments – factories, mines, plantations, shops, or otherwise — with 10 or more employees. Once an establishment crosses that threshold, the Act applies permanently, even if headcount later drops below 10.
Gratuity becomes payable when an employee exits due to retirement, resignation after completing the minimum service period, death (paid to the nominee or heir), or permanent disablement caused by accident or illness.
It is an employer obligation — not a deduction from the employee’s pay. The employee contributes nothing toward it. The liability accrues on the employer’s books from the first day of employment.
Gratuity Eligibility: The 5-Year Rule and the 240-Day Exception
The Standard Rule
Under Section 4(1) of the Payment of Gratuity Act, gratuity is payable after completing five years of continuous service with the same employer.
The 4 Years + 240 Days Rule
This is where most disputes arise. The Act does not define what “completing” five years means when an employee leaves mid-year. Courts have stepped in to fill that gap.
Section 2A of the Act defines “continuous service” – and specifies that working 240 days in a given year of service counts as completing that year. Multiple High Courts have applied this to gratuity eligibility: if an employee completes 240 actual working days in their fifth year of service, they are deemed to have completed five years, even if the calendar total is only four years and eight months.
Based on statutory provisions and judicial precedents, rigid denial of gratuity on the grounds of “not completing five calendar years” may be legally untenable. Labour authorities are likely to rule in favour of the employee if 240 days in the fifth year can be demonstrated. Until a contrary decision is rendered by the Supreme Court, the 240-day principle remains settled and enforceable law guiding gratuity payments across India. Nkrlaw
The 240-day count includes Sundays, public holidays, paid leave, and weekly offs — it is not restricted to days physically worked.
One important caveat: the five-year minimum is waived entirely in cases of death or permanent disablement. Gratuity is payable regardless of tenure in those situations.
Gratuity Calculation Formula in India
For Employers Covered Under the Payment of Gratuity Act
Gratuity = (Last Drawn Basic Salary + DA) × 15/26 × Completed Years of Service
The 15/26 factor means 15 days of wages per year of service, with 26 representing the working days in a month – not 30 calendar days. Using 30 as the denominator (a common error) understates the gratuity amount.
Rounding service years: if an employee completes six years and seven months, it rounds up to seven years. Six years and five months rounds down to six. Anything beyond six months in the final year counts as a full year.
Worked example: Last drawn basic + DA = ₹45,000 | Completed service = 9 years Gratuity = ₹45,000 × 15/26 × 9 = ₹2,33,173
For Employers NOT Covered Under the Act
The formula changes slightly:
Gratuity = (Last Drawn Basic + DA + Sales Commission) × 15/30 × Completed Years
Here the denominator is 30 (not 26), and service is counted in fully completed years only — no rounding up.
Maximum Gratuity Payable
The statutory ceiling for private sector employees is ₹20 lakh. Any amount paid above this is treated as ex-gratia, not gratuity under the Act. For Central Government employees, the ceiling is ₹25 lakh.
Is Gratuity Deducted From Salary?
No — and this is one of the most persistent misconceptions among employees and, surprisingly, some HR teams.
Gratuity is entirely employer-funded. Whether or not the company maintains a dedicated gratuity fund, the legal obligation exists the moment an employee meets the eligibility criteria. An employee who completes five years (or four years and 240 working days) is entitled to gratuity regardless of whether the company has provisioned for it internally.
Gratuity is often shown as a line item in CTC, typically calculated at 4.81% of basic salary – derived from (15/26 × 1/12 × basic). This is a disclosure of employer cost, not a deduction from the employee’s take-home.
Tax Treatment of Gratuity
For private sector employees covered by the Act, the amount exempt from income tax is the least of three figures: the actual gratuity received, 15 days’ salary for each completed year of service, or ₹20 lakh. Any amount above the applicable exemption limit is taxable as income in the year of receipt.
Government employees — central, state, defence, and local authority — receive full tax exemption on gratuity with no ceiling.
Under the new tax regime (from FY 2024–25), gratuity up to ₹5 lakh is also exempt for eligible employees.
CTC Design and the Basic Salary Problem
Since gratuity calculation formula in India is based on basic + DA, companies that suppress the basic component of CTC — a practice used to reduce PF and gratuity liabilities — carry a structural compliance risk. The new Labour Codes require basic wages to constitute at least 50% of total CTC. As basic salary increases, gratuity liability increases proportionally. This needs to be modelled into headcount cost planning, not treated as a back-of-the-envelope adjustment at the time of separation.
Three Operational Mistakes HR and Payroll Teams Make
1. Tracking tenure by calendar dates, not working days
The 240-day rule requires knowing how many days an employee actually worked in their fifth year — not just their joining and leaving dates. Absences, leaves, and layoffs all affect this count. Payroll systems that compute tenure purely from calendar dates will misfire on eligibility for employees near the threshold.
2. Calculating gratuity on gross salary
Gratuity is based on basic + DA only. Bonuses, HRA, conveyance, and other allowances are excluded. Many payroll configurations default to gross unless explicitly adjusted, leading to overstated or understated amounts — both create problems, either at payout or during audits.
3. Not provisioning for gratuity
The Act requires establishments with 10+ employees to maintain a gratuity fund or take out an approved group gratuity insurance policy. Startups and mid-stage companies that skip this treat gratuity as a future cash outflow — which creates concentration risk when multiple long-tenured employees leave in the same period. The liability isn’t just the amount; it’s the timing.
Quick Reference Table
| Parameter | Rule |
|---|---|
| Minimum service (general) | 5 years continuous service |
| Minimum service (edge case) | 4 years + 240 working days in year 5 |
| Minimum service (death/disability) | No minimum |
| Formula (covered employers) | (Basic + DA) × 15/26 × years |
| Formula (non-covered employers) | (Basic + DA) × 15/30 × years |
| Maximum amount (private sector) | ₹20 lakh |
| Maximum amount (Central Govt) | ₹25 lakh |
| Who funds it | Employer only |
| Tax exemption (private, covered) | Least of: actual, 15 days/year formula, ₹20 lakh |
| Applicability threshold | 10+ employees |
Frequently Asked Questions
Is gratuity payable after 4 years of service? Generally no. But if an employee completes 240 working days in their fifth year, multiple High Court rulings and the plain reading of Section 2A support eligibility.
Is gratuity calculated on basic salary or gross salary? Basic salary + Dearness Allowance only. HRA, bonuses, and other allowances are excluded.
What if the company has no gratuity fund? The liability still exists. The employer must pay the due amount within 30 days of it becoming payable, from available operating funds.
Can gratuity be forfeited? In limited circumstances — willful misconduct causing damage to property, or specific offences under the Act. Routine resignation or retirement doesn’t affect entitlement.
Does gratuity apply to contract employees? If a contract employee works directly on the establishment’s payroll and completes the minimum service, yes. Third-party contractors on a vendor’s rolls follow the contractor’s own gratuity obligations.
Gratuity calculation gets complicated exactly at the moments that matter most — employee separations, payroll audits, and workforce restructuring. Having accurate tenure data, a correctly configured payroll system, and clear provisioning in place from the beginning is far less expensive than resolving disputes or funding unexpected liabilities at the back end.
