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What is Gratuity? Definition & Guide

Last updated 3 June 2026

Definition

Gratuity is a lump-sum monetary benefit paid by an employer to an employee as a reward for long-term service upon separation from employment. Governed by the Payment of Gratuity Act, 1972, it becomes payable when an employee completes five or more years of continuous service. The benefit applies to establishments with 10 or more employees.

Detailed Explanation

Gratuity is a critical component of employee compensation in India, serving as both a retention tool and a retirement benefit. The Payment of Gratuity Act, 1972 applies to factories, mines, oilfields, plantations, ports, railway companies, shops, and other establishments employing 10 or more persons. Once the Act becomes applicable to an establishment, it continues to apply even if employee strength falls below 10.

The standard gratuity calculation formula is: Gratuity = (Last drawn salary x 15 x Number of years of service) / 26. Here, “last drawn salary” includes basic pay plus dearness allowance. Service exceeding six months in the final year is rounded up to one full year. The maximum gratuity payable under the Act is INR 20,00,000 (twenty lakh rupees), though employers may pay more as a contractual obligation.

Gratuity becomes payable on superannuation, retirement, resignation after five years of service, death (no minimum service required), or disablement due to accident or disease (no minimum service required). In cases of death, the gratuity amount is paid to the nominee or legal heir. Employers can forfeit gratuity partially or fully if the termination is due to moral turpitude or violent conduct proven through disciplinary proceedings.

Organizations must account for gratuity liability in their financial statements as per Accounting Standard 15 (AS 15) or Indian Accounting Standard 19 (Ind AS 19). Many companies fund gratuity through group gratuity schemes with insurance companies or through an approved gratuity trust.

  • Applicable to establishments with 10 or more employees at any point
  • Employee must complete 5 years of continuous service (except in case of death or disability)
  • Maximum gratuity payable is INR 20,00,000 under the Act
  • Gratuity must be paid within 30 days of it becoming due; delay attracts interest
  • Employer can insure gratuity liability through LIC or other approved insurers
  • Gratuity is tax-exempt up to INR 20,00,000 for employees covered under the Act
  • Nomination must be obtained from every employee within prescribed timelines

How TMS Helps

TMS manages gratuity compliance for all contract and payroll employees, including liability computation, actuarial valuation coordination, and timely payment upon separation. Our systems track service tenure accurately across employment periods, ensuring correct gratuity calculation. We also assist clients in setting up gratuity trusts and insurance policies for provisioning.

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What changed for gratuity under the Labour Codes (2026 position)

The Code on Social Security, 2020 — in force since 21 November 2025 — carries the gratuity framework of the Payment of Gratuity Act forward, but with two changes every employer should have already actioned.

First, fixed-term employees now earn gratuity on a pro-rata basis after completing one year of continuous service, instead of waiting for the five-year mark that continues to apply to regular employees. If your workforce includes fixed-term contracts — common in projects, seasonal operations and contract-heavy sectors — your gratuity liability now begins accruing in year one, and each contract renewal extends it. Employers using fixed-term or contract staffing arrangements should re-run their liability provisioning on this basis.

Second, the Codes introduce a uniform statutory definition of wages that governs the base on which gratuity is computed. Because the definition requires a minimum share of total remuneration to be treated as wages, salary structures that historically kept the basic component low now produce a larger gratuity base — and a larger accrued liability — than the old structure suggested. The calculation formula itself is unchanged; what changes is the number you feed into it. To see the effect on a real salary, use the TMS gratuity calculator, which is maintained against positions verified by the TMS compliance team.

Gratuity in your salary structure: is it part of CTC?

A question employees and finance teams ask constantly: if gratuity only pays out after years of service, why does it appear in the CTC? The answer is that gratuity is a deferred employer cost, not a monthly payment. Many companies include the annual accrual (roughly 4.8 per cent of basic salary, derived from the 15/26 formula over twelve months) as a CTC line item because it is a genuine cost the employer must provision for. It is never deducted from the employee's salary — a common misconception — and it does not reduce monthly take-home pay. The CTC to take-home calculator shows how much of any package is deferred versus paid in hand, before an offer is signed.

When gratuity becomes payable: a quick reference

Separation eventMinimum service requiredWho receives payment
Resignation5 years (regular employees)Employee
Retirement / superannuation5 years (regular employees)Employee
End of fixed-term contract1 year, pro-rata (under the Code on Social Security)Employee
Death in serviceNo minimum serviceNominee or legal heir
Disablement due to accident or diseaseNo minimum serviceEmployee

In every case the employer must pay within 30 days of gratuity becoming due; delayed payment attracts interest. Treat the 30-day clock as part of your exit process, not an afterthought.

What is a gratuity fund, and should your company set one up?

A gratuity fund is a dedicated pool an employer builds to meet future gratuity payouts rather than paying them out of working capital as they arise. In practice, Indian employers fund gratuity in one of three ways: a group gratuity scheme with an insurer, an approved gratuity trust managed by trustees, or unfunded book provisioning backed by actuarial valuation. Funded routes carry two advantages — payouts do not strain cash flow in a heavy-attrition year, and contributions to an approved fund enjoy favourable tax treatment for the employer. For companies past roughly a hundred employees, an unfunded liability quietly compounding on the balance sheet is one of the most common findings in due-diligence exercises. TMS advises clients on provisioning approach and coordinates actuarial valuations as part of our statutory compliance engagements.

Frequently asked questions

What is gratuity in salary?

Gratuity is a lump-sum amount an employer pays an employee for long service, at the time of leaving the organisation. When it appears in a salary structure or CTC, it represents the employer's annual provision for that future payout — it is not deducted from the employee's pay and is never received monthly.

What does gratuity meaning actually cover — is it a tip?

In everyday English "gratuity" can mean a tip, but in Indian employment law it is a statutory retirement and long-service benefit governed by the Payment of Gratuity Act, 1972, now subsumed within the Code on Social Security, 2020. Employers covered by the law must pay it; it is a legal entitlement, not a discretionary reward.

What is a gratuity fund?

A gratuity fund is money an employer sets aside — through an insurer-managed group scheme or an approved trust — to pay future gratuity claims. It converts an unpredictable balance-sheet liability into a planned, tax-efficient contribution, and ensures employees are paid on time even in years of high attrition.

Do fixed-term employees get gratuity before five years?

Yes. Under the Code on Social Security, fixed-term employees are entitled to gratuity on a pro-rata basis once they complete one year of continuous service. The five-year qualifying period continues to apply to regular, open-ended employment.

How is gratuity calculated on the new wage definition?

The formula remains last drawn wages × 15/26 × completed years of service, but "wages" now follows the uniform definition in the Labour Codes, which generally enlarges the base for structures with a low basic component. Run your figures through the calculator linked above for a current estimate.

Need gratuity liability assessed, funded or administered for your workforce? Talk to the TMS compliance team.

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