Gratuity Calculation, Tax & Accounting: Complete Guide 2026

Gratuity is one of the most consistently mismanaged statutory obligations in Indian payroll. Businesses calculate it on gross salary when they should use basic pay plus dearness allowance. They provision nothing year over year, then scramble when a long-serving employee resigns. Their accountant treats the payment as an expense in the year it is paid — which is fine for tax but not for financial statements under AS-15. And when it comes to the ₹20 lakh tax exemption, both employer and employee routinely claim the wrong figure.

This guide covers the Payment of Gratuity Act, 1972 from first principles: who qualifies, how to calculate the amount correctly, what is and is not taxable in the employee''s hands, how the employer takes a deduction, and how to provision for gratuity liability on your books. Examples use real rupee figures throughout.

Who Qualifies for Gratuity

The Payment of Gratuity Act, 1972 applies to factories, mines, oilfields, plantations, ports, and railway companies, as well as every establishment with 10 or more employees at any point during the financial year. Once the Act applies, it continues to apply even if headcount later falls below 10.

An employee qualifies for gratuity if they have completed five years of continuous service with the same employer. The minimum service requirement is waived in cases of death or permanent total disablement — gratuity becomes payable regardless of years worked.

"Continuous service" is defined under Section 2A of the Act. It allows for breaks due to approved leave, strike, or lockout. An employee on maternity leave, sick leave, or an authorised absence does not lose continuity.

Gratuity must be paid within 30 days of it becoming payable. Late payment attracts simple interest at the government-notified rate of 10% per annum from the due date, and employees can enforce this through the Controlling Authority under the Act.

The Gratuity Calculation Formula

The formula under Section 4(2) of the Payment of Gratuity Act, 1972 is:

Gratuity = (Last drawn wages × 15) ÷ 26 × Completed years of service

The division by 26 represents the number of working days in a month (a 6-day week with four Sundays excluded). The multiplication by 15 gives you 15 days of wages per year of service.

What Counts as "Wages" for Gratuity

Wages for gratuity purposes means basic salary plus dearness allowance only. It excludes:

• House Rent Allowance (HRA)
• Overtime wages
• Bonus or commission
• Special allowances or any variable component

This exclusion is the single most common calculation error. If your payroll system calculates gratuity on Cost to Company (CTC) or gross salary, your gratuity figures are almost certainly overstated.

Practical Example 1 — Mid-Career Exit

An employee with a basic salary of ₹55,000 per month resigns after 18 years and 4 months of service.

• Completed years: 18 (4 months is less than 6 → round down to 18)
• Gratuity = (₹55,000 × 15) ÷ 26 × 18 = ₹8,25,000 ÷ 26 × 18 = ₹31,731 × 18 = ₹5,71,154

This is below the ₹20 lakh statutory ceiling, so the full formula amount is payable.

Practical Example 2 — Senior Employee, High Salary

An employee earning basic pay of ₹2,20,000 per month exits after 14 years and 8 months.

• Completed years: 15 (8 months is 6 or more → round up to 15)
• Gratuity = (₹2,20,000 × 15) ÷ 26 × 15 = ₹33,00,000 ÷ 26 × 15 = ₹1,26,923 × 15 = ₹19,03,846

Still under the ₹20 lakh cap — the full amount is payable. Now increase basic to ₹2,60,000 per month for the same 15 years: (₹2,60,000 × 15) ÷ 26 × 15 = ₹22,50,000, which exceeds the ₹20 lakh ceiling. The employer pays ₹20 lakh, not the formula amount.

The Part-Year Rule

For completed years of service, the Act applies a 6-month test on the final partial year:

• 6 months or more in the final partial year → treated as one full year
• Less than 6 months in the final partial year → disregarded entirely

This rule has a meaningful financial impact. For an employee earning ₹60,000 basic pay, the difference between rounding up versus rounding down is one additional year of gratuity — equal to ₹60,000 × 15 ÷ 26 = ₹34,615. Do not assume partial years are always lost.

For employees in establishments not covered by the Act — where the employer voluntarily pays gratuity — a different formula applies:

Gratuity (non-Act) = (Last drawn salary × 15) ÷ 30 × Completed years

Note the divisor shifts from 26 to 30, producing a lower per-day rate. Employees in covered establishments are better protected than those relying on voluntary gratuity schemes that use the non-Act formula.

Tax Exemption for Employees

Gratuity received by an employee is eligible for exemption under Section 10(10) of the Income Tax Act, 2025 (equivalent to the old Section 10(10) of the Income Tax Act, 1961). The exemption operates differently for three categories:

Government Employees

The entire gratuity received is exempt — no ceiling applies.

Non-Government Employees Covered Under the Payment of Gratuity Act

Exempt to the extent of the least of:

1. 1Actual gratuity received
2. 215 days'' salary for each completed year of service (same formula as above)
3. 3₹20 lakh (the current government-notified maximum)

Non-Government Employees NOT Covered Under the Act

Exempt to the extent of the least of:

1. 1Actual gratuity received
2. 2Half month''s average salary for each completed year of service
3. 3₹20 lakh

The half-month method (for non-covered employees) uses average salary of the last 10 months divided by 2, multiplied by years of service. This produces a lower ceiling than the 15/26 method for most employees.

The ₹20 lakh limit is a lifetime cumulative limit per individual, not per employer. If an employee received ₹7 lakh gratuity from a previous employer and claimed that as exempt, only ₹13 lakh remains available from the current employer — even if the formula entitlement is higher.

Tax Calculation Example

Using Example 1 (₹5,71,154 gratuity, 18 years, covered employee):

• 15-day salary ceiling = same as formula = ₹5,71,154
• ₹20 lakh cap: not triggered
• Least of three = ₹5,71,154 → entirely exempt. No tax for this employee.

Now suppose the employer negotiates a higher gratuity of ₹7,50,000 for the same employee:

• Exemption ceiling = ₹5,71,154
• Taxable gratuity = ₹7,50,000 − ₹5,71,154 = ₹1,78,846, added to total income and taxed at slab rates

Employer Tax Deduction

The employer''s tax deduction on gratuity depends on whether contributions flow through an approved gratuity fund.

Approved Group Gratuity Fund (e.g., LIC Group Gratuity Scheme)

Contributions to a government-approved gratuity fund are deductible in the year the contribution is made — under the equivalent of Section 36(1)(v) of the Income Tax Act, 2025. The deduction is limited to the actuarially determined contribution amount. This means your organisation gets a tax shield before the gratuity is paid, spreading the cost over multiple years.

Under an LIC Group Gratuity policy, you pay an annual premium computed by LIC based on your employee headcount, salary levels, and average tenure. This premium is the deductible amount. When an employee exits and gratuity is paid, LIC settles the claim against the policy — the employer''s bank account is not hit directly.

Self-Funded (No Approved Fund)

Where no approved fund exists, gratuity is deductible only when actually paid to the employee. A provision of ₹15 lakh on the balance sheet does not yield a tax deduction in that year. The deduction crystallises when the cash leaves the company.

This creates a deferred tax liability: your provision reduces accounting profit but not taxable income, until the year of payment. CAs managing self-funded gratuity need to track this temporary difference carefully for deferred tax computation under AS-22 (or Ind AS 12).

Accounting Treatment: Provisioning for Gratuity

Companies Applying AS-15 (Employee Benefits)

AS-15 requires companies to recognise a defined benefit obligation for gratuity using the projected unit credit method. An actuary computes the present value of all future gratuity obligations, discounting at the market yield on government bonds of a matching duration.

The accounting entries flow as follows:

Annual provisioning (actuarial assessment):

Dr. Employee Benefits Expense (P&L) [actuarial service cost]

Cr. Gratuity Liability (Balance Sheet)

Actuarial gain or loss:

Dr./Cr. Other Comprehensive Income / Reserves

Cr./Dr. Gratuity Liability

When payment is made:

Dr. Gratuity Liability (Balance Sheet)

Cr. Bank / Cash

If funded through LIC, the policy''s fair value appears as a Plan Asset on the balance sheet. The net defined benefit liability = Defined Benefit Obligation minus Plan Assets. Only the net figure is shown as a liability.

Smaller Businesses Not Required to Apply AS-15

If you are a small or medium company not mandated to apply the full AS-15 standard, a simplified provision-based approach is acceptable. Compute the gratuity entitlement as if all employees resigned on the balance sheet date, and recognise that as a long-term liability.

Example: A business has 30 employees with an average basic pay of ₹40,000 per month and average service of 7 years.

• Per-employee provision = (₹40,000 × 15 ÷ 26) × 7 = ₹23,077 × 7 = ₹1,61,538
• Total provision for 30 employees = ₹48,46,154

This goes to the balance sheet as a long-term liability. The year-on-year increase is charged to P&L as a payroll expense. While this approach does not capture future salary growth or employee turnover adjustments, it prevents the jarring lump-sum expense that hits companies with no provision when a senior employee exits.

Common Gratuity Mistakes to Avoid

Calculating on gross salary, not basic + DA. An employee earning ₹90,000 gross (₹45,000 basic, ₹25,000 HRA, ₹20,000 special allowance) has a gratuity base of ₹45,000, not ₹90,000. Using gross salary inflates the liability by 100% and overpays the employee beyond what the Act requires.

Ignoring the part-year rule. Treating 7 months as zero instead of rounding up to one full year can cost an employee 15 days of basic salary. At ₹60,000 basic, that is ₹34,615 — a meaningful shortfall in what the Act guarantees.

Not provisioning at all. Businesses that carry no gratuity provision are understating their liabilities. When three long-serving employees exit in the same financial year, the entire gratuity expense hits P&L in one shot, distorting that year''s profitability and potentially causing a significant cash flow crunch.

Confusing covered and non-covered employee exemption methods. The 15/26 method applies to Act-covered employees. The half-month average method applies to non-Act employees. Applying the wrong method either shortchanges the employee''s exemption or wrongly overclaims it on their ITR.

Missing the 30-day payment deadline. Courts have consistently upheld employees'' rights to 10% per annum interest on delayed gratuity. If you are disputing the gratuity amount, keep the undisputed portion ready for immediate payment — delay on the undisputed amount is always costly.

Not tracking lifetime exemption. If an employee joining you has prior gratuity receipts, their available ₹20 lakh exemption is reduced. Employers are not responsible for computing this, but your CA advising the employee on ITR needs to track it.

Key Takeaways

• Gratuity is calculated on basic salary + dearness allowance only — never on gross salary or CTC
• The formula is (Last drawn wages × 15) ÷ 26 × Completed years, capped at ₹20 lakh
• Part-years of 6 months or more round up to a full year; under 6 months are disregarded
• The ₹20 lakh tax exemption is a lifetime cumulative limit per employee — carry-forward from previous employers reduces the balance available
• Approved fund contributions (e.g., LIC Group Gratuity) are deductible when paid to the fund; self-funded gratuity is only deductible when paid to the employee
• Companies applying AS-15 must recognise an actuarial defined benefit obligation — a formula-based provision is a simplification, not a substitute