Gratuity: rules, calculation and the liability employers forget

Gratuity is unusual among Indian statutory obligations in that it accrues silently for years and is paid in a lump sum at exit. That combination produces two recurring problems: employers who have never quantified the accrued liability, and employers who withhold payment at exit for reasons that will not stand.

When gratuity applies

The Payment of Gratuity Act, 1972 generally applies to factories, mines, oilfields, plantations, ports, railways, shops and establishments employing ten or more persons, and continues to apply once it has applied.

As with provident fund, coverage is sticky. An establishment that crossed ten employees and later contracted does not fall out.

The qualifying period

The general rule is five years of continuous service.

The important exceptions:

• Death or disablement. Where employment ends because of death or disablement, gratuity is payable regardless of length of service. In the case of death it is paid to the nominee or legal heir.
• Continuous service includes periods of authorised leave, lay-off, and other interruptions that do not break continuity. An employee who was on extended approved leave has not necessarily broken their service.

There has been litigation on how the five years is computed where an employee has served four years and a substantial part of the fifth, with differing views taken in different jurisdictions. Where an employee is close to the threshold, it is worth confirming the position that applies rather than assuming a strict five-year cut-off.

Calculation

For employees covered by the Act:

Gratuity = Last drawn wages × 15 ÷ 26 × completed years of service

Where:

• Last drawn wages generally means basic plus dearness allowance — not gross salary
• 15/26 represents fifteen days’ wages per completed year, treating a month as twenty-six working days
• Completed years — a fraction beyond six months in the final year is conventionally rounded up to a full year

A statutory ceiling applies to the amount payable under the Act — long standing at ₹20 lakh. An employer may pay more contractually; the ceiling limits the statutory entitlement, not generosity.

For employees not covered by the Act but entitled contractually, the basis is whatever the contract or policy states, which is frequently more generous and occasionally much less clear than the employer realises.

Ceilings and formulas are revised from time to time. Confirm the current position.

The liability employers forget

This is the practical heart of the matter.

Gratuity accrues from the first day of service, but is paid years later. An employer with two hundred employees averaging four years of service is carrying a real, quantifiable liability — and a great many Indian companies have never calculated it, never provided for it in their accounts, and have no funding arrangement behind it.

The consequences show up in three places:

Cash flow at exit. A senior employee leaving after fifteen years produces a payment that was never budgeted for.

Due diligence. People-side diligence for an investor or acquirer will look for the accrued gratuity liability. Finding it unquantified and unfunded is a straightforward valuation adjustment, and it is one of the most common findings in HR due diligence.

Audit. Actuarial valuation of the liability is expected in the accounts of companies of a certain size, and the absence of one is visible.

Employers can fund the liability through a gratuity trust or an insurer-managed scheme. Whether to fund is a finance decision. Whether to quantify is not — you are carrying the liability regardless of whether you have measured it.

Forfeiture — narrower than employers assume

Gratuity may be forfeited only in defined circumstances:

• Where termination is for wilful omission or negligence causing damage or loss to the employer — and then only to the extent of the damage
• Where termination is for riotous or disorderly conduct, or any act of violence
• Where termination is for an offence involving moral turpitude committed in the course of employment

Two points employers get wrong:

Forfeiture requires the termination to be for that reason. You cannot dismiss for one reason and forfeit for another discovered later.

Everything else is not a ground. Not serving notice, leaving to join a competitor, failing to complete handover, or an outstanding dispute over company property are not grounds for forfeiture. Employers routinely withhold gratuity as leverage in exactly these situations, and the position does not hold.

Where there is a genuine recoverable amount, the answer is to pursue it as a recovery, not to withhold a statutory entitlement.

Payment timing

Gratuity becomes payable on termination of employment and must be paid within a short prescribed period — conventionally thirty days. Delay beyond that attracts interest.

The common pattern is that gratuity is held pending “completion of formalities” — clearance from IT, handover, return of assets — and the formalities take three months because nobody is driving them. Where that delay is the employer’s, the interest exposure is the employer’s too.

Nomination

Employees should file a nomination, and employers should collect it at joining rather than at exit. Where an employee dies without a valid nomination on file, payment to legal heirs becomes considerably more complicated for the family at the worst possible moment. This is a five-minute administrative step that employers routinely skip.

Practical checks

• Have we calculated our total accrued gratuity liability?
• Is it provided for in our accounts, and is it funded?
• Do we have a current nomination on file for every employee?
• Is anyone approaching five years whose position we should confirm?
• Have we withheld gratuity from any leaver, and on what basis?
• Are we paying within thirty days, and where we are not, whose delay is it?

The first question is the one that matters most, and in my experience most companies below a few hundred employees cannot answer it.