How is gratuity calculated for employees under the Payment of Gratuity Act?

Key Takeaways

1. Gratuity = (15 × Last Drawn Salary × Years of Service) ÷ 26.
2. ₹20 lakh cap: Tax-free and mandatory for all eligible employees.
3. Track tenure meticulously—rounding errors can lead to underpayment.
4. Wisemonk’s EOR services ensure 100% compliance with India’s gratuity laws.

At Wisemonk, we’ve helped hundreds of global employers navigate India’s gratuity calculations while ensuring full compliance with the Payment of Gratuity Act, 1972. Below, we break down the formula, eligibility criteria, and practical examples to simplify this critical statutory obligation.

1. Legal Framework: Who Is Covered?

The Payment of Gratuity Act applies to:

• Organizations with 10 or more employees (including part-time, contractual, and remote workers).
• Employees who complete 5+ years of continuous service (exceptions apply for death/disability).

In our experience, international employers often overlook two key aspects:

1. Continuous service includes periods of leave, layoffs, or transfers.
2. The Act covers all industries, including IT, manufacturing, and startups.

2. Gratuity Calculation Formula

The formula for employees covered under the Act is:
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Gratuity = (15 × Last Drawn Salary × Years of Service) ÷ 26

Breaking Down the Components

Example 1:

• Last drawn salary (Basic + DA): ₹80,000
• Tenure: 10 years 4 months (rounded to 10 years)
• Gratuity = (15 × 80,000 × 10) ÷ 26 = ₹4,61,538

Example 2:

• Last drawn salary: ₹1,20,000
• Tenure: 25 years 7 months (rounded to 26 years)
• Gratuity = (15 × 1,20,000 × 26) ÷ 26 = ₹18,00,000

3. Key Exceptions and Limits

A. Maximum Gratuity Cap

• ₹20 lakh (revised in 2024): Even if the calculated amount exceeds this, employers only pay ₹20 lakh.
  Example: A calculation of ₹22 lakh would result in a payout of ₹20 lakh.

B. Tax Exemption

• Gratuity up to ₹20 lakh is tax-free under Section 10(10) of the Income Tax Act.

C. Death/Disability Cases

• No 5-year requirement: Full gratuity is paid even if the employee dies or becomes disabled.
• Calculation:
  • <1 year of service: 2× basic salary.
  • 1–5 years: 6× basic salary.

4. Common Pitfalls & Compliance Risks

A. Salary Misclassification

• Error: Including HRA or bonuses in the "last drawn salary."
• Risk: Underpayment penalties (up to ₹20,000 + interest).

B. Tenure Miscalculations

• Error: Ignoring fractional years (e.g., 4 years 7 months ≠ 5 years).
• Solution: Use exact months: 4 years 7 months = 4.58 years.

C. Delayed Payments

• Penalty: 10% annual interest on overdue amounts + legal action under Section 9 of the Act.

5. Step-by-Step Calculation Process

Step 1: Verify eligibility (5+ years of service).
Step 2: Calculate last drawn salary (Basic + DA).
Step 3: Determine exact tenure (round up if >6 months).
Step 4: Apply the formula and cap at ₹20 lakh.

Case Study:
An employee with ₹1,00,000 (Basic + DA) and 12 years of service:

• Gratuity = (15 × 1,00,000 × 12) ÷ 26 = ₹6,92,308 (but capped at ₹20 lakh).
• Outcome: Employer pays ₹20 lakh (tax-free).

6. How Wisemonk Simplifies Gratuity Compliance

We help global employers avoid costly errors through:

1. Automated Calculations: Our platform auto-computes gratuity using real-time salary data.
2. Tenure Tracking: Integrates with attendance systems to track service periods accurately.
3. Tax Optimization: Ensure gratuity stays within the ₹20 lakh tax-exempt threshold.
4. Dispute Resolution: Handle employee grievances and EPFO audits on your behalf.

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