Gratuity Calculation 2026: New 1-Year Rule for Fixed-Term Employees Explained

A contract employee who worked for 18 months at a logistics company in Noida resigned in January 2026. Under the old rules, she would receive zero gratuity - she had not completed 5 years. Under the new Labour Codes, she is entitled to pro-rata gratuity for 1.5 years of service. The company had not provisioned for this. The gratuity amount was Rs 12,981. Small for a single employee - but multiply that by 200 contract workers, and the employer faces a Rs 26 lakh unprovisioned liability.

The new 1-year gratuity rule for fixed-term employees is one of the most impactful changes under the Code on Social Security 2020. Combined with the 50% basic wage rule (which increases the gratuity calculation base), employers face a 25-50% increase in gratuity liabilities.

This guide explains who is eligible for gratuity in 2026, the exact calculation formula, how the 1-year FTE rule works, the impact of the 50% wage base, tax treatment, employer obligations, and the accounting impact under Ind AS 19.

What Is Gratuity and Why Does It Matter?

Gratuity is a statutory lump-sum payment made by an employer to an employee as a reward for long-term service, governed by the Payment of Gratuity Act 1972 and now enhanced by the Code on Social Security 2020. It is payable on resignation, retirement, superannuation, death, or disablement.

Under Section 4(2), gratuity is calculated as 15 days' wages for every completed year of service, divided by 26 (working days in a month). The Act applies to every factory, mine, oilfield, plantation, port, railway, shop, or establishment employing 10 or more persons. Once covered, the establishment remains covered even if the employee count drops below 10.

Employers using gratuity calculation and compliance services can ensure accurate provisioning under both the old Act and the new Code, timely payment within 30 days, and correct tax treatment for each employee.

Key Terms You Should Know

• Fixed-Term Employee (FTE): An employee hired for a specific period under a written contract. Under the Code on Social Security 2020, FTEs are entitled to the same wages and benefits as permanent employees, including pro-rata gratuity after 1 year.
• Last Drawn Wages: The salary used for gratuity calculation - basic pay + dearness allowance. Under the 50% wage rule, this base has increased for most employees because basic must now be at least 50% of total remuneration.
• Completed Years of Service: Full years of continuous employment. If service in the final year exceeds 6 months, it is rounded up to the next full year. For example, 7 years and 8 months = 8 years for gratuity calculation.
• Pro-Rata Gratuity: For FTEs with service between 1 and 5 years, gratuity is calculated proportionately - (15 × wages × years of service) ÷ 26, same formula as permanent employees but with a lower eligibility threshold of 1 year instead of 5.
• Section 53 (Code on Social Security 2020): The provision that makes fixed-term employees eligible for gratuity on completion of 1 year of continuous service - replacing the 5-year requirement under the old Act for this category of workers.
• Rs 20 Lakh Tax Exemption: Under Section 10(10)(iii) of the Income Tax Act, gratuity received by a private-sector employee covered under the Act is exempt up to Rs 20 lakh (lifetime aggregate across all employers). Amounts above this are taxable at slab rates.

Who Is Eligible for Gratuity Under the New Rules?

Eligibility for gratuity in 2026 depends on the type of employment - permanent or fixed-term - and the circumstances of termination.

• Permanent employees - eligible after 5 years of continuous service on resignation, retirement, or superannuation (same as before)
• Fixed-term employees - eligible after 1 year of continuous service on completion or termination of the contract (NEW under Code on Social Security 2020)
• All employees (permanent or FTE) - eligible irrespective of service duration in case of death or disablement due to accident or disease
• Establishments with 10 or more employees - the Act applies to factories, shops, offices, and all commercial establishments
• Contract workers engaged through a contractor - the contractor is primarily liable; the principal employer has secondary liability if the contractor defaults
• Teachers in private educational institutions - covered under the Act since the 2009 amendment

Employers managing payroll compliance services must now track two separate eligibility timelines - 5 years for permanent employees and 1 year for FTEs - and provision gratuity liability accordingly for both categories.

Legal Framework: Payment of Gratuity Act 1972 vs Code on Social Security 2020

The MoLE FAQ dated 30 December 2025 confirmed that the revised wage definition under Section 2(y) applies to gratuity calculation from 21 November 2025. Employers must calculate gratuity for any employee leaving after this date on the new wage base - even if the employee's tenure started years before the code commenced.

How to Calculate Gratuity: Step-by-Step Process

1. Determine employee type and eligibility. Is the employee permanent (5-year requirement) or fixed-term (1-year requirement)? Has the employee completed the minimum service? For death/disablement, no minimum service applies. Check the employment contract and HR records.

2. Identify the last drawn wages. Under the new wage definition, "wages" = basic pay + DA. Basic + DA must be at least 50% of total remuneration per Code on Wages Section 2(y). If the employer recently restructured salary to comply with the 50% rule, use the restructured basic. Exclude HRA, bonus, overtime, commission, and other allowances.

3. Count completed years of service.Count full calendar years from date of joining to date of exit. If service in the final year exceeds 6 months, round up to the next full year. For example: joined 15 June 2019, resigned 10 January 2026 = 6 years and 7 months = 7 years. Employers using payroll processing and management services can automate the service calculation with the rounding rule and generate the gratuity computation sheet as part of the full-and-final settlement process.

4. Apply the gratuity formula. Gratuity = (15 × last drawn wages × completed years of service) ÷ 26. Example: wages Rs 40,000/month, 7 years service → Gratuity = (15 × 40,000 × 7) ÷ 26 = Rs 1,61,538.

5. Check against the Rs 20 lakh tax exemption cap. If the calculated gratuity exceeds Rs 20 lakh, the excess is taxable at the employee's slab rate. The Rs 20 lakh is a lifetime aggregate - gratuity received from previous employers counts toward this cap.

6. Pay within 30 days and issue Form L. Gratuity must be paid within 30 days of it becoming payable (date of resignation, retirement, or superannuation). The employee applies using Form I (or nominee files Form J/K in case of death). The employer issues Form L (notice determining gratuity payable). Delay attracts interest at the rate notified by the government.

Documents and Forms Required for Gratuity

• Form I - application by employee for gratuity (submitted within 30 days of it becoming payable)
• Form J - application by nominee if employee is deceased
• Form K - application by legal heir if no nominee is designated
• Form L - notice by employer to the Controlling Authority and employee showing gratuity amount determined
• Form F - nomination form (employee must submit within prescribed time after completing 1 year of service)
• Employment contract or appointment letter - to verify FTE status and contract period
• Salary records - last drawn basic + DA for gratuity computation
• Service records - date of joining, date of exit, and any breaks in service
• Previous employer gratuity certificate - for computing lifetime Rs 20 lakh exemption
• Actuarial valuation report - for Ind AS 19 / AS 15 gratuity liability provisioning

Gratuity Calculation: Worked Examples at Different Salary Levels

The following table provides gratuity calculations for permanent and fixed-term employees at different salary levels under the new 50% wage base.

Note: Under the old salary structure (basic at 35% of CTC), the wages for a Rs 50,000/month CTC employee were approximately Rs 17,500. Under the new 50% rule, wages are Rs 25,000. The gratuity for 10 years of service increases from Rs 1,00,962 to Rs 1,44,231 - a 43% increase. This is the direct financial impact of the 50% wage rule on gratuity liability.

Common Mistakes to Avoid in Gratuity Calculation and Payment

Mistake 1: Assuming the 1-year rule applies to all employees. The most widespread misconception. The 1-year gratuity rule applies ONLY to fixed-term employees and contract workers. Permanent employees still require 5 years of continuous service. Many media reports incorrectly state "gratuity after 1 year for everyone" - this is wrong.

Mistake 2: Calculating gratuity on the old basic (pre-50% restructuring). If an employee leaves after 21 November 2025, gratuity must be calculated on the new wage base where basic + DA is at least 50% of total remuneration. Using the pre-restructuring basic results in under-payment - which is a violation of the Act. Employers should ensure their income tax return filing reflects the correct gratuity deduction and TDS treatment based on the new wage base.

Mistake 3: Not provisioning for FTE gratuity liability. Many employers treated contract/FTE gratuity as zero because employees rarely completed 5 years. With the 1-year rule, every FTE completing 12 months is now eligible. Companies with large contract workforces face significant unprovisioned liabilities.

Mistake 4: Delaying gratuity payment beyond 30 days. Gratuity must be paid within 30 days of it becoming payable. Under the Code on Social Security, full-and-final settlement of all salary dues must be completed within 2 working days of exit. Delays attract interest and can lead to prosecution.

Mistake 5: Not accounting for the Ind AS 19 past service cost impact. The 1-year FTE rule and the 50% wage base constitute a plan amendment under Ind AS 19. The entire increase in gratuity liability must be recognised immediately in the P&L as past service cost - not amortised over future periods. Companies preparing March 2026 accounts must account for this.

Penalties for Non-Payment or Delayed Payment of Gratuity

The Payment of Gratuity Act and Code on Social Security impose strict penalties for non-payment, delayed payment, and non-compliance with gratuity provisions.

Under Section 9 of the Payment of Gratuity Act, the employer must determine the gratuity amount and notify the employee and the Controlling Authority within 30 days of it becoming payable. If the employer fails to pay within this period, interest is payable on the delayed amount at a rate notified by the government (typically 10% per annum).

Under Section 9(2), if there is a dispute about the amount, the employer must deposit the undisputed portion with the Controlling Authority within 30 days. The disputed portion is settled through adjudication.

Under Section 9(1), failure to pay gratuity within the prescribed period makes the employer liable for prosecution. The penalty is imprisonment for a minimum of 6 months (extendable to 2 years) and a fine. The Controlling Authority can also order attachment and sale of the employer's property to recover gratuity dues.

Additionally, under the new Labour Code, the full-and-final settlement deadline of 2 working days applies to all salary dues. While gratuity payment specifically follows the 30-day window, the employer must at minimum acknowledge the gratuity liability and initiate the calculation within the 2-day F&F window.

How Gratuity Connects with Other Provisions

Gratuity sits alongside PF registration and ESI as one of the three employer-funded statutory benefits in India. While PF is a monthly contribution that builds over time, gratuity is a lump-sum payment triggered at exit. The 50% wage rule under the Code on Wages affects both - increasing the PF contribution base and the gratuity calculation base simultaneously.

From an income tax perspective, gratuity received by an employee covered under the Act is exempt up to Rs 20 lakh under Section 10(10)(iii). The employer's gratuity provision is deductible as a business expense under Section 40A(7) - but only to the extent of contributions made to an approved gratuity fund or premiums paid to an approved insurance policy. Unfunded gratuity (pay-as-you-go) is deductible only when actually paid.

For accounting purposes, gratuity is a defined benefit obligation under Ind AS 19 / AS 15 and requires actuarial valuation at each reporting date. The 1-year FTE rule and 50% wage base change constitute a plan amendment - companies must recognise the full increase in the gratuity defined benefit obligation as past service cost in the P&L for the period in which the law became effective (November 2025). This is a non-recurring charge that will impact FY 2025-26 profit figures.

Permanent Employees vs Fixed-Term Employees: Gratuity Comparison

Key Takeaways

The Code on Social Security 2020, effective 21 November 2025, introduces pro-rata gratuity for fixed-term employees after 1 year of continuous service - reducing the eligibility from 5 years. The 5-year rule continues to apply to permanent employees.

Gratuity is calculated using the formula (15 × last drawn wages × completed years of service) ÷ 26, where wages now means basic + DA which must be at least 50% of total remuneration under the Code on Wages - increasing the gratuity base by 25-50% for most employers.

The gratuity tax exemption remains at Rs 20 lakh for private sector employees and Rs 25 lakh for government employees. The employer must pay gratuity within 30 days of it becoming payable - delay attracts interest and potential prosecution.

Employers must now provision gratuity liability for both permanent employees and FTEs. Under Ind AS 19, the 1-year FTE rule and 50% wage base constitute a plan amendment requiring immediate recognition of the increased liability as past service cost in the P&L.

The combination of the 1-year FTE rule and the 50% wage base increases overall gratuity liability by an estimated 25-50% for companies with significant contract or fixed-term workforce - requiring updated actuarial valuations and potentially funded gratuity schemes to manage cash flow impact.

Need Help with Gratuity Calculation and Compliance?

Calculating gratuity correctly under the new rules - with the 1-year FTE eligibility, the 50% wage base, the rounding rule, tax exemption tracking across employers, and Ind AS 19 provisioning - requires coordination between payroll, HR, finance, and the company's actuary.

Explore our gratuity calculation and compliance services for end-to-end support - from eligibility assessment and formula computation to actuarial valuation coordination, Form L issuance, and full-and-final settlement processing.

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