Gratuity rules: India’s new labour framework could significantly increase gratuity payouts for employees, but it may also create unintended tax implications if corresponding changes are not made in tax laws. The Code on Social Security, 2020, set to take effect from November 2025, introduces a broader definition of “wages,” fundamentally altering how gratuity is calculated for private sector employees.

The increase comes from a broader wage definition under the new labour code, which raises the base for gratuity calculation. However, tax exemption is still computed using a narrower salary definition (basic pay + DA), creating a gap where a portion of higher gratuity becomes taxable.

Salary definition

According to O.P. Yadav, former Principal Commissioner of Income Tax, under the earlier Payment of Gratuity Act, 1972, gratuity was computed using only basic pay and dearness allowance (DA). This narrow definition allowed employers to optimise salary structures by keeping basic pay relatively low and allocating a higher share to allowances such as house rent allowance (HRA), bonuses, and special allowances. As a result, the wage base used for gratuity calculation remained limited, effectively containing employer liability.

The new labour code changes this equation. While the gratuity formula — 15 days’ wages for every completed year of service—remains unchanged, the definition of wages has been significantly expanded. It now includes basic pay, DA, and retaining allowance, along with a critical “50% rule.” If excluded components exceed 50% of total remuneration, the excess must be added back to wages, thereby increasing the base used for gratuity computation.

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“This is a structural shift in how gratuity is determined. The expanded wage definition ensures that employees receive benefits on a more realistic representation of their earnings,” Yadav noted in a column he wrote for a news website.

Gratuity payouts

This change is expected to materially increase gratuity payouts, particularly for employees with heavily allowance-driven salary structures. Sectors such as IT, financial services, and corporate roles—where flexible compensation design is common—are likely to see the most pronounced impact. Over a long tenure, even a modest increase in the wage base can translate into a substantially higher retirement benefit.

However, the tax framework has not yet been updated to reflect this shift. While gratuity under the earlier regime was largely exempt up to ₹20 lakh, the Income-tax provisions continue to calculate exemption based only on basic pay and DA. This creates a structural mismatch between labour law and tax law.

“There is a disconnect between how gratuity is calculated under the Social Security Code and how it is taxed under existing income-tax provisions,” Yadav noted. “This could result in employees receiving higher gratuity on paper but facing an unexpected tax burden in practice.”

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Revised wage base

For instance, consider an employee whose revised wage base increases gratuity to ₹13.85 lakh under the new code. The tax exemption, however, may still be restricted to ₹10 lakh based on basic pay. The remaining ₹3.85 lakh becomes taxable, even though the total payout is well within the ₹20 lakh statutory ceiling.

“This mismatch can lead to higher tax outgo and may also trigger interpretational disputes,” Yadav added. “Without alignment, dual computation systems will continue to create confusion for both taxpayers and administrators.”

From a policy perspective, this gap raises concerns around legislative coherence. The intent of the labour code is to strengthen social security by expanding the wage base, but the absence of corresponding tax amendments risks diluting the net benefit to employees.

Experts suggest that either legislative amendments or administrative clarification by the Central Board of Direct Taxes (CBDT) will be necessary to resolve this issue. Until then, employees approaching retirement and HR teams designing compensation structures will need to factor in the potential tax impact.

“A clear and timely intervention is essential to ensure that enhanced gratuity benefits are not eroded by avoidable tax friction,” Yadav said.

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Published on: Apr 16, 2026 1:58 PM IST