Gratuity is an important financial benefit for employees who dedicate several years of service to an organisation. It is a way for the employer to express appreciation for an employee’s long-term contribution. However, calculating gratuity can seem confusing when an employee’s Salary keeps changing because of promotions, increments, or variable Pay. Understanding the correct method helps both employees and HR professionals ensure that the right amount is calculated as per the Payment of Gratuity Act, 1972.

What Is Gratuity?

Gratuity is an amount of money given by the employer to an employee when he/she resigns, retires, or gets fired, but on the condition that he/she has worked continuously for at least five years. It is regulated by the Payment of Gratuity Act of 1972, which establishes the criteria for eligibility, the calculation procedure, and the rights of employees.

This benefit is applicable to establishments with ten or more employees. Once it becomes applicable, the employer must continue to provide gratuity even if the number of employees later falls below ten.

Formula for Gratuity Calculation

The general formula followed under the Payment of Gratuity Act is:

Gratuity = ^{15 × Last Drawn Salary × Years of Service}⁄₂₆

Where:

• 15 represents the number of days’ Salary for each completed year of service.
• Last Drawn Salary = Basic Pay + Dearness Allowance.
• 26 is the assumed number of working days in a month.

For companies not covered under the Act, some employers use the formula:

Gratuity = ^{15 × 49,000 × 11}⁄₂₆ = ₹310,385

The key difference lies in the divisor — 26 for organisations under the Act and 30 for those outside its scope.

The Problem When Salary Keeps Changing

In many sectors, such as technology, sales, and finance, salaries do not remain constant. They change frequently because of:

• Annual appraisals or mid-year hikes
• Promotions introducing new pay scales
• Performance-based incentives
• Restructuring of salary components

This raises a common question — which Salary should be used to calculate gratuity: the current one, the average of all years, or a combination?

According to the Payment of Gratuity Act, the last drawn Salary is the one that matters most. That means only the employee’s most recent basic pay plus dearness allowance, right before leaving the job, is considered for computation.

Example: Gratuity Calculation with Salary Revisions

Take this example to understand the concept more clearly:

An employee works for 10 years and 8 months in the same organisation with the following salary changes:

At the time of leaving the company, the last drawn Salary (Basic + DA) is ₹49,000.

Total service period = 10 years and 8 months, which is rounded up to 11 years as per the Act.

Applying the formula:

Gratuity = ^{15 × 49,000 × 11}⁄₂₆ = ₹310,385

Hence, even though the Salary changed multiple times, gratuity is always calculated using the final drawn Salary.

When to Use Average Salary

Certain employees may not have a fixed salary structure, especially those earning piece-rate wages or working in roles where Pay fluctuates monthly. In such cases, gratuity may be based on the average Salary of the preceding three months.

Similarly, private establishments not covered under the Payment of Gratuity Act may use an internal policy to compute gratuity based on the average of recent salaries rather than the last drawn amount. This approach maintains fairness where earnings are unpredictable or variable.

Treatment of Partial Years of Service

While calculating gratuity, partial years of service are handled as follows:

• If the number of months worked beyond full years is more than six months, the duration is rounded up to the next year.
• If it is less than six months, it is ignored.

For example:

• 7 years and 7 months are treated as 8 years.
• 7 years and 4 months are treated as 7 years.

This rounding off simplifies the calculation and ensures uniformity.

Tax Rules on Gratuity

Gratuity is partially or fully exempt from income tax, depending on the type of employment:

• For government employees, the entire gratuity amount is exempt.
• For non-government employees, the exemption limit is ₹20 lakh (as per current law) or the actual gratuity received, whichever is lower.

Any amount received over and above the exempted limit becomes taxable as per the income tax slab applicable to the individual.

Components Included in Last Drawn Salary

While calculating gratuity, only certain components of the salary structure are counted. Understanding this helps avoid mistakes.

Included:

• Basic Pay
• Dearness Allowance (if applicable)

Excluded:

• House Rent Allowance (HRA)
• Performance bonus or incentive pay
• Overtime payment
• Special or transport allowances

The focus is on fixed components that are consistently part of the Salary.

Common Mistakes to Avoid

1. Including monthly bonuses or allowances: These are not part of the statutory definition of Salary under the Gratuity Act.
2. Ignoring the last six months’ changes: When salaries change right before resignation, ensure the latest structure is used.
3. Skipping rounding rules: Service months over six must be rounded up for fair calculation.

By keeping these in check, HR departments and employees avoid disputes and errors in payout.

Making Gratuity Calculation Easier

With frequent salary revisions, manual calculation often becomes tedious and prone to error. Modern payroll systems and digital tools help in computing gratuity by automatically fetching the latest basic Pay and years of service. These automated systems also ensure compliance with legal norms and save time during full and final settlements.

Conclusion

Even when salaries keep changing due to promotions, appraisals, or variable Pay, gratuity is always calculated based on the last drawn basic Salary and dearness allowance before an employee leaves the organisation. In certain cases of variable wages, employers can consider the average of the last few months for fairness.

For accuracy and convenience, employees and HR departments can use a gratuity calculator to compute the amount as per the applicable law. Understanding these nuances ensures transparency in every gratuity calculation and helps both employers and employees plan smoothly for the future