Rewriting compensation procedures: how India’s new Labour Codes are driving a compensation overhaul

Kajol Pokkhriyal

Nishith Desai Associates, Bengaluru

kajol.pokkhriyal@nishithdesai.com

Somya Bhargava

Nishith Desai Associates, New Delhi

somya.bhargava@nishithdesai.com

Introduction

The four Labour Codes in India are: the Code on Wages, 2019 (Wage Code); the Occupational Safety, Health and Working Conditions Code, 2020 (OSH Code); the Code on Social Security, 2020 (Social Security Code); and the Industrial Relations Code, 2020 (Industrial Relations Code). Collectively known as the Labour Codes, they have resulted in a major overhaul in the approach taken by human resource operations and corporate compliance for employers. Chief among these reforms is the impending overhaul of employee compensation procedures, a subject which has dominated public and corporate discourse due to its substantial fiscal implications on employers’ balance sheets.

To comprehend this statutory transition, one must decipher how the new legislative mandates disrupt compensation frameworks which have previously been adjusted by employers to optimise short-term liquidity. This article examines the significant changes introduced by the Labour Codes, evaluating their direct impact on specific wage components, corporate liabilities, and the broader mechanics of payroll restructuring.

‘Wages’ under the Labour Codes and its impact on allowance cushioning

In general, labour laws dealt with their respective provisions largely in isolation such that there was no single standard across the former legislations. Now, under the Labour Codes, the legislature aims to provide uniformity in several aspects. One such is the definition of ‘wages’, which has been standardised and must be followed when making statutory payments under the respective Codes.

According to the revised definition of wages, there are certain specific components that form part of the inclusions and exclusions of what constitutes ‘wages’, while requiring that exclusions in the form of allowances, do not exceed 50 per cent of the cost to company (CTC). For that purpose, where components of the exclusions list tip higher than the included components (eg, basic pay, dearness allowance, and retaining allowance, if any), certain components such as house rent allowance, conveyance allowance, and overtime allowance, etc., will need to be added back to the inclusions list for the purposes of statutory payouts.

In this regard, while employers do not automatically need to undertake a restructuring of their compensation structure, the calculation metrics may need to undergo a change depending on how an employer originally structured their employee compensation.

Another impact of these revised computation metrics is that it has ended an employer’s ability to increase the allowances and other variable components under the CTC, while limiting the basic salary components which were typically used for calculation of statutory payments such as gratuity, etc. Generally, employers followed the allowance cushioning practice to offer competitive packages while limiting their obligations for payouts in case of separations, as these largely remained beyond the scope of the calculation of such payouts. Given the revision under the Labour Codes, even where the employer offers allowances greater than the basic compensation, these will be factored into the ‘wages’ calculation where they are in breach of the 50 per cent threshold. Consequently, this shift has also substantially increased corporate talent expenditure, driving an exponential escalation in severance pay to employees.

In this context, it is also pertinent to examine the treatment of statutory bonus and performance-related bonus under the new wages framework. Statutory bonuses have been specifically excluded from the definition of ‘wages’ and form part of the exclusion list which is to be considered for the purposes of the 50 per cent threshold. In contrast, performance-related incentives, target-based bonuses and other variable compensation components do not form part of ‘wages’, as they dependent on the fulfilment of specified performance criteria and are not paid uniformly, ordinarily or universally to all employees. Accordingly, while statutory bonus may influence the operation of the 50 per cent exclusion rule, performance-based compensation continues to remain outside the scope of ‘wages’.

Impact on terminal payouts and take-home pay

In the context of terminal payouts such as gratuity, which is now governed under the Social Security Code, the mandatory 50 per cent wage rule directly disrupts legacy compensation models that suppressed basic salary in favour of inflated allowances. As the new wage definition establishes a higher statutory baseline for calculation, there is a corresponding increase in employers’ long-term gratuity payout obligations. Similar implications would follow for the other terminal payout, that is, retrenchment compensation under the Industrial Relations Code, which is payable to ‘worker’ category employees on termination of employment.

Paradoxically, while these revisions escalate overall corporate restructuring costs, they are simultaneously poised to compress the net take-home pay of certain employees stemming from the new, expanded definition of ‘wages’ used across all statutory payouts, including the Employees’ Provident Fund (EPF). For employees whose EPF contributions are already mapped above the statutory ceiling, any upward recalibration of the basic salary to meet the 50 per cent threshold will automatically mandate higher employee-matching EPF deductions, thereby reducing their immediate monthly take-home liquidity. As a result, some employees may find that even where they receive a salary increment or an increase in their overall CTC, the corresponding increase in monthly take-home pay may be lower than anticipated, and in certain cases may even fall due to enhanced statutory deductions.

Impact on payout timelines

Another crucial development with respect to HR practices is the timelines for payroll processing. Under the Wage Code, which has ended the wage threshold for its applicability as existed under the former Payment of Wages Act, 1936, separated employees, whether on account of resignation, termination, retrenchment or due to closure of establishment, are required to be paid their wages within two working days of such separation.

Entitlements for fixed-term workers

The Labour Codes have introduced another critical feature into the existing employment regime through the explicit statutory recognition of fixed-term employees, including referencing such arrangements in the Model Standing Orders issued under the Industrial Relations Code. While fixed-term employees were previously governed under the former laws largely by implication, the Codes have introduced specific statutory entitlements which had previously been outside of their scope.

For this reason, the Labour Codes have specifically provided for gratuity benefits to fixed-term employees on a pro-rata basis on completion of a specified period. In this regard, according to the Social Security Code, read together with the Central Rules, fixed-term employees with at least one year of service are entitled to gratuity on a pro-rata basis on the termination of their contract. This differs from the previous rules, under which gratuity was an employee entitlement for completing at least five years, excluding cases of death or disablement due to accident or disease. While the Central Rules under the Social Security Code directly govern multi-state establishments or those falling under the central sphere, several states have already mirrored this one-year benchmark in their respective draft Rules. This alignment strongly indicates that individual state Rules will follow suit, ensuring cross-jurisdictional uniformity for single-state operations.

Similarly, the Industrial Relations Code entitles a fixed-term worker to gratuity where they render service under the contract for a period of at least one year, as well as to retrenchment compensation where the worker’s employment is terminated prior to the end of their fixed-term employment contract.

Conclusion

Generally speaking, the Labour Codes’ implementation marks a permanent, structural overhaul for corporate compensation strategies – a transition away from allowance-heavy structures towards standardised transparency. By enforcing a uniform definition of ‘wages’ anchored by the 50 per cent allowance cap, the new Codes have triggered a profound cascading effect on statutory liabilities.

The primary weight of this legislative overhaul falls on statutory benefits and operational timelines. First, the restructuring fundamentally alters the calculation baseline, expanding long-term liabilities such as gratuity, the provident fund, and retrenchment compensation, etc. Second, the Codes introduce a major inclusionary shift by formally bringing fixed-term employees into the statutory fold, guaranteeing them gratuity entitlements from which they were previously excluded.

Coupled with uncompromising 48-hour timelines for final payouts, these revisions establish a highly regulated, time-bound system, which will have an inevitable impact on the way in which employers structure their compensation procedures. For the corporate sector, adapting to this overhaul represents a fundamental shift in capital allocation and financial governance, serving as the modern baseline for legal compliance and sustainable talent management.