Wage Structuring Under India's New Labour Codes & Its Tax Implications

I. Introduction

The enactment of India's four Labour Codes represents a fundamental shift from the erstwhile fragmented and statute-specific wage framework to a consolidated and standardised regulatory regime governing remuneration and social security. By subsuming multiple labour statutes into a unified framework, the Codes seek to bring uniformity and enhanced employee protection in matters relating to wages and social security benefits. While the Codes primarily operate within the domain of labour and social security law, their implications extend well beyond employment compliance.

In particular, the introduction of a uniform statutory definition of "wages", applicable across the Codes, coupled with a quantitative restriction on the proportion of allowances and exclusions that may be carved out from such definition, marks a departure from long-standing salary structuring exercised by the employers. These changes materially disrupt established remuneration and payroll structuring models, which were often optimised for tax efficiency under the Income Tax Act, 1961. As a result, employers are likely to witness a recalibration of salary components, leading to increased wage bases for statutory contributions and a consequential impact on taxable salary, exemptions, deductions, and tax withholding obligations, thereby giving rise to significant income-tax and payroll implications.

II. The Uniform Definition of "Wages" and the 50% Threshold

A. Statutory Composition of Wages

From a wage structuring and tax perspective, the Code on Wages, 2019 and the Code on Social Security, 2020 are of central relevance. Both Codes adopt a uniform statutory definition of "wages" and have been introduced with the objective of removing interpretational inconsistencies and divergent practices that existed across earlier labour legislations.

Under this definition, wages consist of:

• basic pay,
• dearness allowance, and
• retaining allowance (where applicable).

The definition expressly excludes several components traditionally used in salary structuring, including:

• house rent allowance,
• overtime wages,
• statutory or incentive bonus,
• commission,
• employer's contribution to the provident fund,
• gratuity,
• conveyance allowance, travel reimbursement, and other amenity-based payments.

B. The 50% Rule

The statutory definition of "wages" is, however, subject to an important qualification set out in the first proviso to Section 2(y). This proviso imposes a cap, providing that the total value of components expressly excluded from the definition of wages cannot exceed 50% of an employee's total remuneration or cost to company ("CTC"). Where the value of such excluded components exceeds this threshold, the excess portion, excluding gratuity and retrenchment compensation, is deemed to constitute "wages" for the purposes of statutory computation.

This reclassification is neither discretionary nor dependent on any determination by regulatory authorities. It is a statutory deeming mechanism that will apply automatically once the prescribed limit is crossed. Consequently, the manner in which salary components are labelled or described in employment contracts or payroll structures does not prevail over the statutory framework. Even if certain elements continue to be characterised as "allowances" in contractual documentation, the law mandates their treatment as wages to the extent the 50% threshold is exceeded, thereby expanding the wage base for social security contributions and related statutory obligations.

C. Alignment with Judicial Precedent

The statutory architecture adopted under the Labour Codes is not an isolated legislative development but is firmly rooted in established judicial principles. This approach reflects and codifies the principles laid down by the Supreme Court in Regional Provident Fund Commissioner (II) v. Vivekananda Vidyamandir & Ors. (2019 SCC OnLine SC 291), where the Court held that allowances which are paid uniformly to all employees and are not linked to any additional output, special skill, performance incentive, or contingency cannot be excluded from "basic wages" for the purposes of provident fund contributions. The Court categorically disapproved of artificial salary bifurcation and held that such structuring, when undertaken with the objective of reducing statutory contributions, cannot be sustained in law

III. Implications under the Income Tax Act, 1961

The Labour Codes do not directly amend the Income Tax Act, 1961, nor do they seek to redefine the scope or meaning of "salary" for income tax purposes. The taxation of income under the head "Salaries" continues to be governed by Sections 15, 16, and 17 of the Income-tax Act, read together with the applicable provisions relating to exemptions, deductions, and valuation rules. The two statutory regimes therefore operate independently, with the Labour Codes confined to the domain of labour regulation and social security.

Notwithstanding this statutory separation, the Labour Codes have significant indirect implications, such as the mandatory restructuring of salary components to align with the uniform definition of "wages," and the prescribed limits on exclusions under labour law alter the factual composition of employee remuneration. These changes have a direct bearing on the base figures relevant for income tax computation, including taxable salary, eligibility for exemptions, and the quantum of deductions linked to salary components.

Accordingly, the resulting tax consequences do not arise from any legal reclassification under the Income Tax Act itself, but as a consequential effect of payroll restructuring undertaken to ensure labour law compliance. In practice, employers may experience increased taxable salary, reduced exemption efficiency, and corresponding adjustments in tax deduction at source ("TDS") obligations, thereby necessitating a reassessment of existing payroll and tax compliance frameworks.

IV. Provident Fund

A. Increased Contributions as a Structural Outcome

The requirement that basic pay and dearness allowance together constitute a minimum of 50% of total remuneration directly increases the base on which provident fund contributions are calculated. This leads to a corresponding increase in both employee and employer contributions.

B. Employee Contribution and Section 80C

Employee contributions to recognised provident fund continue to qualify for deduction under Section 80C, subject to the overall cap of ₹1.5 lakh per annum. In practice, many salaried employees already exhaust this limit through a combination of PF contributions, insurance premiums, ELSS investments, and housing loan principal repayments. In such cases, the incremental PF contribution resulting from wage restructuring does not yield additional tax benefit, effectively reducing disposable income. This has particular relevance for mid to senior-level employees whose basic salaries are adjusted upward to meet the statutory threshold.

Additionally, the employee contributions to NPS continue to be governed independently of wage restructuring. Thus, an employee may claim an additional deduction of ₹50,000 under Section 80CCD(1B), over and above the Section 80C limit, provided the employee opts for the old tax regime.

Where employer contributions are linked to a percentage of basic wages, an increase in the basic pay results in a higher employer contribution. Under the new tax regime, such employer contributions are deductible up to 14% of basic wages, within the same overall ceiling of ₹7.5 lakh. Accordingly, while higher wages do not directly enhance the quantum of employee-side NPS deductions, they may influence the overall attractiveness of employer-funded NPS contributions, particularly for high-income employees opting for the new tax regime.

C. Employer Contribution and Perquisite Taxation

Employer contributions to NPS are deductible under the Income Tax Act, subject to differing limits under the old and new tax regimes:

• under the old tax regime, employer contributions are deductible up to 10% of salary (basic pay plus dearness allowance, where applicable);
• under the new tax regime, the deduction limit is enhanced to 14% of salary.

These deductions are, however, subject to the aggregate annual cap of ₹7.5 lakh, which applies collectively to employer contributions towards:

• recognised provident fund,
• NPS, and
• approved superannuation funds.

Any excess beyond this threshold becomes taxable under Section 17(2) and must be included in salary income. Therefore, the employers must ensure that payroll systems track cumulative employer contributions across these instruments to avoid under-reporting and short deduction of tax.

D. Impact on Employee State Insurance

Under the Code on Social Security, 2020, ESIC coverage has been extended nationwide, removing the earlier restriction to notified areas. Eligibility is now linked to the redefined concept of "wages" rather than gross salary, which may expand the pool of covered employees. While this may increase overall coverage and compliance costs for employers, per-employee ESI contributions may reduce as contributions are calculated on the narrower wage base.

E. TDS Implications

Section 192 of the Income Tax Act, 1961 casts an obligation on employers to estimate the employee's income chargeable under the head "Salaries" for the relevant financial year and to deduct tax at source on such estimated income at the applicable average rate. This estimation must reflect the actual salary structure and applicable exemptions and deductions as they stand during the year.

The restructuring of salary components pursuant to the Labour Codes is likely to alter multiple inputs relevant for TDS computation. An increase in the wage base may result in higher employer and employee provident fund contributions, which in turn affects the quantum of deductions available under Section 80C and the taxability of employer contributions beyond the statutory thresholds prescribed under Section 17(2). Similarly, changes in the composition of allowances may impact the availability and extent of exemptions, including those relating to house rent allowance and other salary-linked exemptions.

These shifts necessitate a recalibration of the monthly tax deduction at source to ensure that the aggregate TDS for the year aligns with the revised estimate of taxable salary. Failure to appropriately factor in such changes may result in short deduction of tax, exposing employers to interest liability and potential penal consequences under the Act.

V. Gratuity

A. Labour Law Expansion under the Social Security Code

The Code on Social Security, 2020, introduces a significant change by extending gratuity eligibility to fixed-term employees on a pro rata basis after completion of one year of service. For regular employees, the five-year continuous service requirement continues to apply, subject to judicially recognised exceptions such as death or disablement. As gratuity is calculated on the basis of last drawn wages, any increase in basic pay and dearness allowance directly inflates gratuity liability. Employers engaging fixed-term employees must therefore recognise gratuity as a definite and accruing liability, rather than a contingent one.

B. Income Tax Treatment of Gratuity

Section 10(10) of the Income Tax Act, 1961 provides an exemption in respect of gratuity received by an employee, subject to the conditions and limits prescribed therein. For non-government employees, the maximum exemption is capped at ₹20 lakh, being the overall lifetime limit, and this statutory ceiling remains unchanged notwithstanding the expanded scope and recalibration of wage definitions under the Labour Codes. The Labour Codes, while potentially increasing gratuity liability by broadening the wage base for computation under labour law, do not operate to enhance or modify the corresponding exemption limit under the Income Tax Act.

As a consequence of higher or more uniform wage bases, gratuity amounts may accrue at an accelerated pace over the period of service. This may lead to an earlier exhaustion of the ₹20 lakh exemption threshold, particularly in cases where an employee has received gratuity from prior employment and has already utilised a portion of the lifetime exemption. Therefore, any gratuity received in excess of the available exempt limit would accordingly become chargeable to tax under the head "Salaries" in the year of receipt.

In this context, accurate computation and disclosure of gratuity payments have increased significance. Employers are required to correctly reflect taxable and exempt portions of gratuity in Form 16, while employees must ensure that gratuity received is appropriately tracked to avoid inadvertent non-compliance or under-reporting of taxable income.

VI Bonus

The Code on Wages substantially carries forward the framework of the Payment of Bonus Act, 1965, with respect to eligibility, quantum, and computation of statutory bonus. Eligible employees continue to be entitled to a minimum bonus of 8.33% of wages, irrespective of allocable surplus, and a maximum bonus of 20%, subject to the availability of allocable surplus and the operation of the statutory set-on and set-off mechanisms. While the Code consolidates the law on wages and bonuses, it does not materially alter the fundamental principles governing bonus entitlement.

From an income tax perspective, a bonus constitutes income chargeable under the head "Salaries" and is taxable in the year of receipt, in accordance with Section 15 of the Income Tax Act, 1961. Bonus payments are accordingly subject to tax deduction at source under Section 192 and must be aggregated with the employee's regular salary for the purposes of computing tax liability at applicable slab rates. Given the potential increase in the wage base resulting from the revised definition of "wages" under the Labour Codes, the absolute quantum of bonus payable may increase, thereby impacting taxable salary and TDS computations.

Employers are therefore required to ensure that bonus payments, including any arrears or adjustments arising from revised wage structures, are accurately captured in payroll systems and correctly disclosed in Form 16. Any misalignment between actual bonus payments and TDS deductions may expose employers to compliance risks, including short deduction and corresponding interest and penalty exposure under the Income Tax Act.

VII. House Rent Allowance

A. Statutory Framework

The exemption in respect of House Rent Allowance ("HRA") continues to be governed by Section 10(13A) of the Income Tax Act, 1961, read with Rule 2A of the Income Tax Rules, 1962, and remains available only to taxpayers opting for the old tax regime. The quantum of exemption is restricted to the least of the following amounts:

• the actual HRA received by the employee;
• the excess of rent paid over 10% of "salary"; or
• 50% of "salary" in the case of employees residing in metro cities, or 40% in the case of non-metro cities.

For the purposes of this computation, "salary" is defined restrictively and includes only basic pay and dearness allowance, to the extent such allowance forms part of retirement benefits. Other allowances and perquisites are expressly excluded from this computation.

B. Impact of Wage Restructuring

The upward adjustment of basic pay and dearness allowance to comply with the 50% wage requirement under the Labour Codes has a direct bearing on the computation of HRA exemption. As the definition of "salary" for HRA purposes is limited to basic pay and dearness allowance, any increase in these components correspondingly raises the 10% of salary threshold used in the exemption formula. In practical terms, this often results in a reduction in the exempt portion of HRA, even where the actual rent paid by the employee remains unchanged.

This impact is particularly evident where HRA has historically served as a significant tax-efficient component of employee compensation. Consequently, wage restructuring undertaken to meet labour law requirements may lead to a reduction in take-home pay for employees opting for the old tax regime.

VIII. Other Allowances and Limits of Re-Characterisation

Allowances such as special allowance, conveyance allowance, meal allowance, and leave travel allowance (where exemption conditions are not satisfied) continue to be taxable as salary under Sections 15 and 17 of the Income Tax Act. It is critical to note that:

• the 50% add-back rule applies only for labour law purposes, and
• it does not, by itself, convert allowances into basic salary for income tax purposes.

Nevertheless, the indirect effect of increased basic pay often results in a higher overall taxable income, even if the tax character of allowances remains unchanged.

IX Old versus New Tax Regime

The restructuring of wages under the Labour Codes has important implications under both old and new income tax regimes. While the Labour Codes leave the tax law unchanged, the resulting increase in basic pay and related components can materially affect taxable income under each regime.

Under the old tax regime, a range of exemptions and deductions remain available, which can help absorb the impact of higher reported salary. These include exemptions such as House Rent Allowance (HRA) and Leave Travel Allowance (LTA), as well as deductions under Chapter VI-A such as Sections 80C (e.g., investments in specified instruments), 80D (health insurance premiums), and interest on housing loans under Section 24(b). These provisions can substantially reduce taxable income, and their availability may mitigate the effect of an increased wage base resulting from labour law-driven restructuring.

In contrast, the new tax regime under Section 115BAC offers lower slab rates but disallows most of the exemptions and deductions that are available under the old regime. Under the new regime, benefits such as HRA and LTA exemptions, Chapter VI-A deductions (like Section 80C and 80D), and interest on housing loans under Section 24(b) are generally unavailable. As a result, higher basic wages and increased statutory components translate directly into higher taxable income with fewer avenues for adjustment.

In this context, the choice of tax regime becomes more consequential where wage restructuring increases the share of basic pay and other core salary components. Employers are therefore required to obtain declarations from employees regarding their choice of tax regime at the beginning of the financial year, and to compute TDS in accordance with the relevant provisions and administrative guidance, including CBDT Circular No. 03/2025 dated 20.02.2025 on TDS from salaries under Section 192.

Therefore, accurate regime selection and consistent application throughout the year are essential to prevent short deduction of tax and related compliance risks, and to align payroll withholding with the employee's optimal tax position.

X. Conclusion

The Labour Codes, though framed as labour welfare legislation, have fundamentally altered the economic and tax architecture of salaried employment in India. By prescribing a uniform definition of wages and limiting the extent to which allowances may be excluded, the Codes compel a shift towards substance-based remuneration structures. This realignment has cascading implications across provident fund contributions, gratuity accruals, bonus computation, HRA exemptions, and the overall tax liability of employees.

Therefore, wage restructuring can no longer be viewed as a narrow labour law exercise. Employers must adopt an integrated approach that aligns labour law compliance with income tax implications, payroll accuracy, and effective employee communication. Inadequate planning or execution may expose employers to regulatory risk, tax non-compliance, and heightened employee grievances, potentially resulting in disputes and litigation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.