New Labour Codes: Settlement Agreements and Contracting Out – Is it a possibility?

With the coming into force of the new labour codes on 21 November 2025, the revised definition of ‘wages’ has assumed critical importance for the computation of statutory dues. The definition adopts a bifurcated structure, clearly distinguishing between inclusions and exclusions, and the notional wage amount on the basis of which social security contributions and other statutory benefits are required to be paid.

In practice, while the terms of employment for white‑collar employees are typically governed by appointment letters and employment contracts, the engagement of blue‑collar workers is often regulated through settlement agreements entered into under labour laws. Such settlement agreements have long been used as an effective tool to ensure industrial harmony and avoid protracted disputes between employers and workmen.

However, settlement agreements frequently include clauses providing that certain payments made thereunder shall not be taken into account for the computation of statutory dues or benefits. In light of the expanded definition of ‘wages’ under the new labour codes, critical questions have been raised as to whether pending re-negotiation of such settlement agreements in alignment with the new regime, the settlement agreements can override statutory mandates or whether the labour codes must prevail. It is also pertinent to analyse whether components that form part of inclusions as per the new definition can be excluded through wage settlement agreements; and whether components that form part of exclusions fail the test laid down in the case of Vivekanand Vidyamandir. 

Judicial Precedents

There have been some cases with respect to the principle of contracting out of statutory obligations. Two cases that have considered this issue include The Regional Commissioner, Employees Provident Fund, Tamil Nadu and Pondicherry States v. The Management of Southern Alloy Foundries (P) Ltd.[1](‘Alloy Foundries’) and EID Parry (India) Ltd. v. Regional Commissioner, Provident Fund, Tamil Nadu[2](‘EID Parry’).

The Madras HC, in the Alloy Foundries case, clarified that if the employer and the employees have agreed to exclude ‘special allowance’ from being a part of basic wages or dearness allowance, it will not be included. The Court noted that the regional commissioner of EPF does not have the authority to deem the special allowance to be something that it is not, i.e., basic wages or dearness allowance. Accordingly, because the special allowance did not form part of dearness allowance, the regional commissioner could not direct that it ‘deemed to be dearness allowance’.

Similarly, in the EID Parry case, the Madras HC addressed if the ad hoc allowance paid to all employees formed a part of ‘basic wages’ under Section 2(b) of the Employees' Provident Fund and Family Pension Fund Act, 1952 (‘EPF Act’). The settlement agreement clearly stated that the ad hoc allowance shall not be considered for statutory benefits including gratuity, provident fund, bonus and employee state insurance (‘ESI’). The Court clarified that an allowance, which was explicitly excluded from the application of PF, was not intended to form a part of basic wages simply because it was paid to all employees.

Further, the Court noted that the definition of wages must be interpreted in light of the terms of the settlement agreement. The intention of the parties to the contract is essential to determine if the allowance will form a part of wages. The definition of wages under Section 2(b) clearly states ‘in accordance with the terms of the contract of employment’. The court noted that the parties were rather trying to function within the statutory framework. Therefore, if the parties, in accordance with the terms of the contract of employment, agree that a particular allowance should be excluded, it cannot be treated as basic wages. Accordingly, in both cases, the agreements did not amount to ‘contracting out’ of statutory provisions.

Code on Social Security with respect to ‘contracting out’:

Section 161 of the Code on Social Security, 2020, gives the code an overriding effect over and above any inconsistent law, agreement, contract, or award. However, the proviso to Section 161 does clarify that employees and employers are free to enter into agreements that grant privileges or rights more favourable than those provided under the Code on Social Security.

The determination of what constitutes ‘more favourable’ terms remains inherently open to interpretation and may vary depending on the factual and legal context. There lies an inherent contradiction between increase in social security benefits and direct impact of net take home salary. Employer and employee can balance this contradiction by way of terms of contract.

While the labour codes seek to guarantee minimum wages and social security protections, uncertainty persists as to the extent of contractual flexibility permitted in structuring remuneration. Specifically, whether contractual arrangements that exclude certain CTC components from the computation of social security contributions continue to remain valid on the ground that they are more beneficial to the employees as employees seek for more take home salary. This further raises the broader issue of whether such structuring constitutes legitimate compensation design or impermissible contracting out of statutory obligations under the new labour codes.

This remains a nuanced issue and warrants closer examination, particularly in balancing contractual autonomy with the underlying objectives of labour welfare legislation. 

[The authors are Executive Partner, Associate Partner, Associate and Assistant Manager, respectively, in Labour & Employment Law practice at Lakshmikumaran & Sridharan Attorneys]

[1] (1982)ILLJ28Mad

[2] (1984)ILLJ300Mad