Written by Khushi Jain pursuing B.A. LL.B. (Hons.) at Dr. Ram Manohar Lohiya National Law University, Lucknow
Imagine an employee who worked in a company for 15 years without getting any salary but only the assurance of payment. Suddenly the company goes bankrupt and sells all the assets. While Insolvency and Bankruptcy Code, 2016 (“IBC”) revolves around the objective of asset maximization, it falls short to cover such employer’s liability to employees in essence.
Based on this precise conundrum, the blog firstly, analyses the current statutory provisions and judgements based on this aspect. Secondly, it critically analyses these provisions to identify major challenges and limitations. Thirdly, towards the end, the blog provides plausible solutions to build an employee-sensitive insolvency framework capable of reconciling commercial efficiency.
EXISTING LEGAL ANATOMY of Employee Claims under IBC
IBC primarily recognise employees through the narrow lens of “operational creditors” under Section 5(21), IBC. Their claims are grouped alongside trade creditors, suppliers, service providers and vendors, even though employment-related dues differ fundamentally in both purpose and character.
In Sashi Kanta Jha v. Devi Prasad (2025), a distinction was drawn between service and welfare claims. Service claims arise directly from the contractual relationship between employer and employee. These include unpaid wages, salary, overtime, commissions, reimbursements, incentives, and contractual allowances. Welfare claims, on the other hand are statutory or social security entitlements intended to protect employees against economic vulnerability. Gratuity, provident funds, pensions, statutory bonus, leave encashment, retrenchment compensation, and certain terminal benefits fall within this category.
However, not all employee welfare entitlements receive the same treatment once insolvency commences. The IBC itself creates different levels of protection where Provident fund, pension fund, and gratuity fund are excluded from the liquidation estate under Section 36(4)(a)(iii). Wages and salary are prioritised under Section 53. Leave encashment, bonus, retrenchment compensation, etc. have been treated inconsistently by different adjudicating authorities, particularly regarding their classification and priority.
It creates a doctrinal inconsistency where on one hand unpaid gratuity is treated as operational debt under Section 9, IBC, decisions such as State Bank of India v. Moser Baer Karamchari Union and Sunil Kumar Jain v. Sundaresh Bhatt recognise gratuity as a statutory welfare entitlement protected under Section 36(4), contradicting treatment of employee claims.
CHALLENGES AND LIMITATIONS
The distinction is difficult to justify from the standpoint of labour welfare. An employee’s entitlement to accumulated leave is earned over years of service in much the same way as gratuity. Statutory bonus also represents deferred remuneration intended to ensure equitable sharing of economic gains between employers and employees. Their underlying economic function differs substantially from trade debts owed to suppliers or service providers.
The inconsistency becomes even more pronounced where employers fail to establish or adequately maintain gratuity funds. Although employees possess an independent statutory right under the Payment of Gratuity Act, 1972, judicial interpretation has frequently focused upon whether an identifiable gratuity fund exists for the purpose of invoking Section 36(4)(a)(iii). Consequently, in the absence of gratuity funds, if employee worked for 15 years and company became insolvent, he won’t get any benefit under Section 36.
Furthermore, the waterfall mechanism under Section 53 also enlists only the time period of one year of services rendered to employer to be distributed from liquidation assets. It culminates to very marginal or no recovery of the employee’s hard-earned money from the employer.
The differential treatment accorded to employee claims under the IBC invites scrutiny under Article 14 of the Constitution, which permits reasonable classification but prohibits arbitrariness. While the Code protects provident fund, pension fund and gratuity fund from the liquidation estate, other welfare-oriented benefits such as leave encashment, statutory bonus and retrenchment compensation receive no comparable protection.
Banks diversify risk through lending portfolios, negotiating security interests and price insolvency risk into credit agreements. Employees possess no comparable ability to hedge against the insolvency of their employer.
SUGGESTIONS AND CONCLUSION
The IBC classifies creditors in a binary manner, i.e. either financial or operational creditors, totally ignoring that even employment-related claims are not homogeneous. While claims like unpaid wages and salaries are the exchange of work for money, other benefits like gratuity, leave encashment, statutory bonus, and retrenchment compensation are more to do with labor welfare legislations and conceptually represent deferred social security rather than mere commercial obligations.
First of all, the Employee Welfare Claim should be identified as a separate type. Although courts in the case judgments mentioned here have separated service and welfare claims, it should be the point of entering into law and implementing similar systems. This sort of classification would more accurately portray the reason behind labor welfare legislation and is aimed at providing a reasonable ground for different treatment during insolvency proceedings.
Second, the safety granted by Section 36(4)(a)(iii) should not be limited only to the presence of a separate gratuity or welfare fund. The exclusion on statute should be linked to the employee’s accumulated welfare entitlement itself and not to the employer’s way of keeping accounts. The employee’s statutory rights cannot be extinguished or weakened just because the employer has failed to set up a gratuity fund.
Besides, the legislator must make it obligatory for employers to keep adequately funded and segregated employee welfare funds for statutory terminal benefits, mainly gratuity. Even though the Payment of Gratuity Act 1972 makes it compulsory to pay gratuity, it doesn’t always require the creation of a separate gratuity fund for the employer. This has led to cases under the IBC where the lack of a separate and marked gratuity fund has, in some instances, put employees’ right to claim protection under Section 36(4)(a)(iii) at risk. Because of this, Parliament should consider making it mandatory to set up dedicated trusts or approved irrevocable funds for gratuity, which will be regularly financed or backed by insurance. Besides, these funds must remain a separate entity from the employer’s general assets and should be explicitly excluded from the insolvency estate. Reliably securing statutory welfare liabilities during normal business activities instead of just dealing with them after insolvency is the point of this reform, which would also reduce litigation.
Third, more consistency is required to be between the IBC and labour welfare legislation in India. The statutes like Payment of Gratuity Act 1972 Code on Social Security, 2020, and Payment of Bonus Act, 1965 rely on the Constitution of India’s promise to protect labor against economic imbalances. The IBC ought not to be given a reading that ends up negating these statutes unless Parliament has explicitly shown such an intention. Both, the legislature clarifying its position or the Supreme Court providing authoritative guidance would greatly lessen the present uncertainty over the dealing with employee welfare claims.
Eventually, India could take a leaf out of the book of those countries which have made employee protection during insolvency a part of their legal system. For instance, employees in the United Kingdom enjoy protection through the Employment Rights Act 1996, which makes the National Insurance Fund responsible for paying certain employment benefits like unpaid wages, holiday pay, statutory notice pay and statutory redundancy pay in cases of employer insolvency.
In a similar vein, the Fair Entitlements Guarantee Act 2012 of Australia sets up the Fair Entitlements Guarantee (FEG) scheme, which grants eligible employees with government-funded payments for unpaid wages, annual leave, long-service leave, payment in lieu of notice and redundancy pay after employer liquidation. The Commonwealth is then subrogated to the employee’s rights and may recover the amounts from the insolvent estate.
Also, Canada’s Wage Earner Protection Program Act establishes the Wage Earner Protection Program (WEPP) that ensures very fast payment of unpaid wages, vacation pay, termination pay and severance pay in case the employer goes bankrupt or is put into receivership. In fact, the Government then takes over the employee’s claim against the employer’s estate to the extent of the payment made.
These countries endorse a shared view: the wellbeing of employees should not hinge solely on the leftover value of the insolvent estate. Contrary to joining in the scramble for insufficient assets with commercial creditors, employees are provided with an immediate statutory escape route, while the State steps in to bear the risk of recovery. Although India’s insolvency regime is structured differently, the fundamental reasoning is just as strong. Parliament might want to consider introducing an employee protection scheme similar to that of other countries either via a separate insolvency compensation fund or by adding a guarantee scheme within the existing social security structure under the Code on Social Security, 2020.
The issue is not that employee claims do not merit being given priority over all other creditors, but should insolvency laws continue to assess fundamentally different employment rights through a uniform commercial perspective.
Caveat: The views, analyses, and information presented in this article are provided in good faith and for general informational purposes only. No representation or warranty, express or implied, is made regarding the accuracy, adequacy, validity, reliability, or completeness of the information. Readers should conduct their own research and seek professional guidance where appropriate. Neither the author nor the publisher shall be held responsible for any loss, liability, or consequence arising from reliance on this content.
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