Are ESOPs “Wages”? Decoding Section 2(y) of the New Labour Code 2026

The operationalisation of the four Labour Codes on May 8 and 9, 2026, has fundamentally rewritten the rules of employment in India.

For the startup ecosystem, the notification of over 30 gazette rules represents a “compliance cliff.” While founders have historically focused on “burn rates” and “product-market fit,” they must now confront a complex regulatory reality: The Wage-Pull-Back.

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Employee Stock Option Plans (ESOPs) are the primary tool for attracting top-tier talent without depleting cash reserves. Under the legacy regime, these were viewed strictly as “perquisites” or capital gains, safely tucked away from the definition of “wages.” However, under the Code on Wages, 2019, that safety net has vanished.

If your startup is planning a liquidity event or a buyback in this new era, your equity strategy might accidentally trigger a retrospective financial crisis.

The New Labour Code seeks to standardise the definition of wages across all four codes (Wages, Social Security, Industrial Relations, and Occupational Safety). The goal was to prevent “salary masking,” where employers kept the Basic Pay low to minimise contributions to the Provident Fund (PF) and Gratuity.

To understand if your ESOPs are wages, you must understand the Section 2(y) Tripartite Structure:

1. The Inclusions:

   • Basic Pay: The core salary.

   • Dearness Allowance (DA): Cost of living adjustments.

   • Retaining Allowance: Payments made to retain an employee.

2. The Exclusions:

   The Code lists 11 specific items that are not wages, provided they don’t cross a certain limit:

   • Statutory Bonus.

   • House Rent Allowance (HRA).

   • Employer’s PF and Pension contributions.

   • Conveyance/Travel allowance.

   • Gratuity and Retrenchment compensation.

   • “The value of any house-accommodation, or of supply of light, water, medical attendance or other amenity.” (This is the crucial category for ESOPs).

3. The 50% Proviso:

   This is the most critical rule of 2026. If the total of all Exclusions exceeds 50% of the Total Remuneration, the excess amount is “pulled back” and added to the Basic Wage.

The Code on Wages, 2019, defines wages as “all remuneration… expressed in terms of money or capable of being so expressed.” To identify the liability trigger, we must analyse the three stages of an ESOP through the lens of Section 2(y).

• Stage 1: Grant, here the company offers an option at a predetermined price. Legally, this represents a promise of a future right rather than an immediate exchange of money, meaning no wage liability exists because there is no immediate monetary value for the employee to realise.

• Stage 2: Vesting, during this stage the employee earns the right to exercise options by reaching specific milestones or tenure. However, it remains a contingent right without legal ownership of shares; therefore, no wage liability arises as the potential benefit is not yet “capable of being expressed in money” or reflected on a salary slip as an actual payment.

• Stage 3: Exercise and Ownership, here the employee pays the exercise price to officially become the legal owner of the shares. This shift triggers a definitive monetary event; the employee pays the exercise amount and relevant taxes to the government, and the salary slip captures the amount.

  At this point, the employee fully becomes the owner, and the difference between the Fair Market Value (FMV) and the Exercise Price is treated as a taxable “perquisite” under Indian Tax Law, which can potentially trigger wage classification under the 50% proviso of the Code on Wages, 2019.

As mentioned above, the “Basic Wage” must be at least 50% of the total pay. If your “Exclusions” (which include HRA, PF, and “other amenities” like ESOPs) exceed 50%, the excess is pulled back into the Wage definition.

The “Buyback” Complication: Asset Sale or Remuneration?

In the startup ecosystem, exercise is often immediately followed by a Buyback. This occurs when a company, preparing for a new funding round, buys back shares from employees to consolidate equity.

From a purely commercial standpoint, the employee is selling an asset they own, and the company is paying the market value for that asset. On the surface, this should not reflect as “wages” on a salary slip. However, the legal trap lies in how this payment is categorized under the new Code. Because the Code on Wages defines wages broadly as “all remuneration… capable of being expressed in money,” any massive cash inflow to an employee from their employer—even if structured as an asset purchase—risks being classified as “other remuneration.”

This classification places the entire buyback amount into the 50% Proviso calculation, potentially triggering a retrospective “pull-back” into the Basic Wage and creating an massive, unplanned PF and Gratuity liability for the startup.

Let’s understand this by way of an example: Consider an early-stage engineer, “Aarav,” who cashes out during a successful funding round.

• Aarav’s Annual CTC: INR 20,00,000 (Basic: INR 10L | Allowances: INR 10L).

• ESOP Buyback Value: INR 50,00,000

Total Remuneration: INR 20,00,000 + INR 50,00,000 = INR 70,00,000.

The 50% Ceiling: 50% of INR 70,00,000 = INR 35,00,000.

Actual Exclusions: INR 10,00,000 (Allowances) + INR 50,00,000 (ESOP) = INR 60,00,000.

The “Pull-Back”: The exclusions (INR 60L) exceed the ceiling (INR 35L) by INR 25,00,000.

The Consequence: This INR 25 Lakhs is now legally “Wages.” The startup is suddenly liable for back-dated PF, Gratuity, and leave encashment based on a wage of INR 35 Lakhs instead of the budgeted INR 10 Lakhs.

For a startup with 50 employees cashing out, this could create a multi-crore liability that destroys the company’s cash runway.

Startups must also navigate the “Universality Test” derived from the Vivekananda Vidyamandir Supreme Court legacy. The court has historically held that payments made “ordinarily and necessarily” to all employees are part of the wage base.

• The Risk of “All-Hands” Equity: If a startup grants ESOPs to everyone as part of its core culture, it unintentionally proves that equity is a universal, non-discretionary component of the wage.

• The Discretionary Defence: To keep ESOPs out of the wage base, they must be structured as discretionary incentives rather than a contractual right for all employees.

To protect your startup from a “Wage-Pull-Back” during a regulatory audit, your ESOP Plan and Appointment Letters must be updated immediately with these three safeguards:

Under Section 2(y), the law excludes the “value of any house-accommodation… or other amenity” from the definition of wages. Therefore, we recommend explicitly characterising your ESOP Plan in the Plan Document as an “incentive and amenity provided for long-term retention.” as this will align the equity benefit with the statutory exclusions listed in the Code, helping to categorise it as an “allowance” rather than “Basic Pay” during a 50% Proviso calculation.

The “Universality Test” suggests that if a payment is a contractual right for everyone, it is more likely to be considered a “wage.” Therefore, it is important to ensure that the Board retains “absolute discretion” over the timing, eligibility, and execution of grants and buybacks. Because if a payment is a discretionary incentive rather than a contractual right, it is harder for regulatory authorities to argue it is “remuneration ordinarily payable” to the employee.

A massive liquidity event can trigger unplanned PF and Gratuity liabilities that exceed a startup’s remaining cash. Therefore, we highly recommend that buyback agreements and appointment letters include a “Net-of-Statutory-Costs” clause:

By implementing these strategies, startups can ensure that a successful funding round or a necessary disciplinary action does not inadvertently lead to a compliance-driven bankruptcy.

In the pre-2026 era, ESOPs were a simple tax matter. In the May 2026 era, they are a high-stakes labour law liability.

Are your stock options “wages”? The answer is: “Only if you haven’t structured your 50% cap to account for liquidity events.” Startups that fail to perform a “Migration Audit” of their salary structures and ESOP plans today are essentially waiting for their most successful moment—a liquidity event—to trigger a compliance-driven bankruptcy.