Understanding the GST Compensation Cess in India
The GST Compensation Cess, established by the 2017 Act, aims to reimburse Indian states for revenue shortfalls post-GST implementation. While most goods will see its discontinuation from September 2025, it will persist for tobacco and related products until COVID-19 related state compensation debts are settled. The cess is collected by most taxpayers on specific goods and services, and its ITC can only offset other compensation cess liabilities. States' compensation is calculated based on a projected 14% revenue growth against actual earnings, with the central government exploring options like formula revision or market borrowing to cover deficits.
The Goods and Services Tax (Compensation to States) Act of 2017 imposes the GST Compensation Cess. This levy aims to offset revenue losses experienced by Indian states following the introduction of GST on July 1, 2017. The cess was initially planned for a five-year duration or as specified by the GST Council. During the anticipated 56th GST Council meeting on September 3, 2025, a streamlined GST rate structure was introduced. The previous four slabs (5%, 12%, 18%, 28%) were consolidated into a simpler framework:
- Standard Rate: 18% for the majority of goods and services.
- Merit Rate: 5% for essential goods and priority sectors.
- Demerit Rate: 40% applied selectively to luxury and 'sin' items.
As of September 22, 2025, the GST compensation cess will no longer apply to most goods. However, it will continue for tobacco and associated products like cigarettes, pan masala, gutkha, chewing tobacco, zarda, unmanufactured tobacco, and bidis. This continuation is mandated until the central government settles all outstanding loan and interest payments, which were accumulated to offset state revenue deficiencies during the COVID-19 pandemic. Following the complete discontinuation of the cess, tobacco and related items will only be subject to a 40% GST rate. The precise date for this cessation will be announced by the Finance Ministry once all related financial obligations are resolved.
Who is Required to Collect GST Compensation Cess?
Taxpayers involved in providing specified goods or services, excluding exporters and those under the composition scheme, are required to collect the compensation cess. This also extends to compensation cess levied on specific goods imported into India. Exporters are eligible to claim a refund for any compensation cess paid on their exports.
What Goods are Covered Under Compensation Cess?
The GST (Compensation to States) Act of 2017 outlines various goods subject to the compensation cess and their corresponding rates, which are updated periodically. A comprehensive list is provided below:
| Goods | GST Compensation Cess |
|---|---|
| Cut tobacco | 0.14R per unit |
| Unmanufactured tobacco (with lime tube) – featuring a brand name | 0.36R per unit |
| Unmanufactured tobacco (without lime tube) – with a brand name | 0.36R per unit |
| Branded tobacco refuse | 0.32R per unit |
| Tobacco extracts and essence bearing a brand name | 0.36R per unit |
| Tobacco extracts and essence not bearing a brand name | 0.36R per unit |
| Filter khaini | 0.56R per unit |
| Jarda scented tobacco | 0.56R per unit |
| Cheroots and Cigar | 21% or 4170 per thousand, whichever is higher |
| Cigarillos | 21% or Rs. 4170 per thousand, whichever is higher |
| Cigarettes containing tobacco excluding filter cigarettes, of length not more than 65mm | 5% + 2076 per thousand |
| Cigarettes containing tobacco apart from filter cigarettes, of length more than 65mm and up to 75mm | 5% + 3668 per thousand |
| Filter cigarettes of length (including the length of the filter, the length of filter being 11 millimetres or its actual length, whichever is more) not exceeding 65 millimetres | 5% + Rs.2076 per thousand |
| Filter cigarettes of length (including the length of the filter, the length of filter being 11 millimetres or its actual length, whichever is more) exceeding 65 millimetres but not exceeding 70 millimetres | 5% + Rs.2747 per thousand |
| Filter cigarettes of length (including the length of the filter, the length of filter being 11 millimetres or its actual length, whichever is more) exceeding 70 millimetres but not exceeding 75 millimetres | 5% + Rs.3668 per thousand |
| Cigarettes of tobacco substitutes | Rs.4006 per thousand |
| Cigarillos of tobacco substitutes | 12.5% or Rs. 4,006 per thousand whichever is higher |
| Smoking mixtures for pipes and cigarettes | 290% |
| Branded ‘hookah’ or ‘gudaku’ tobacco | 0.36R per unit |
| Tobacco used for smoking ‘hookah’ or ‘chilam’ commonly known as ‘hookah’ tobacco or ‘gudaku’, not bearing a brand name | 0.12R per unit |
| Other water pipe smoking tobacco not bearing a brand name | 0.08R per unit |
| Other smoking tobacco bearing a brand name | 0.28R per unit |
| Other smoking tobacco not bearing a brand name | 0.08R per unit |
| Homogenised or reconstituted tobacco, bearing a brand name | 0.36R per unit |
| Chewing tobacco (without lime tube) | 0.56R per unit |
| Chewing tobacco (with lime tube) | 0.56R per unit |
| Preparations containing chewing tobacco | 0.36R per unit |
| Pan masala (gutkha) containing tobacco | 0.61R per unit |
| All goods, other than pan masala containing tobacco ‘gutkha’, bearing a brand name | 0.43R per unit |
| All goods, other than pan masala containing tobacco ‘gutkha’, not bearing a brand name | 0.43R per unit |
| Snuff | 0.36R per unit |
| Preparations containing snuff | 0.36R per unit |
| Coal, ovoids, briquettes, and similar solid fuels manufactured from lignite, coal, whether or not agglomerated, excluding jet, peat (including peat litter), whether or not agglomerated | Rs.400 per tonne |
| Aerated waters | 12% |
| Lemonade | 12% |
| Others | 12% |
| Motorcycles of engine capacity exceeding 350 cc | 3% |
| Aircrafts (including helicopters, etc.) for personal use | 3% |
| Yacht and other vessels for pleasure or sports | 3% |
| Motor vehicles for the transport of not more than 13 persons, including the driver | 15% |
| Motor vehicles, excluding ambulances, three-wheelers and vehicles of engine capacity not exceeding 1500cc and of length not exceeding 4000 mm, with both spark-ignition internal combustion reciprocating piston engine and electric motor as motors for propulsion or with with both compression-ignition internal combustion piston engine [diesel-or semi diesel] and electric motor as motors for propulsion | 15% |
| Petrol, liquefied petroleum gas (LPG) or compressed natural gas (CNG) driven motor vehicles of engine capacity not exceeding 1200cc and of length not exceeding 4000mm. | 1% |
| Diesel driven motor vehicles of engine capacity not exceeding 1500cc and of length not exceeding 4000mm. | 3% |
| Motor vehicles of engine capacity not exceeding 1500 cc | 17% |
| Motor vehicles of engine capacity exceeding 1500 cc other than motor vehicles specified against entry at S. No 52B | 20% |
| Motor vehicles of engine capacity over 1500cc, popularly known as Sports Utility Vehicles (SUVs) including utility vehicles. | 22% |
How to Utilise Input Tax Credit (ITC) of Compensation Cess?
Input Tax Credit (ITC) generated from the compensation cess is exclusively applicable for offsetting compensation cess liabilities that arise from outward supplies.
How to Calculate Compensation Cess?
The compensation cess is imposed in addition to the standard GST amount on specific supplies. Its calculation mirrors that of GST; the stipulated rate is applied to the transaction value, as defined by Section 15 of the CGST Act 2017, to determine the cess liability.
How Will the Compensation Cess be Distributed to the States?
The compensation amount designated for distribution to individual states is determined through the following procedure:
Step 1: Establish Base Revenue
Establish the base revenue, which is the state's tax revenue from the fiscal year 2016-17.
Step 2: Project Future Revenue
Project future revenue for each fiscal year, assuming a 14% growth rate. This projected figure represents the revenue a state would have potentially generated without GST implementation. This calculation covers a five-year transitional period, reflecting the initial duration of the compensation cess.
Step 3: Determine Compensation Payable
Determine the compensation payable for each fiscal year using the following calculation:
| Description | Amount |
|---|---|
| Projected Revenue for the Financial Year | xxx |
| Less: Actual Revenue Earned by the State | xxx |
| Equals: Compensation Payable to the State | xxx |
This provisional calculation leads to bi-monthly payments to the states. Any surplus remaining in the compensation fund at the conclusion of the transitional period will be allocated between the Central government and the states according to an agreed-upon formula.
Ways to Acquire Funds for Distributing Compensation Cess?
Currently, compensation payments for the final quarter of FY 2019-20 are in arrears, with the compensation fund facing a growing deficit, largely due to the global economic slowdown caused by the pandemic. The Central government has several approaches to address this funding shortfall:
- Revising the compensation cess calculation formula.
- Increasing the compensation cess rate or expanding the list of commodities subject to the cess.
- Securing funds through market borrowings.