When the Goods and Services Tax (GST) was introduced in 2017, it changed how indirect taxes worked across states. Under the earlier tax system, states collected many different levies on goods and services within their borders. GST replaced all that with a destination-based tax, where the state where goods or services are consumed gets the revenue. This brought uniformity and simplicity.
But it also raised an important question: what if some states earned less revenue after the switch to GST? To support states during this transition, the GST Compensation Cess was introduced. This was a special tax charged on certain goods in addition to regular GST.
In this blog, we explain what compensation cess is, how it works now, and who needs to pay it.
GST Cess Applicability
The gst cess applicability has changed significantly after the major tax reforms that started on 22 September 2025. Prior to that date, many luxury items, sin goods (like aerated drinks, luxury vehicles, and tobacco products) attracted compensation cess in addition to GST. This was to generate funds to compensate states for any loss in revenue from the GST rollout.
With the new structure in place, compensation cess has been discontinued on most of those products. It now applies mainly to tobacco and related products (such as cigarettes, beedi, gutkha, chewing tobacco, and pan masala) and will continue only until the outstanding obligations of the compensation fund (including loan repayment and interest) are fully cleared.
This means that for most goods that previously attracted cess — like cars, coal, aerated drinks, and motorcycles — compensation cess no longer applies from late September 2025 onwards.
What Is GST Compensation Cess?
The GST Compensation Cess is an additional tax that was first introduced when GST began in July 2017. The purpose was simple: help states transition smoothly to the new tax regime without revenue shocks. Under the GST (Compensation to States) Act, this cess was collected alongside regular GST and placed in a dedicated GST Compensation Fund.
The fund was then used to compensate states for any shortfall in revenue, calculated on the basis of projected growth rates, for the first few years after GST rollout. While the original plan was for this cess to last five years (till June 2022), it continued beyond that because the central government used borrowings to pay compensation amounts, especially around the pandemic period.
Over time, the cess collections helped states meet their revenue needs without disruption.
Why Was the GST Compensation Cess Introduced?
Under the earlier indirect tax system, states relied on multiple levies like VAT, excise, and entry taxes. After GST, these disappeared, and tax revenue became destination-based. This meant states that produced goods could see lower tax collections if goods were consumed in other states.
To reassure states and secure their agreement to adopt GST nationally, the compensation mechanism was added. The idea was that if a state’s actual GST revenue was lower than its guaranteed level, the difference would be made up from the compensation fund funded by this cess.
This move helped ensure that the shift to a unified tax system did not leave any state financially disadvantaged.
How Is GST Compensation Cess Collected?
When compensation cess is applicable to a good, it is charged in addition to the regular GST rate. The cess amount is calculated based on the taxable value of the product. For imports of goods subject to compensation cess, the cess is also payable at the time of import, along with GST and customs duty.
For example:
- If a tobacco product is sold domestically by a registered supplier, GST and compensation cess are calculated separately on the taxable value and charged together.
- If a tobacco product is imported, cess is charged along with IGST and customs duties at the port.
It’s important to note that under the current regime, most products no longer attract compensation cess. Only tobacco and closely related products continue to do so until the outstanding liabilities of the compensation fund are settled.
Who Needs to Pay GST Compensation Cess?
Registered Taxable Persons
If you are a registered taxpayer supplying goods that currently attract compensation cess, you must collect and remit this cess along with the regular GST. This applies to manufacturers, traders, wholesalers, and retailers of those goods (for example, tobacco products and similar items still under cess).
Exceptions and Special Cases
- Exporters
Exports of goods that attract compensation cess in the domestic market are normally zero-rated under GST. Exporters can claim a refund of the cess paid on goods that are exported. This ensures that exports remain competitive and not burdened by taxes meant for the domestic market. - Composition Scheme Taxpayers
Small taxpayers registered under the GST Composition Scheme pay tax at a fixed rate on turnover instead of regular GST and are not required to collect compensation cess. This is because composition schemes are designed to simplify tax compliance for smaller businesses. - Goods No Longer under Cess
If you supply goods that no longer attract compensation cess after the reform (like luxury cars, aerated drinks, coal, etc.), you are not required to pay compensation cess even if those products previously had it.
What Happens to the Cess Money?
All the money collected as compensation cess is credited to the GST Compensation Fund. The main use of this fund has been to make up for revenue shortfalls of states as agreed under the Compensation Act.
After the September 2025 reform and with most cess items removed, the cess revenue has dropped significantly because it now applies only to tobacco products. The government continues to use these funds to settle outstanding compensation liabilities, including repayment of borrowings taken during the pandemic period. These collections are being used to repay outstanding compensation-related borrowings, after which the compensation cess is expected to be phased out.
Some policy proposals also suggest that once the compensation cess ends fully, the government will replace it with other targeted levies, such as specific excise duties on harmful goods like tobacco, to ensure taxation remains high on products with health risks.
Current Status and What to Expect Next
After the GST reform effective from 22 September 2025, the compensation cess has disappeared on most goods. Only tobacco and closely related products still attract this tax, and only until the compensation fund’s outstanding liabilities are cleared. Collections for these goods have fallen compared to earlier years, reflecting the narrower scope of cess applicability.
Once the repayment of compensation-related loans and interest is complete, the compensation cess may be fully discontinued. Meanwhile, new tax laws are being introduced to replace the cess on tobacco and pan masala with different levies, to maintain high taxation on harmful products while protecting revenue collections.
Conclusion
The GST Compensation Cess was a carefully designed support mechanism during the early years of GST implementation. It helped states manage revenue changes as the tax structure shifted. After the major tax reform of 2025, the compensation cess has been largely phased out for most goods. At present, it mainly applies to tobacco and closely related products, and only so long as outstanding compensation-related liabilities remain to be settled.
If you are a registered taxpayer dealing in goods that currently attract compensation cess, ensure that it is collected and remitted correctly along with GST. If your goods no longer fall under compensation cess after the reform, you are not required to pay it. Staying updated with official notifications issued by tax authorities and decisions of the GST Council will help you remain compliant and avoid penalties.
