Normally the contractor will bill the principal employer on actual salaries paid to his employees engaged for the principal employer plus the contributions he pays on that wages towards ESI, EPF, Welfare Fund etc, plus monthly element of statutory bonus payable by him and the service charge. The Service Tax is calculated at the applicable rate (10.3%) on the sum total of the charges, ie, wages+ statutory contributions and payments+ his service charges (means his own take as contractor). If your practice is to bill only wages part and then collect the statutory payments separately, then the Service Tax authority's demand is correct because in your bill you have only mentioned the payouts to workers. It should have been the total cost to contractor that is recovered from the principal employer that is subject to service tax. Now it has become the contractor's liability to pay the service tax. Had it been billed on gross, he could have collected it from the Principal employer.
Regards,
Madhu.T.K