Sadly this is true for this game. I had my paladin fell because the second (always the second) NPC character died while on her party.
FDR, I let an NPC die on purpose and sure enough, that was the issue. I agree, this is a strange rule, and very unconducive to playing a Paladin. Losing LOH and other powers mid-dungeon is a big loss for my party. I also dont have 3000 gold to atone after every side quest. It may have been put in place to prevent the cheat of accepting an NPC only to let them die so as to loot their items? But certainly, if my Paladin is fighting in the front rank (as he normally does), Im not sure how he is being held accountable for, say, shieldless Thock getting split in half by the single stroke of a frost giant. However, I assume it is hard-coded, as I am playing vanilla ToEE not Temple+.
If this is the norm for paladins in ToEE, then I think I now know why I don't recall seeing it before. I don't recall playing a paladin in ToEE before, but maybe I have a very long time ago. But I do recall playing a paladin in KotB, again, many years ago, but I don't recall ever taking on any NPCs. In ToEE, I rarely take on any NPCs, and if I do it would be for a very short amount of time. So, what's the moral of the paladin's story? Never take on the responsibility of NPCs
In vanilla ToEE, paladins are held accountable for every action the party takes simply by association. Remember the drinking contest in Hommlet? If you have a paladin in party, he or she will fall after it.
Yeah, I remember posts and discussions about paladins and the drinking contest, but that's a little different than people in your party that die in combat.
Think of NPCs as retainers, the paladin simply cannot recruit retainers to help him/her with the dying.
I'm not sure how hard coded it actually is. One thing that is hard coded is that a bunch of reputations (by number) trigger adding the fallen condition. However, it doesn't look like the DLL code adds reputations on its own, so those might just be controlled by script. If allowing NPCs to die triggers a reputation, and that reputation is on the list, that would explain it. But then the question is whether selecting that number was intentional (in that respect) or not.