* Producer price index rises 0.4 percent in October
* PPI increases 2.8 percent year-on-year
* Core PPI gains 0.2 percent, up 2.3 percent year-on-year
WASHINGTON, Nov 14 (Reuters) - U.S. producer prices rose more than expected in October, driven by a surge in the cost of services, leading to the biggest annual increase in wholesale inflation in over 5-1/2 years.
Tuesday's report from the Labor Department also showed steady gains in underlying producer prices, which support expectations of a gradual increase in inflation and keep the Federal Reserve on track to raise interest rates in December.
The producer price index for final demand increased 0.4 percent last month after a similar gain in September. In the 12 months through October, the PPI jumped 2.8 percent, the largest increase since February 2012.
The PPI rose 2.6 percent year-on-year in September. Economists had forecast the PPI edging up 0.1 percent last month and increasing 2.4 percent from a year ago.
Prices for services advanced 0.5 percent last month after increasing 0.4 percent in September. A 24.9 percent surge in margins for fuels and lubricants retailing accounted for almost half of the increase in the cost of services last month.
That helped to offset a 4.6 percent drop in the cost of gasoline. Wholesale gasoline prices soared 10.9 percent in September in the aftermath of Hurricane Harvey, which struck Texas in late August and reduced refining capacity in the Gulf Coast area.
Gasoline prices are falling amid ample crude oil supplies. Last month's rise in prices received by the nation's farms, factories and refineries was also driven by rising costs for goods such as pharmaceutical preparations, fresh and dry vegetables, meat and tobacco.
The dollar pared losses against a basket of currencies after the data, while prices for U.S. Treasuries fell.
A key gauge of underlying producer price pressures that excludes food, energy and trade services rose 0.2 percent last month. It has increased by the same margin for three straight months. The so-called core PPI increased 2.3 percent in the 12 months through October after advancing 2.1 percent in September.
A weakening dollar could gradually lift core PPI. The dollar has this year lost 5.4 percent of its value against the currencies of the United States' main trading partners.
Inflation has remained stubbornly low, despite the labor market nearing full employment. The main inflation measure tracked by the Fed has remained below the U.S. central bank's 2 percent target since mid-2012.
Despite moderate price pressures, the Fed is expected to raise interest rates next month. There is cautious optimism that tightening labor market conditions will spur faster wage growth next year.
The Fed has increased borrowing costs twice this year. October's consumer inflation data scheduled for release on Wednesday could shed more light on the future course of monetary policy.
Last month, food prices rose 0.5 percent after being unchanged in September. Core goods increased 0.3 percent after a similar gain in the prior month. Prices for passenger cars were unchanged last month. The government introduced new motor vehicle pricing models into the survey in October.
The cost of healthcare services gained 0.3 percent after being unchanged in September. Those costs feed into the Fed's preferred inflation measure, the personal consumption expenditures (PCE) price index excluding food and energy. (Reporting By Lucia Mutikani; Editing by Andrea Ricci)