It's not actually compulsory to send by registered mail if the buyer paid using PayPal. There are other ways of proving that the item has been posted, but it's true that PAYPAL will not accept most of them.
If a seller sends by registered mail, the fact that a buyer paid by PayPal is moot anyway. The seller should check with AP to see whether the parcel has been delivered. If it's gone missing, the seller's best method to keep the customer happy is to instantly refund the buyer, and then put in a claim to AP. No need to let PayPal become involved at all. The real protection here is through AP because it was sent via registered mail.
HOWEVER - huge caveat - the seller should ALWAYS always always always refund the buyer through ONE MEANS ONLY: through PayPal, as a refund (not as a payment). The reason for this is that if the seller refunds in any other way (let's say by sending a cheque, or cash, or as a PayPal payment, or a Paymate payment, etc.), PayPal will regard it as the BUYER NOT HAVING BEEN REFUNDED, if the buyer goes ahead and lodges a dispute / claim.
If the registered post item is marked by AP as having been delivered, then the seller should not refund the buyer. In this case, if the buyer then proceeds with a PayPal dispute, the evidence which the seller has (of having sent by registered post) is PROTECTION AGAINST A CLAIM OF INR if the seller knows the item has been delivered. Pardon me if I stress this: the only protection PayPal really offers by the seller using registered post is against PayPal forcibly taking funds from the seller to refund the buyer in the case of the item being marked as delivered by AP. (Note the irony? PayPal will protect you against PayPal.)
The seller might have other evidence that the item was posted, but he/she will have more difficulty in submitting that proof to PayPal and in getting PayPal to accept it. In some cases, buyers have received their refund through PayPal (from the seller's fund), and the seller, after failing to convince PayPal that the item was sent, then lodges a dispute to the Financial & Banking Ombudsman against PayPal. As long as the seller has evidence that will satisfy the OMBUDSMAN that the item was sent (and that doesn't require registered post by any means, just proof of postage, and perhaps a Stat Dec), PayPal will be ordered to refund the seller. PayPal will not in that case be able to recover the refund from the buyer, since their own investigation found in favour of the buyer (irrespective of whether the buyer was being honest or not).
For the buyer, you're not likely to end up being out of pocket with INR under PayPal's current User Agreement unless the seller is able to convince PayPal that he/she sent the item although the evidence is false. I have heard of some fraudulent tracking information being used in some cases, to the buyer's detriment. This occurred in some overseas transactions (I don't have a reference to them, sorry).
But virtually in every case, the buyer is in a position of advantage. You just need to state that the item wasn't received. If it was not sent by trackable means, the seller is unable to provide PayPal with the burden of proof, and the seller's account will be forced to pay for the refund. Even if the seller hasn't got the money in his/her PayPal account, so far I haven't heard of buyers not being refunded as long as their purchase complies with the eBay/PayPal Buyer Protection Policy; in those cases, eBay will go after the seller to recuperate the refund.
If by any chance you are not refunded, you can still contact the Ombudsman and open a claim against PayPal.