Office 365 documents are not being labelled automatically.

Vinay 

Thanks for posting your issue. Based on your description and what is happening, the most likely cause would be the priority you have set your policies to. The "Confidential" policy sounds like it is set as the higher priority policy, which sets the default label to "none", so any user in both the "Confidential" and "Internal" groups will receive the "no default label" setting from the "Confidential" policy.

You can fix this by selecting the check box next to the "Confidential" policy and moving it to "0" using the arrows on the screen, which makes it the lowest priority. See the below image:

You can read the information at this link for more information. Please feel free to follow up if this does not resolve the issue.

https://learn.microsoft.com/en-us/microsoft-365/compliance/sensitivity-labels?view=o365-worldwide#label-policy-priority-order-matters