Leave Encashment Tax in India: The ₹25 Lakh Exemption Explained

Most salaried people in India build up a bank of unused earned leave, and most employers will pay it out in cash at some point. That payment is called leave encashment, and how it is taxed depends almost entirely on when you receive it.

The short version: encash leave while you are still working and every rupee is taxed as salary. Encash it when you leave the job — on retirement or resignation — and a large part of it, up to ₹25 lakh across your whole career, can be tax-free. This guide explains how that exemption is worked out, why the answer is often smaller than people expect, and what to check on your full and final settlement.

What leave encashment is

Your employment contract or the company's leave policy gives you a number of earned or privileged leave days each year. Unused days usually carry forward up to a ceiling. Leave encashment is the cash value of those unused days, calculated on your salary at the time of payment.

It is not a separate benefit the law grants you. Whether you can encash leave at all, how many days carry forward and how the daily rate is computed are all set by your employer's policy (and, for some sectors, by state shops-and-establishments rules or factory law). Tax law only decides how much of whatever you receive is taxable.

Encashment while you are still employed

Some employers let you encash part of your leave balance every year, or at intervals. Money received this way is fully taxable as part of your salary in the year you receive it. There is no exemption for in-service encashment, for government or private employees alike.

Your employer will include it in your salary for TDS, so the monthly deduction in the month of payment jumps. It appears in Form 16 as part of gross salary.

That makes annual encashment a plain cash-flow choice rather than a tax-planning one: the money is taxed at your marginal rate either way. Carrying leave forward instead keeps the option of a tax-free payout later, when you leave the job, which is where the exemption below comes in.

Encashment on retirement or resignation

The exemption applies to leave encashment received at the time of leaving employment — on retirement (superannuation or otherwise) and also on resignation. Despite the word "retirement" in most summaries, someone who resigns at 32 to join another company qualifies just as a 60-year-old retiree does.

How much is exempt depends on who your employer was:

• Central or state government employees — the entire amount received on retirement is exempt. There is no ceiling.
• Everyone else — private-sector employees, and employees of public-sector undertakings, local authorities and most statutory bodies — get a partial exemption, equal to the lowest of four limits. Anything above that is taxable as salary.

The four-limit formula

For a non-government employee, the exempt portion is the lowest of these four figures:

Two definitions make or break the calculation:

• "Salary" here is narrow. It means basic pay, dearness allowance if the terms of employment count DA for retirement benefits, and commission paid as a fixed percentage of turnover. It does not include HRA, special allowance, bonus or most other components. For a CTC-heavy private salary where basic is 40% of gross, this matters a great deal.
• "Completed years" means whole years. Eight years and eleven months of service is eight completed years for limit 4.

Limit 4 is the one that catches people out. If your employer is generous and lets you accumulate 60 days of leave a year, the formula still only credits 30 days per completed year. The extra leave can still be paid to you — it just becomes taxable.

A worked example

Asha resigns from a private company after 9 years and 7 months. Her basic pay was ₹60,000 a month for the last 10 months, and her terms do not count DA towards retirement benefits. She has 240 days of unused leave and the company pays her ₹4,80,000 for it (240 days at a daily rate of ₹2,000, as per its policy).

1. Limit 1: ₹25,00,000 (assuming no earlier claim)
2. Limit 2: amount received = ₹4,80,000
3. Limit 3: 10 × ₹60,000 = ₹6,00,000
4. Limit 4: completed years = 9 → max 270 days credited; she has 240, so 240 days count. 240 ÷ 30 = 8 months × ₹60,000 = ₹4,80,000
5. Exempt = lowest = ₹4,80,000 → taxable = ₹0

Now change one fact: her company's policy let her accumulate 400 days, paid at ₹8,00,000. Limit 4 now caps the credit at 270 days (9 × 30), worth 9 months × ₹60,000 = ₹5,40,000. Limit 3 is ₹6,00,000, so the lowest is ₹5,40,000. Exempt: ₹5,40,000. Taxable: ₹2,60,000, added to her salary for the year.

The leave encashment calculator runs the same four limits on your own numbers.

The ₹25 lakh cap is per lifetime

Limit 1 is not refreshed every time you change jobs. If you claimed an exemption of ₹4,80,000 on leaving your first employer, your remaining ceiling for every future employer is ₹20,20,000. Most people never get near ₹25 lakh, but long careers with senior salaries can.

Two practical consequences:

• Keep the record. Your full and final settlement statement and Form 16 from each employer are the evidence of what you have already used.
• Tell your new employer only if it matters. The exemption is computed by the employer paying you, who has no automatic view of your history. If you are near the cap, check the computation in your settlement rather than assuming it is right — and correct it in your return if it is not.

Receiving encashment from two employers in the same year (say, a job that ends and another that ends again) also uses the same single ceiling.

Death, government service and the tax regimes

• Encashment paid to legal heirs after an employee's death is not taxable in their hands. It is not salary of the heir, and the deceased never received it.
• Government employees remain fully exempt on retirement. Their in-service encashment is still taxable like anyone else's.
• Old regime vs new regime. This exemption is one of the few that survive in the new tax regime. Leave encashment on retirement or resignation is exempt under both, so it should not be a reason to pick one regime over the other. The new regime guide covers what does and does not carry across.
• Encashment as part of a VRS package is assessed separately from the VRS compensation exemption. Both can apply.

What changes under the Income-tax Act, 2025

The Income-tax Act, 1961 was replaced by the Income-tax Act, 2025 from 1 April 2026, and most section numbers changed with it. Leave encashment is no exception: the exemption most guides, payslips and older Form 16s describe as "Section 10(10AA)" sits under a new section number in the 2025 Act.

The substance has been carried across — the ₹25 lakh lifetime ceiling, the four-limit formula for non-government employees and full exemption for government employees. For a return covering the year to 31 March 2026, the 1961 Act's references still apply. For later years, expect your Form 16 and the return form to use the new numbering, and use the official income tax portal's mapping if you need to cite the section.

Before you sign a full and final settlement, check three things: the leave balance it pays, the "salary" figure used (basic plus eligible DA, not gross), and the completed years of service. Those three inputs decide the exempt amount; everything else is arithmetic. The full and final settlement guide covers the rest of the exit paperwork, including gratuity.