Leave Encashment

Section numbers here are from the Income tax Act, 1961, the operative law for the current filing cycle. This article is for general information and does not constitute tax advice.

Only encashment at exit qualifies

This is the point that decides everything else on this page. Only encashment at retirement, superannuation, or resignation qualifies for the Section 10(10AA) exemption. Leave encashed while still actively employed, an annual encashment of unused leave during service, for instance, is fully taxable as ordinary salary with normal TDS, the exemption below has no application to it at all. Whether the payout is tax-free is a question of why you were paid, not how much.

Government employees: fully exempt

Government employees get full exemption on leave encashment received at retirement, with no rupee ceiling, the same pattern as gratuity.

Non-government employees: the least of four figures

The exemption is the least of:

• Actual leave encashment received
• ₹25 lakh
• Ten months’ average salary
• The cash equivalent of unused leave at credit, capped at 30 days per completed year of service even if the employer’s own leave policy grants more

The fourth limb is easy to miss. An employer that grants 45 days of leave per year still has the exemption computation capped at 30 days per completed year, regardless of what the employee actually accrued or was entitled to encash under company policy.

Worked example: the surprising limb

An employee retires after 20 years at a company that let leave accumulate generously, up to 45 days a year. At exit, 620 days sit unused. The 10-month average of basic and DA is ₹60,000 a month, giving a per-day rate of ₹2,000. The employer pays out the full 620 days: ₹12,40,000.

Limb	Amount
Actual leave encashment received	₹12,40,000
Statutory cap	₹25,00,000
Ten months’ average salary	₹6,00,000
Cash equivalent, capped at 30 days × 20 years (600 days)	₹12,00,000

Most people assume the 30-day cap or the ₹25 lakh ceiling is what limits the exemption here, since those are the two figures everyone remembers. Neither is. The ten months’ average salary limb, easy to overlook because it looks like a generous number on its own, turns out to be the smallest of the four and is what actually governs. Exemption: ₹6,00,000. Taxable: ₹6,40,000, more than half the payout, despite 620 days genuinely sitting unused and well within the employer’s own policy.

The 25 lakh rupee figure is recent, and lifetime

The ₹25 lakh figure replaced a ₹3 lakh cap that had stood unchanged since 2002, raised by CBDT notification with effect from 1 April 2023. Anyone comparing against older material or an earlier retirement in the same career should check which figure applied at the time. Like the gratuity cap, it is a lifetime ceiling aggregated across every employer, not reset at each job, so an earlier claim reduces what is available now.

It sits alongside gratuity, not against it

Retirement often produces both leave encashment and a gratuity payout in the same financial year. The two exemptions are computed entirely independently, with their own separate caps, and do not offset or interact with each other, covered from the gratuity side in Gratuity.

Relief for a large lump sum

Where the taxable portion of a leave encashment payout is large and paid as a lump sum, Section 89 relief, claimed via Form 10E, can reduce the tax impact of the bunching by spreading it against the years it effectively relates to, worth checking whenever a retirement payout pushes a single year’s income unusually high.