When you retire after years of saving your earned leaves, the cash your employer pays for those unused days is called leave encashment. Whether leave encashment tax applies depends on two things: when you receive the payment and who your employer is. For private-sector employees, up to Rs 25 lakh can be completely tax-free at retirement. This guide explains the four-limit formula, the government vs private rules, and how the provision moved from Section 10(10AA) to Section 19 under the new Income-tax Act, 2025.
Quick answer
Leave encashment received at retirement (including superannuation) is tax-free for government employees with no ceiling, and tax-free up to Rs 25 lakh for private employees under a four-limit test. Leave encashment received while you are still employed is fully taxable as salary. The exemption works under both the old and the new tax regime.
Leave encashment tax at a glance
| Situation | Government employee | Private employee | Received while in service |
|---|---|---|---|
| Tax treatment | Fully exempt, no ceiling | Exempt up to Rs 25 lakh (four-limit test) | Fully taxable as salary |
| Provision | Section 10(10AA)(i) | Section 10(10AA)(ii); Section 19 of the new Act from FY 2026-27 | Taxed as salary, TDS by employer |
| Regime effect | None | None — works in old and new regimes | Relief under Section 89(1) possible |
By the numbers
- Rs 25,00,000 — the lifetime tax-free ceiling for non-government employees, notified by CBDT Notification No. 31/2023 dated 24 May 2023 and clarified in CBDT Circular No. 15/2023 dated 28 November 2023 (per taxguru.in).
- Rs 3,00,000 to Rs 25,00,000 — the Budget 2023 hike, an 8.33-times jump. The old Rs 3 lakh cap had stayed unchanged since 2002 (per taxguru.in).
- 30 days — the maximum leave per completed year of service that counts for the exemption calculation.
- 10 months — the average-salary window used in the four-limit test, taken from the months immediately before retirement.
What changed and what stayed the same
Changed: The Union Budget 2023 raised the exemption ceiling for non-government employees from Rs 3 lakh to Rs 25 lakh, effective from AY 2024-25. And from FY 2026-27 (Tax Year 2026-27), the Income-tax Act, 2025 takes over — Section 10(10AA) of the old Act becomes Section 19 of the new Act. For FY 2025-26, the 1961 Act still governs, so your current returns and Form 16 will still cite 10(10AA).
Stayed the same: The four-limit formula, the government vs private distinction, the lifetime nature of the Rs 25 lakh cap, and the full taxability of in-service encashment. The renumbering changed the address, not the content.
The four-limit exemption formula for private employees
For a non-government employee receiving leave encashment at retirement, the exempt amount is the least of these four figures:
- Actual amount received — whatever the employer paid as leave encashment.
- Rs 25,00,000 — the notified lifetime ceiling. This is the total you can claim tax-free across your entire career, not per employer.
- Ten months’ average salary — the average of Basic + Dearness Allowance earned in the ten months immediately before retirement.
- Cash equivalent of unavailed leave — computed as (unavailed leave days ÷ 30) × ten months’ average salary. Only up to 30 days of leave per completed year of service counts, and leave you already took is subtracted first.
Anything above the smallest of these four is added to your taxable salary income.
What counts as “salary” here
For the ten-month average, “salary” means Basic pay + Dearness Allowance (only if DA forms part of your retirement benefits under your terms of employment) + commission expressed as a fixed percentage of turnover. HRA, bonuses, and other allowances do not count. This narrow definition matters — a high CTC with a low basic gives a smaller ten-month average and therefore a smaller exemption.
Worked example: Rs 9 lakh encashment after 22 years
Take a private-sector employee retiring after 22 years of service:
- Basic salary: Rs 75,000 per month; DA: Rs 10,000 per month
- Leave earned: 30 days × 22 years = 660 days; unavailed leave: 480 days
- Leave encashment received: Rs 9,00,000
Step 1 — Ten months’ average salary: Rs 75,000 + Rs 10,000 = Rs 85,000 per month. Rs 85,000 × 10 = Rs 8,50,000.
Step 2 — Cash equivalent of unavailed leave: (480 ÷ 30) × Rs 85,000 = 16 × Rs 85,000 = Rs 13,60,000.
Step 3 — Apply the four limits:
| Limit | Amount |
|---|---|
| Actual encashment received | Rs 9,00,000 |
| Lifetime ceiling | Rs 25,00,000 |
| Ten months’ average salary | Rs 8,50,000 |
| Cash equivalent of leave | Rs 13,60,000 |
The least is Rs 8,50,000 — fully exempt. The balance, Rs 9,00,000 − Rs 8,50,000 = Rs 50,000, is taxable as salary.
Government employees: full exemption, no ceiling
Central and state government employees get the simplest deal: the entire leave encashment paid at retirement is fully exempt under Section 10(10AA)(i), with no Rs 25 lakh ceiling and no four-limit calculation. Employees of public-sector undertakings (PSUs), banks, and autonomous bodies are treated as non-government for this purpose — they follow the private-employee rules above.
What if you resign instead of retiring?
The Act covers payment “on retirement whether on superannuation or otherwise.” In practice, this includes resignation and other exits that your service rules treat as retirement. So a private employee who resigns after years of service and receives encashment in the full-and-final settlement can claim the same four-limit exemption — it is not restricted to superannuation at 58 or 60. What does not qualify is encashment received while you continue in the same job.
Encashment received while still in service
If your employer pays leave encashment during your employment — for example, an annual encashment of accumulated leave — the amount is treated as ordinary salary and is fully taxable. Your employer deducts TDS on it under the normal salary-TDS provisions (Section 192, now Section 392 under the new Act).
One relief is available: Section 89(1). Because a lump-sum encashment can push you into a higher slab for one year, Section 89(1) spreads the extra tax burden across the years the leave was earned. Claim it by filing Form 10E online before filing your return — without Form 10E, the relief is not allowed.
On death of the employee
When an employee dies, any leave encashment paid to the legal heirs is fully exempt. The heirs do not apply the Rs 25 lakh ceiling or the four-limit calculation — the payment is simply tax-free in their hands. This is one of the few terminal benefits where the heirs are treated better than the employee would have been.
The Rs 25 lakh lifetime rule across employers
The ceiling is per employee, not per employer. If you claimed a Rs 10 lakh exemption when leaving your first company, only Rs 15 lakh of the ceiling remains for the next one. Each time, the four-limit test is applied afresh, but the Rs 25 lakh figure in the test is reduced by whatever you already claimed.
Practical tip: when you join a new employer, tell the payroll team how much leave-encashment exemption you have already used. They need it to compute correct TDS on any future encashment. Keep your old Form 16 / full-and-final statements as proof — the assessing officer can ask for them.
Old regime vs new regime
The leave-encashment exemption is tied to the nature of the receipt, not to any investment or deduction chapter. So it works identically under both regimes — unlike HRA or 80C, it is not one of the exemptions the new regime takes away. The regime choice only affects the tax rate on the taxable balance, if any. (Old vs new regime comparison for FY 2026-27.)
Practical impact: the rupee saving
In the worked example above, Rs 8,50,000 of the Rs 9,00,000 encashment was exempt. At a 30% marginal slab, that exemption saves Rs 2,55,000 in tax (8,50,000 × 30%); at the 20% slab it saves Rs 1,70,000. Only the Rs 50,000 balance is taxed — Rs 15,000 at 30%. Compare this with the pre-2023 position, when only Rs 3 lakh was exempt: the Budget 2023 hike alone saved this retiree about Rs 1,65,000 in tax.
Like gratuity, leave encashment is one of the retirement benefits worth planning around — our gratuity tax guide covers the other big one.
Frequently asked questions
What is the maximum tax-exempt leave encashment amount?
For private-sector employees, the exempt amount is the least of four figures — actual receipt, Rs 25 lakh, ten months’ average salary, and the cash equivalent of unavailed leave — with Rs 25 lakh as the lifetime ceiling across all employers. Government employees have no ceiling; their entire encashment at retirement is exempt.
Is leave encashment fully tax-free for government employees?
Yes. Leave encashment paid at retirement to central or state government employees is fully exempt under Section 10(10AA)(i), with no monetary limit and no formula to apply. PSU and bank employees do not get this — they are treated as non-government employees.
Is leave encashment received while still in employment taxable?
Yes. Any encashment received before retirement is treated as salary and is fully taxable in that year, with TDS deducted by the employer. You can soften the slab-jump effect by claiming Section 89(1) relief through Form 10E.
Is leave encashment received by a legal heir after an employee’s death taxable?
No. Leave encashment paid to legal heirs on the employee’s death is completely exempt. The Rs 25 lakh ceiling and the four-limit calculation do not apply to the heirs.
Can leave encashment tax relief be claimed more than once?
Yes, but within the lifetime cap. You can claim the exemption each time you receive encashment on retirement or separation from a different employer. Amounts already claimed are subtracted from the Rs 25 lakh ceiling for the next claim.
Is leave encashment exemption available in the new tax regime?
Yes. The exemption is available under both the old and the new tax regime because it is based on the nature of the receipt, not on deductions. Only the tax rate on any taxable balance changes with the regime.
Is the Rs 25 lakh limit per employer or lifetime?
It is a lifetime limit per employee, aggregated across all employers. Inform each new employer’s payroll team of the exemption already claimed so that TDS on future encashments is computed correctly.
How is leave encashment calculated for a private employee?
Take your ten months’ average salary (Basic + DA), compute the cash equivalent of your unavailed leave as (leave days ÷ 30) × that average (capped at 30 days per year of service), note the actual amount received, and apply the Rs 25 lakh ceiling. The smallest of the four numbers is exempt; the rest is taxable salary.
Official sources
- Income-tax e-filing portal — incometax.gov.in
- Income-tax Act text — India Code
- CBDT official site (Notification No. 31/2023; Circular No. 15/2023) — incometaxindia.gov.in
Reviewed by Asuthod Rathod, CA. Last updated: 20 October 2026. Based on Section 10(10AA) of the Income-tax Act, 1961 (Section 19 of the Income-tax Act, 2025 from FY 2026-27) and CBDT Notification No. 31/2023. Tax rules change — check incometax.gov.in for updates.
This article provides general information and does not constitute personal tax advice.
Editorial byline for eircicai income tax guides — covering the Income Tax Act, 2025, section renumbering, regime comparison, and deductions. Content is reviewed by Asuthod Rathod, CA.