Leave Encashment Tax Exemption — Rs.25 Lakh Limit Explained FY 2025-26

Leave encashment, also called leave salary or earned leave encashment, is the monetary compensation paid to an employee for the earned or privilege leave that has accumulated but not been availed during service. Employees accrue earned leave at a prescribed rate — typically 1 day per 20 working days under the Factories Act — and many organisations allow accumulation of such leave for encashment at retirement, resignation, or during service on special occasions.nnThe tax treatment of leave encashment under Section 10(10AA) of the Income Tax Act 1961 depends on two factors: the type of employer (government versus private) and the timing of encashment (during service versus at retirement or termination). Government employees — central government, state government, and local authority employees — are fully exempt from tax on all leave encashment, whether received during service or at retirement. This complete exemption recognises the government service framework and has no monetary cap.nnFor non-government employees (private sector, public sector undertakings, and semi-government bodies), the tax treatment is more nuanced. Leave encashment received during the continuance of service — as an annual payout or during mid-service — is fully taxable as salary income at slab rates with no exemption available. Only leave encashment received at the time of retirement, resignation, or superannuation qualifies for the Section 10(10AA) exemption, subject to the prescribed limits and formula.

For non-government employees receiving leave encashment at retirement or resignation, the exemption under Section 10(10AA)(ii) is computed as the least of four amounts: (1) the actual leave encashment received, (2) the cash equivalent of leave standing to the credit of the employee at the time of retirement calculated at 10 months of average salary, (3) the amount specified by the Central Government — currently Rs.25 lakh, and (4) the average monthly salary multiplied by the number of months of earned leave standing to the employee's credit (subject to a maximum of 30 days per year of service).nnLet us work through a practical example. An employee retires after 25 years of service with average monthly salary (basic + DA) of Rs.80,000. Earned leave accumulated: 300 days (12 days per year x 25 years). Leave encashment paid by employer: Rs.8,00,000 (300 days x Rs.80,000/30). The four amounts are: (1) Rs.8,00,000 actual; (2) 10 months average salary = 10 x Rs.80,000 = Rs.8,00,000; (3) Rs.25,00,000 (government limit); (4) Average monthly salary x leave months = Rs.80,000 x 10 months (300 days / 30) = Rs.8,00,000. The least of the four = Rs.8,00,000. Entire leave encashment of Rs.8,00,000 is exempt.nnIn a scenario where leave accumulation is higher — say 600 days — and salary is Rs.1,20,000 per month: actual encashment = Rs.24,00,000, 10 months salary = Rs.12,00,000, government limit = Rs.25,00,000, average salary x leave months = Rs.1,20,000 x 20 months = Rs.24,00,000. Least = Rs.12,00,000. Only Rs.12,00,000 is exempt. The balance Rs.12,00,000 is taxable as salary.

A critical distinction that many employees and HR professionals overlook is that the Section 10(10AA) exemption applies only to leave encashment received at the time of retirement, superannuation, or resignation — not to encashment during the continuance of employment. Many organisations offer annual leave encashment schemes where employees can convert accumulated leave into cash each year while still in employment. These annual mid-service encashments are fully taxable as salary income.nnFor employees receiving annual leave encashment during service, the employer must deduct TDS under Section 192 treating the encashment amount as part of the annual salary. The employee must declare this in their ITR as salary income with no exemption available under Section 10(10AA). This is a frequently misunderstood area — employees sometimes incorrectly claim the Rs.25 lakh exemption on mid-service annual encashments, which invites scrutiny during assessment.nnTo optimise tax on leave encashment, employees approaching retirement should consider whether to encash leave annually during service (fully taxable each year) or accumulate the maximum permissible leave and encash it entirely at retirement (eligible for Section 10(10AA) exemption up to Rs.25 lakh). For high-income employees in the 30% bracket, deferring encashment to retirement can save Rs.7,50,000 or more in tax on Rs.25 lakh of accumulated leave encashment.

The employer is responsible for computing the exempt portion of leave encashment and deducting TDS only on the taxable portion under Section 192. For leave encashment at retirement, the employer computes the four-way minimum formula, exempts the minimum amount, and deducts TDS on the balance at the employee's applicable tax slab rate.nnWhere an employee receives leave encashment from multiple employers during their career — which is common with job changes before the final employer — the Rs.25 lakh aggregate limit applies across all employers combined, not per employer. If an employee received Rs.10 lakh in leave encashment from a previous employer (already exempt), the remaining exemption with the current employer is Rs.15 lakh. The employee must disclose previous leave encashment exemptions claimed to the current employer in Form 12B so the employer correctly limits the exemption.nnForm 16 issued by the employer must clearly show the leave encashment amount in the gross salary and the exempt portion under Section 10(10AA) as a deduction. When the employee files their ITR, the exempt leave encashment is declared in Schedule S (salary) under Section 10(10AA) exemptions. The taxable portion is included in total income and taxed at applicable rates.

Leave encashment exemption under Section 10(10AA) is claimed in the income tax return by declaring the exempt amount as an exemption under Section 10 in Schedule EI (Exempt Income) or Schedule S (Salary), depending on the ITR form used. The taxpayer must have the employer's Form 16 showing the gross leave encashment and the computed exempt portion as a basis for the ITR entry.nnFor ITR-1 and ITR-2 filers (salaried individuals), the leave encashment exemption is pre-filled in the salary schedule based on Form 16 data if the employer has correctly reported it. If the Form 16 is incorrect or the employer has not correctly computed the exemption, the employee must manually override the pre-filled figures and enter the correct exempt and taxable amounts.nnDocumentation to retain: the employer's leave encashment computation sheet showing the four-way minimum calculation, Form 16 showing the exempt amount, and the employer's letter confirming the terms of leave encashment including average salary computation. For employees who claim Rs.25 lakh exemption at retirement, it is advisable to retain the calculation worksheet as the Income Tax Department may query the basis of exemption during scrutiny, particularly for large exempt amounts near the Rs.25 lakh ceiling.