Priya, a manager in a private company, leaves after 12 years with 150 days of unused earned leave. The employer pays her ₹3.5 lakh for it, and she assumes all of it is tax free. Some of it may be, but not necessarily. Leave encashment tax depends on who your employer is, how much leave you had, your last ten months’ pay and a ceiling that applies across every job you will ever leave.
This guide explains how the exemption is worked out for salaried employees under the Income-tax Act, 2025, which applies from 1 April 2026. It covers the four-way test for private employees, the rule for government staff, a worked example and the mistakes that lead to tax surprises. It is general information, not personal tax advice.
When leave encashment is taxed
Money paid for leave is salary. Section 16 of the Income-tax Act, 2025 says “salary” includes any payment received by an employee for a period of leave not availed of, and section 15 makes salary taxable under the head “Salaries”. So if your employer lets you encash some leave in the middle of a job, the full amount is added to that year’s salary and taxed at your slab rate. There is no exemption for in-service encashment.
The relief applies only to the cash equivalent of earned leave paid when you retire “whether on superannuation or otherwise”, the wording the Act uses. “Otherwise” covers a resignation or a termination, not just retirement at 60. That is why the rule matters to anyone changing jobs after many years of service, and not only to those near retirement.
The leave encashment tax rule in section 19
The exemption now sits in section 19 of the Income-tax Act, 2025, which lists deductions from salary in a table. The table has two entries on leave. Entry 13 covers employees of the Central Government or a State Government. Entry 14 covers everyone else, including employees of private companies, public sector undertakings and banks. Under the earlier Income-tax Act, 1961 this was section 10(10AA), so older articles and your past payslips may use that number.
The Act refers to a “deduction” from salary, so the exempt part is simply left out when your taxable salary is computed. The rest stays in. A notified amount is also part of the test, and the limit set in 2023 was ₹25 lakh, covered below.
The four limits for private employees
For a non-government employee the exempt amount is the lowest of four figures:
- the amount of leave encashment you actually received;
- the cash equivalent of the earned leave at your credit when you left, counting no more than 30 days for each year of actual service;
- ten times your average monthly salary for the ten months immediately before you left;
- the amount notified by the Central Government (set at ₹25 lakh by a 2023 notification; check the current figure).
Whichever is smallest becomes exempt, and anything above it is taxable. In practice the second and third limits do most of the cutting. A limit of that size bites only for very senior people with long service and high pay. The third limit is the one many people miss: ten months of salary is a hard cap, however many leave days you have saved. If your average monthly salary is ₹70,000, no more than ₹7 lakh can be exempt in any case.
What counts as salary in the ten-month average
The Act’s explanation for this entry says “salary” includes dearness allowance, if the terms of employment so provide, and leaves out all other allowances and perquisites. In plain terms, take your basic pay and any dearness allowance that is part of your terms, and leave out HRA, special allowances, bonus and the value of perks such as a company car. The average is of the ten months just before you left. If your salary was revised during that stretch, it is the average of the ten months that counts, not the last month alone.
The same definition is used for the daily rate when your employer turns leave days into rupees. The Act does not say how many days make a month for this purpose; companies often divide monthly salary by 30. Your employer’s leave policy decides how many days are encashable and at what rate. The tax limit only caps the part that can be tax free.
A worked example
The figures below are illustrations. Assume the average of basic pay plus dearness allowance over the last ten months is ₹70,000 a month, the daily rate is salary divided by 30, and the employer pays the full cash equivalent of the leave you have.
| Case | Leave and service | Cash received | Test 2 (30 days a year) | Test 3 (10 months) | Exempt | Taxable |
|---|---|---|---|---|---|---|
| A | 200 days, 25 years | ₹4,66,667 | ₹17.5 lakh | ₹7 lakh | ₹4,66,667 | Nil |
| B | 400 days, 25 years | ₹9,33,333 | ₹17.5 lakh | ₹7 lakh | ₹7,00,000 | ₹2,33,333 |
| C | 200 days, 5 years | ₹4,66,667 | ₹3,50,000 | ₹7 lakh | ₹3,50,000 | ₹1,16,667 |
In case A, the leave actually paid is the smallest figure, so it is fully exempt. In case B, the ten-month cap of ₹7 lakh bites, leaving ₹2,33,333 to be taxed as salary. If your marginal rate were 30%, that would be about ₹70,000 of tax before cess. In case C, the employee has only 5 years of service, so only 150 days (5 x 30) count, which is ₹3.5 lakh.
Priya, from the opening example, had 150 days over 12 years. At a salary of ₹70,000 she would receive ₹3.5 lakh, and as it is below all the other limits, it is fully exempt. Her assumption turned out to be right, but only because the figures were small. To model the tax on any taxable portion, use the income tax calculator.
The notified limit is cumulative
The Act treats this limit as a running total, not an annual one. Where leave salary is received from more than one employer in the same tax year, the total deduction cannot exceed the limit. The Act’s formula is A minus B: A is the notified limit, and B is the total of such payments received in earlier years and already allowed as exempt. So if the limit is ₹25 lakh and you claimed ₹10 lakh exempt when you left a first employer, only ₹15 lakh is left for any later employer.
Most people leave service only once or twice with large leave balances, so the ceiling is rarely the problem. Keep your Form 16 or the leave encashment letter from each employer so you can show what you claimed earlier. The figure was raised from ₹3 lakh to ₹25 lakh by Notification No. 31/2023 dated 24 May 2023, with effect from 1 April 2023, as reported by the press. We could not open the notification text itself, and some tax department pages still show older figures. The 2025 Act leaves the amount to a Central Government notification, so check the current figure on the Income Tax Department site before you plan around it.
The rule for Central and State Government employees
Entry 13 is simpler. For a Central or State Government employee, the Act exempts the entire cash equivalent of earned leave at credit at the time of retirement, whether on superannuation or otherwise. There is no ten-month test, no 30-days-a-year test and no money ceiling. The employee has to be of the Central Government or a State Government, so staff of public sector companies and banks fall in entry 14, not entry 13. If you moved from a government job to a private one, your leave payment at the private employer is tested under entry 14.
How to report it
Your employer should show the exempt portion in the salary break-up when it prepares Form 16, and deduct tax on the balance as part of your salary. Check this before you file. Compare the leave payment on your payslip with the exemption shown in your Form 16. If you are given a full-and-final settlement letter, work out the four limits yourself. Payroll teams sometimes take the full amount as exempt, or apply only the old ₹3 lakh limit, so a quick check against the table above is worth it.
If you filed a return with the full amount exempt and the employer’s TDS shows otherwise, expect a mismatch. The Annual Information Statement may show the salary your employer reported. See our guides on Form 16 and AIS for how to read them. If the taxable part is large because you also received arrears or a bonus in the same year, our guide on section 157 relief explains how to spread the tax.
Planning your exit when the leave balance is large
If you are close to leaving a private job with a big balance, a few checks can reduce leave encashment tax. First, read your company’s leave policy to see how many days can be encashed at exit and whether the rate is basic pay alone or basic plus dearness allowance. Second, remember the ten-month average is fixed by what you were paid in those months, so a salary revision just before you leave can raise the cap. Third, ask the payroll team to share its working of the exempt amount in writing. A written working makes it easy to spot a mistake and to answer a notice later.
Do not time your resignation around the exemption alone. The tax at stake is only on the amount above the lowest of the four limits, so a person with a modest balance may owe nothing. A person with a very large balance should still compare the tax on the excess with other considerations, such as notice pay and the date of the last working day. The leave encashment tax on that excess is charged at your slab rate for the year.
Mistakes to avoid
- Assuming that all leave encashment is exempt, including in-service encashment, which is fully taxable.
- Counting the CTC or gross salary instead of basic pay plus dearness allowance in the ten-month average.
- Forgetting the 30 days per year of service cap when you have saved a large leave balance in a short career.
- Ignoring an exemption claimed in an earlier job when the cumulative limit is worked out.
- Not checking the Form 16 for the exempt amount shown by the employer.
Key takeaways
- Leave pay is salary; the relief applies only to leave encashed on leaving service, whether through retirement, resignation or otherwise.
- Government employees get the whole amount exempt under entry 13; others get the lowest of four figures under entry 14.
- Ten months of average basic pay plus dearness allowance is a hard cap for private employees.
- The notified limit (₹25 lakh under the 2023 notification; check the current figure) is cumulative across employers, reduced by exemptions claimed earlier.
- Check your Form 16 and settlement letter against the four limits before filing your return.
