Leave Encashment Taxation 2026: ₹25 Lakh Exemption, Calculation & Examples

Leave encashment is the amount an employee receives for unutilised earned leave. Its tax treatment depends mainly on when it is received and whether the employee is a Government employee or a non-Government employee. The current Income Tax Department guidance continues to recognise a ₹25 lakh ceiling for the specified non-Government retirement/resignation exemption.

Taxability at a glance

How the exemption is calculated for a non-Government employee

The exempt amount is the least of the following:

1. actual leave encashment received;
2. cash equivalent of eligible unutilised earned leave;
3. 10 months' average salary; or
4. ₹25,00,000, reduced by exemption already allowed in earlier relevant years where applicable.

The Income Tax Department's current guidance explains that the average salary is based on the prescribed salary components for the last 10 months. For practical payroll working, this generally includes basic salary, dearness allowance to the extent it forms part of retirement benefits, and eligible turnover-based commission where the conditions are met.

30-day earned-leave restriction

For exemption purposes, earned leave entitlement is generally restricted to a maximum of 30 days for each completed year of service with the relevant employer. An employer's HR policy may allow accumulation at a higher rate, but the tax exemption computation does not automatically follow that more generous policy.

Example

Assume a private-sector employee receives ₹12 lakh as leave encashment on retirement. Ten months' average salary is ₹9 lakh, the cash equivalent of eligible unutilised leave is ₹10 lakh, and the employee has not claimed any earlier leave-encashment exemption.

The least is ₹9 lakh. Therefore, ₹9 lakh is exempt and the balance ₹3 lakh is taxable as salary, subject to the employee's final tax computation.

₹25 lakh is not a fresh limit for every employer

The ₹25 lakh ceiling is not intended to reset each time an employee changes jobs. CBDT's 2023 clarification states that where exempt leave encashment has already been allowed, the available ceiling is reduced accordingly. Employees with multiple employers or earlier retirement/resignation payments should therefore keep old Form 16s and settlement statements.

Leave encashment during service

Mid-service or annual leave encashment is generally taxable as salary. Payroll teams should not apply the retirement exemption merely because the payment relates to accumulated leave. The reason for payment—during service versus on retirement/resignation—is critical.

Section 89 relief

Income Tax Department guidance recognises that relief under section 89 may be relevant for taxable leave encashment received during employment where the statutory conditions are met. This is a separate relief mechanism; it does not convert the payment itself into an exempt receipt.

Payroll and employee checklist

1. Identify whether the payment is during service or on retirement/resignation.
2. Confirm Government versus non-Government employment status.
3. Obtain the leave ledger and completed years of service.
4. Compute eligible leave using the 30-day-per-year restriction.
5. Calculate the prescribed average salary.
6. Check exemption already claimed from earlier employers/years.
7. Apply the least-of-four test.
8. Reflect taxable and exempt portions correctly in payroll/Form 16.
9. Keep the calculation with the full-and-final settlement file.

Common mistakes

• Using the old ₹3 lakh ceiling instead of ₹25 lakh.
• Claiming full exemption for every private-sector retirement payment.
• Using gross CTC rather than prescribed salary components.
• Ignoring earlier exemption claims.
• Using an HR leave policy of more than 30 days per year directly in the tax formula.
• Treating mid-service leave encashment as retirement exemption.

Frequently asked questions

Official references

• Income Tax Department — Salary guidance
• CBDT — ₹25 lakh leave encashment exemption notification summary