Leave encashment tax exemption explained: ₹25 lakh limit under Section 10(10AA), AY 2026-27 rules, PSU/bank carve-out, worked examples, and ITR filing steps.
Leave encashment up to ₹25 lakh is tax-free for non-government employees under Section 10(10AA), on retirement or resignation. Government employees get full exemption with no cap at all. Anything above that limit, after adjusting for exemption you've already used at an earlier job, gets taxed like regular salary. Here's exactly how the math works.
Leave encashment is simply the cash your employer pays you for earned leave you never used. It counts as salary for tax purposes, but Section 10(10AA) of the Income-tax Act, 1961 lets you keep a chunk of it tax-free, depending on why you're leaving and who you work for.
This guide covers income earned in FY 2025-26, filed as AY 2026-27. That falls under the old Income-tax Act, 1961, not the new one. The Income-tax Act, 2025 only kicks in for income earned from 1 April 2026 onward, so every section number here is from the 1961 Act, checked against CBDT's own notification.
Applies to | Does NOT apply to |
|---|---|
Salaried employees retiring or resigning with unused earned leave | Freelancers and the self-employed (no employer to encash leave with) |
Central and State Government employees (full exemption, no cap) | Casual or contract staff without a formal leave policy |
Private-sector employees (exemption capped at ₹25 lakh) | Leave encashed while still working (fully taxable, though Section 89 relief may soften it) |
PSU and nationalised bank employees (treated as private, not government) | Unpaid or sick leave your company doesn't let you encash |
Legal heirs receiving encashment after an employee's death (fully exempt) | — |
Here's the bit most guides quietly skip over. Employees of Public Sector Undertakings and nationalised banks are not treated as government employees for this exemption, even though PSUs are technically "State" under Article 12 of the Constitution for other legal matters. The Delhi High Court settled this back in Kamal Kumar Kalia v. Union of India (2019), leaning on the Supreme Court's earlier reasoning in A.K. Bindal v. Union of India that PSU staff can't claim the same legal status as Central or State government servants. So if you work at a nationalised bank or a PSU, you fall under the same ₹25 lakh limit as any private employee, not the unlimited government exemption. Plenty of retirees learn this the hard way when their refund gets held up.
For government employees, leave encashment received on retirement is 100% exempt under Section 10(10AA)(i). No ceiling, no fine print.
For everyone else, private sector, PSU, and bank employees included, Section 10(10AA)(ii) exempts the least of these four amounts:
The actual leave encashment amount you received
₹25,00,000 (a lifetime limit, reduced by anything you've already claimed at an earlier employer)
10 months' average salary (basic + DA) drawn right before you retired or resigned
The cash value of your unused leave, capped at 30 days for every completed year of service, valued at that same 10-month average salary
The ₹25 lakh figure isn't a round policy number someone picked out of thin air. Notification No. 31/2023, dated 24 May 2023, raised it from the old ₹3,00,000 (a figure that had been frozen since 2002) to ₹25,00,000, effective 1 April 2023. You can read the notification yourself on the Income Tax Department's website.
This limit is lifetime, not per job. Claimed exemption at a previous employer already? Your current employer's ₹25 lakh ceiling shrinks by that amount. Most online calculators skip this step entirely. Toolisky's own leave encashment tax calculator factors it in automatically, so you don't have to track it by hand.
One question worth settling properly here: does the exemption apply on resignation, or only on formal retirement? The notification's own wording covers employees "who retire, whether on superannuation or otherwise," and tax authorities have consistently read "otherwise" to include resignation. So leave encashment on resignation and leave encashment on retirement are treated exactly the same way. What's different is leave encashed while you're still employed. That portion is fully taxable as salary, no exemption at all, though Section 89 relief might help if it relates to earlier years.
Most articles show you one example where the ₹25 lakh cap is the deciding factor. Real cases don't always play out that way, so here are two that don't.
Example 1 (the common case): Priya Deshmukh retires after 20 years
Priya's last drawn basic plus DA is ₹68,000 a month. Her company caps encashable leave at 300 days, and she has the full 300 days banked. Her average basic plus DA over the last 10 months came to ₹65,000, slightly lower than her final salary because of a mid-year increment.
Actual amount received: ₹68,000 ÷ 30 × 300 days = ₹6,80,000
Statutory limit: ₹25,00,000
10 months' average salary: ₹65,000 × 10 = ₹6,50,000
Leave credit (30 days × 20 years = 600 days, capped at her actual 300-day balance), valued at ₹65,000 ÷ 30 × 300 = ₹6,50,000
The smallest of the four is ₹6,50,000. That becomes her exempt amount. The remaining ₹30,000 gets taxed as salary. Notice the ₹25 lakh ceiling never even enters the picture here. Legs three and four bind first, which is what happens for most mid-income retirees.
Example 2 (the edge case): Farida Sheikh switches jobs after already claiming exemption once
Farida retired from her first employer in 2019 after 15 years and claimed ₹3,00,000 exemption then, back when the limit was still ₹3 lakh. She's now resigning from her second employer after 10 years there. Her last drawn basic plus DA is ₹3,00,000 a month, and her 10-month average matches it. She has a 300-day leave balance.
Actual amount received: ₹3,00,000 ÷ 30 × 300 = ₹30,00,000
Statutory limit, reduced for her earlier claim: ₹25,00,000 − ₹3,00,000 = ₹22,00,000
10 months' average salary: ₹3,00,000 × 10 = ₹30,00,000
Leave credit (30 × 10 = 300 days, matching her balance), valued at ₹3,00,000 ÷ 30 × 300 = ₹30,00,000
This time the smallest figure is ₹22,00,000, so the reduced lifetime cap is what actually binds. Farida's exempt amount is ₹22,00,000, and ₹8,00,000 gets taxed. Had she forgotten her earlier claim, she'd have wrongly assumed the full ₹25 lakh was still hers to use, and ended up under-reporting her taxable income without even realising it.
Follow this sequence every time you're working out a leave encashment calculation:
Work out your per-day salary: (basic + DA) ÷ 30.
Multiply that by the number of leave days you actually encashed.
Check how much of your lifetime ₹25 lakh cap is still available.
Multiply 10 months' average basic plus DA.
Multiply that same average per-day rate by 30 days for every completed year of service, capped at your real leave balance.
Take the smallest of the four numbers. That's your exemption. Subtract it from what you actually received to get the taxable portion.
In-service encashment works completely differently. If you cash out leave while you're still employed, the entire amount gets added to your salary and taxed at your slab rate; no exemption applies at all. What you can do is claim relief under Section 89(1) if the payment relates to earlier years, using Form 10E.
Here's a real worked relief calculation, not just "go file Form 10E." Vikram received ₹90,000 as in-service leave encashment in FY 2025-26, relating to leave he'd earned back in FY 2023-24.
Step A, year of receipt (FY 2025-26, new regime): Income excluding the ₹90,000 is ₹14,00,000; including it, ₹14,90,000. Tax on ₹14,00,000 comes to ₹93,600 with cess; tax on ₹14,90,000 comes to ₹1,07,640. Step A = ₹1,07,640 − ₹93,600 = ₹14,040.
Step B, earlier year (FY 2023-24, old regime): Income excluding that year's share is ₹6,00,000; including it, ₹6,90,000. Tax on ₹6,00,000 is ₹33,800; tax on ₹6,90,000 is ₹52,520. Step B = ₹52,520 − ₹33,800 = ₹18,720.
Relief equals Step A minus Step B, which comes to a negative number here, so the relief is Nil. Vikram doesn't owe extra tax either way, but he also gets zero cash benefit from Section 89, contrary to what a lot of people assume happens automatically. Run your own numbers through Toolisky's Form 10E calculator before you file, rather than guessing.
These two get mixed up constantly because both show up in the same full-and-final settlement. They're actually governed by completely different laws.
Leave encashment falls under Section 10(10AA), capped at ₹25 lakh for non-government staff, and depends on your leave balance and salary. Gratuity is governed by the Payment of Gratuity Act, 1972, worked out as (last drawn salary × 15 × years of service) ÷ 26, and separately exempt up to ₹20 lakh under Section 10(10). You can claim both exemptions independently; one doesn't eat into the other. Check your own gratuity payout with Toolisky's gratuity calculator.
For AY 2026-27, most salaried employees file either ITR-1 or ITR-2, depending on their other income sources. If you're not sure which one applies to you, Toolisky's guide on choosing the right ITR form walks through it step by step. Your employer's Form 16 should already split the leave encashment figure into exempt and taxable portions under Schedule S. Cross-check this yourself using the formula above; payroll teams do get the 10-month average wrong from time to time.
Portal menu names and field labels do change from year to year, so confirm the exact steps on incometax.gov.in at the time you file, rather than relying on screenshots from an older filing season.
Your employer showed the wrong exempt amount in Form 16. Recompute the four-part formula yourself using your actual leave balance and 10-month average. If your figure differs from Form 16, report the correct amount in your ITR directly. Your return isn't bound by whatever Form 16 says; it's bound by the actual law.
TDS got deducted on the full amount, ignoring the exemption. This happens often when payroll still applies the old ₹3 lakh limit by mistake. File your return claiming the correct ₹25 lakh-based exemption, and claim back the excess TDS as a refund.
You forgot to account for exemption already claimed at a previous employer. If the department later spots the mismatch through AIS, expect a notice under Section 143(1). Keep your old Form 16 or exemption certificate somewhere safe, and file a revised return under Section 139(5) if you catch the error before they do.
Document | Digital copy okay? | Where to get it |
|---|---|---|
Form 16 from your current employer | Yes | Employer's payroll or HR portal |
Leave balance certificate | Yes | HR department |
Salary slips for the last 10 months | Yes | Employer's payroll system |
Proof of exemption claimed at a previous employer, if any | Yes | Old Form 16 or your earlier F&F settlement letter |
Death certificate and legal heir certificate (death-in-service cases only) | Yes | Municipal office or court |
Under-reporting your taxable leave encashment can attract a penalty of 50% of the tax on the under-reported amount under Section 270A, rising to 200% if it's treated as misreporting rather than an honest mistake. Miss your ITR deadline of 31 July 2026 (31 December 2026 for a belated return), and you're looking at a ₹5,000 late fee under Section 234F if your total income crosses ₹5 lakh, plus 1% monthly interest under Section 234A on whatever tax remains unpaid.
Both are treated identically under Section 10(10AA). The notification covers employees who "retire, whether on superannuation or otherwise," and that language has consistently been read to include resignation. The ₹25 lakh limit and the four-part formula apply the same way either time.
No. Several ITAT rulings hold that such payments aren't taxable in the hands of the heirs, since they aren't "employees" and the amount counts as a capital receipt rather than salary. This holds for both government and private-sector cases.
₹25 lakh, same as private-sector employees. Courts have repeatedly held that PSU and bank staff don't count as government employees for this particular exemption, even though they technically work for state-owned entities.
Yes. Section 10(10AA) exemption applies whether you're on the old or the new tax regime. Switching regimes doesn't touch your eligibility for this one.
Most salaried employees can use ITR-1, unless they have capital gains beyond the ITR-1 threshold, foreign assets, or other income that pushes them into ITR-2. Check the exact eligibility rules before you pick.
Yes, fully. There's no exemption for leave you encash while still on the payroll; it simply gets added to your salary and taxed at your slab rate. You may be able to claim Section 89(1) relief through Form 10E if it relates to earlier years, though the relief isn't guaranteed to work out in your favour.
Yes, and it's easy to miss. The ₹25 lakh limit is lifetime, not per employer. Your current employer's exemption ceiling shrinks by whatever you already claimed, so keep your old Form 16 handy when you're working this one out.
File a revised return under Section 139(5) before 31 March 2027 for AY 2026-27, and make sure you've filed Form 10E online first. Relief claimed without a filed Form 10E gets disallowed during processing, even if the rest of your return goes through fine.
Take the smallest of four figures: the actual amount received, ₹25 lakh minus any prior claims, 10 months' average basic plus DA, and your leave balance valued at 30 days per year of service. Whichever of these comes out lowest is your tax-free amount.
No. Form 10E is only needed when you're claiming Section 89(1) relief on arrears or in-service encashment. A straightforward retirement or resignation exemption under Section 10(10AA) doesn't require it at all.
Yes, through your ITR. Work out your actual exempt amount using the four-part formula, report the correct taxable figure in your return, and claim the excess TDS back as a refund.
Not in substance. The ₹25 lakh limit, the four-part formula, and the full government-employee exemption all carry forward unchanged into the new Act. The exact section number under the 2025 Act hasn't been confirmed yet in official sources at the time of writing; for your AY 2026-27 filing right now, the old Act and Section 10(10AA) still apply, and there's nothing extra you need to do about this.
Pull your last 10 months' salary slips and your leave balance certificate today, and work through the four-part formula yourself instead of trusting Form 16 blindly. Toolisky's leave encashment tax calculator will give you the exact exempt and taxable split in seconds. For the official notification itself, head to incometaxindia.gov.in.
For educational purposes only. Verify all figures at official sources before acting. Toolisky is not affiliated with any government body. Consult a qualified CA or legal professional before making compliance decisions. See toolisky.com/accuracy-and-limitations.
Border tax payment 2026: pay checkpost tax on Parivahan, fix a pending or failed transaction, verify your receipt, and check state-specific rates.
Aug 31, 2026
Section 87A proviso explained: first proviso rebate limits vs the second proviso's capital-gains bar, with FY 2025-26 math and real fixes for demand notices.
Aug 19, 2026
Section 87A rebate on lottery income is not allowed under Section 115BB, even below ₹12 lakh. See exact FY 2025-26 tax math, rules, and TDS rate details.
Aug 12, 2026
