Leave encashment exemption: what employers must know (2026)

An employee puts in her resignation after 14 years. As your payroll team begins the full and final settlement, a question comes up: she has 310 accumulated earned leave days on record. How much of the leave encashment payout is tax-exempt? How much TDS does the company deduct? And does the answer change depending on which tax regime she has chosen?

These are questions every employer needs to answer correctly, because errors in TDS computation at the time of settlement attract interest, demand notices, and reconciliation problems when the employee files their ITR. This guide covers everything an employer must know about leave encashment exemption: how it is calculated, when it applies, and what your obligations are as a deductor.

What is leave encashment? 

Leave encashment is the payment made by an employer to an employee in lieu of unused accumulated leaves. Most companies allow employees to accumulate earned leave (also called privilege leave) over years of service. When an employee exits the organization, or in some cases during active service, the employer pays out the cash equivalent of those unused leaves.

There is no universal statutory right to leave encashment in the private sector (unlike gratuity, which is governed by the Payment of Gratuity Act, 1972). However, most organized-sector employers include it as a standard benefit in their HR policy. Once your policy provides for encashment, you cannot arbitrarily deny it. Government employees have a statutory right to leave encashment under the applicable service rules.

Is leave encashment taxable? 

The tax treatment of leave encashment depends entirely on when it is paid and who the employer is.

During active service: Leave encashment paid while the employee is still employed is fully taxable as salary income in the year of receipt, for all employees in all sectors. There is no exemption. The amount is added to the employee's taxable salary and TDS is deducted at the applicable slab rate. Employers who run annual encashment schemes, for example paying out carry-forward leave every December, must include the full payout in the salary computation and deduct TDS accordingly.

At retirement, superannuation, or resignation: This is where the exemption under Section 19 of the Income Tax Act, 2025 (previously Section 10(10AA) of the Income Tax Act, 1961) applies. The tax treatment differs based on the type of employer.

Exemption for government vs. non-government employees 

Central and state government employees: Leave encashment received at the time of retirement or superannuation is fully exempt from income tax, with no upper limit and no formula calculation required. The entire amount is tax-free.

Non-government employees (private sector, PSUs, LLPs, trusts, autonomous bodies): The exemption is partial and is calculated using a four-limit formula. The exempt amount is the lowest of four prescribed figures. Any amount received above the exempt portion is taxable as salary income.

On death of an employee: If an employee dies during service, the leave encashment paid to the legal heirs is fully tax-exempt with no upper limit, regardless of whether the employer is government or private. This is a settled position based on CBDT Circular No. 309 dated July 3, 1981. No TDS is to be deducted on such payments.

Tax regime and section 

The exemption is governed by Section 19 of the Income Tax Act, 2025 (previously Section 10(10AA) of the Income Tax Act, 1961). The substantive rules, the Rs 25 lakh ceiling, the four-limit formula, and the full exemption for government employees are all carried forward unchanged under the new Act. What changed is the section number and the structure: the new Act consolidates salary-related deductions and exemptions into Section 19, written in plain language without the provisos and explanations that characterized the old Act.

The Section 19 exemption (previously Section 10(10AA)) is available under both the old tax regime and the default new tax regime under Section 202 of the Income Tax Act, 2025 (previously Section 115BAC). This is one of the exemptions the new regime explicitly retains. The employee's regime choice has no bearing on whether they qualify for the leave encashment exemption or on how the four-limit formula is applied.

The four-limit formula for non-government employees 

For non-government employees, the leave encashment exemption at retirement or resignation under Section 19 of the Income Tax Act, 2025 (previously Section 10(10AA)) is the lowest of the following four amounts:

Limit A: The actual amount of leave encashment received from the employer.

Limit B: Ten months of average salary. Average salary means the average of the last 10 months' salary immediately preceding the date of retirement or resignation, calculated as basic pay plus Dearness Allowance (DA, only if it forms part of retirement benefits) plus commission (only if it is a fixed percentage of turnover). All other components including HRA, special allowance, overtime, and bonus are excluded.

Limit C: The cash equivalent of unutilised leave, calculated as salary per day multiplied by the number of eligible leave days. For this purpose, the tax law caps the recognized leave accumulation at 30 days per completed year of service, regardless of how many days your company's policy actually credits per year. If your company credits 45 days per year but the employee has served 12 completed years, the maximum days recognized for tax purposes is 360 (30 x 12), not 540.

Limit D: Rs 25,00,000. This is the lifetime ceiling introduced via CBDT Notification No. 31/2023 (effective April 1, 2023) and continues unchanged for Tax Year 2026-27. It is a cumulative lifetime cap, not a per-employer or per-year limit.

The exempt amount is whichever of these four figures is lowest. The taxable portion is the actual encashment received minus the exempt amount.

The Rs 25 lakh limit, lifetime cap

This is one of the most important and most misunderstood aspects of the exemption. The Rs 25 lakh ceiling applies across all employments over an employee's entire working life. If an employee claimed Rs 10 lakh exemption when they resigned from a previous employer, the remaining cap available at the next exit event is Rs 15 lakh, not Rs 25 lakh.

As an employer, you cannot know this unless the employee tells you. Your responsibility is to ask every employee at the time of full and final settlement for a written declaration of any prior leave encashment exemption already claimed, along with supporting documentation such as Form 130 (previously Form 16) from the previous employer. Without this declaration, you risk computing TDS on the wrong exempt amount, which creates a demand notice for the employee and a compliance issue for you.

Worked example 

Ravi resigns from a private company in September 2026 after 12 completed years of service. His details:

• Average monthly salary (basic + DA) over the last 10 months: Rs 90,000

• Total earned leave balance: 420 days (company credits 35 days per year)

• Actual leave encashment received: Rs 12,60,000

• Prior leave encashment exemption claimed from any previous employer: nil

Applying the four limits:

• Limit A (actual amount received): Rs 12,60,000

• Limit B (10 months' average salary): Rs 9,00,000 (Rs 90,000 x 10)

• Limit C (cash equivalent of capped leave): 30 days x 12 years = 360 days; salary per day = Rs 90,000 / 30 = Rs 3,000; 360 x Rs 3,000 = Rs 10,80,000

• Limit D (statutory ceiling): Rs 25,00,000

The lowest of the four is Limit B: Rs 9,00,000.

Exempt amount: Rs 9,00,000 Taxable amount: Rs 12,60,000 minus Rs 9,00,000 = Rs 3,60,000 (taxed at Ravi's applicable slab rate)

Employer TDS obligations on leave encashment 

As the deductor, here is what your payroll team must do correctly at the time of full and final settlement:

Obtain a prior exemption declaration. Before computing TDS, ask the employee in writing whether they have claimed Section 19 exemption (previously Section 10(10AA)) in any earlier year. The disclosure obligation rests with the employee, but your TDS computation suffers if you do not ask. Reduce the Rs 25 lakh lifetime ceiling by any amount previously claimed before arriving at Limit D.

Apply the four-limit formula correctly. Use only basic pay, DA forming part of retirement benefits, and fixed-percentage commission in the salary base. Exclude HRA, bonus, and special allowances. Cap the leave calculation at 30 days per completed year of service, not the days your company policy actually credits.

Deduct TDS on the taxable portion only. The exempt amount is reported in Form 130 (previously Form 16) under the salary computation. The taxable portion forms part of the gross salary and is taxed at the employee's slab rate.

Do not deduct TDS on encashment paid to legal heirs. If you are paying out leave encashment following an employee's death, the entire amount is tax-free for the heirs and no TDS applies.

For government employers: No TDS is to be deducted on leave encashment paid at retirement. The full amount is exempt.

Leave encashment rules for private companies: key points 

• There is no statutory minimum for leave encashment entitlement in the private sector. The entitlement is governed entirely by the company's HR policy.

• Once your policy provides for encashment, you cannot deny it arbitrarily.

• The Factories Act, 1948 governs earned leave accumulation for factory workers, with carry-forward capped at 30 days for adult workers. State-level Shops and Establishments Acts apply to other categories, with limits varying by state.

• For tax purposes, regardless of your company's actual leave credit policy, Section 19 of the Income Tax Act, 2025 caps the recognized accumulation at 30 days per completed year of service.

• Leave encashment is settled as part of the full and final settlement, alongside gratuity, pending salary, and notice pay.

• Only accumulated Earned Leave (EL) or Privilege Leave (PL) is generally eligible for encashment.

• Payouts received during active service are fully taxable.

The standard formula is: (Basic Salary + Dearness Allowance) ÷ 30 × Number of Unused EL Days

Managing leave encashment in your payroll system 

Getting the policy right is one part of the job. Making sure your payroll system executes it accurately every month and at exit is another. In Zoho Payroll, you can manage and automate leave encashment by configuring your leave types and general attendance preferences. The system calculates the payout using unused earned leave days and factors it directly into the monthly pay run, reducing the risk of manual errors in both the encashment amount and the TDS deduction.

The way forward 

Leave encashment exemption is straightforward in principle but produces errors in practice because employers miss the lifetime cap, miscalculate the salary base, or fail to collect prior exemption declarations. Here is a checklist for your payroll and HR teams:

• Collect a written declaration from every exiting employee on prior leave encashment exemptions claimed under Section 19 (previously Section 10(10AA)), with supporting Form 130 or Form 16 documentation

• Compute the salary base using only basic pay, DA forming part of retirement benefits, and fixed-percentage commission: exclude HRA, bonus, and allowances

• Cap the leave balance at 30 days per completed year of service for tax purposes, regardless of actual leave credits in your HRMS

• Apply all four limits and use the lowest figure as the exempt amount

• Deduct TDS on the taxable portion at the employee's applicable slab rate and report it correctly in Form 130

• Do not deduct TDS on leave encashment paid to the legal heirs of a deceased employee

• For government employees, do not deduct TDS on leave encashment at retirement

About Zoho Payroll 

Zoho Payroll is a cloud-based payroll software built for Indian businesses. It automates full and final settlement calculations, including leave encashment, gratuity, and TDS computation, so your team processes exits accurately and on time. Learn more at zoho.com/in/payroll/

Frequently asked questions 

• What is the leave encashment exemption limit in India? 

For non-government employees, the exemption under Section 19 of the Income Tax Act, 2025 (previously Section 10(10AA) of the Income Tax Act, 1961) is capped at Rs 25,00,000 as a lifetime limit, effective from April 1, 2023. Government employees enjoy full exemption with no upper limit. The Rs 25 lakh limit is unchanged for Tax Year 2026-27.

• What is the leave encashment exemption section under the Income Tax Act, 2025? 

The exemption is governed by Section 19 of the Income Tax Act, 2025, which replaced Section 10(10AA) of the Income Tax Act, 1961 from Tax Year 2026-27 onwards. The substantive rules and the Rs 25 lakh limit are unchanged.

• How is the leave encashment exemption calculated? 

For non-government employees, the exempt amount is the lowest of: (a) actual amount received, (b) 10 months' average salary (basic + eligible DA + fixed commission), (c) cash equivalent of leave capped at 30 days per completed year of service, and (d) Rs 25,00,000 lifetime ceiling reduced by any prior exemption claimed.

• Is leave encashment taxable during service? 

Yes, fully. Leave encashment paid while the employee is still employed is treated as salary income and taxed at the applicable slab rate. No exemption applies during service.

• Is leave encashment taxable on retirement? 

For government employees: no, it is fully exempt. For non-government employees: partially exempt up to the amount calculated using the four-limit formula under Section 19, subject to the Rs 25 lakh lifetime cap. The amount above the exempt portion is taxable as salary.

• Is leave encashment exemption available under the new tax regime? 

Yes. The Section 19 exemption (previously Section 10(10AA)) is explicitly retained under the default new tax regime under Section 202 of the Income Tax Act, 2025 (previously Section 115BAC). The employee's regime choice does not affect the exemption calculation.

• What is earned leave encashment? 

Earned leave (also called privilege leave) is leave that employees accumulate through active service, typically at a rate set by the employer's policy. Earned leave encashment is the payment made for unused earned leave at the time of exit or, in some companies, during service under an annual encashment scheme.

• Are there leave encashment rules for private company employees? 

There is no statutory minimum entitlement to leave encashment for private sector employees. The entitlement, quantum, and conditions are governed by the company's HR policy. For tax purposes, the recognized accumulation is capped at 30 days per completed year of service under Section 19 of the Income Tax Act, 2025, regardless of the actual policy.

• What happens to leave encashment when an employee dies? 

Leave encashment paid to the legal heirs of a deceased employee is fully tax-exempt in their hands, with no upper limit and regardless of whether the employer is government or private. No TDS is to be deducted by the employer on such payments. (Source: CBDT Circular No. 309, dated July 3, 1981.)

• What is the leave encashment formula? 

The gross leave encashment payable is typically: (monthly salary divided by the number of working days in a month as per company policy) multiplied by the number of leave days being encashed. For the tax exemption calculation, the four-limit test under Section 19 of the Income Tax Act, 2025 (previously Section 10(10AA)) determines how much of that amount is exempt.