"Leave encashment is fully tax-free": What ITA 2025 actually says

Every retirement season, the same claim circulates in office WhatsApp groups and on LinkedIn: "Leave encashment on retirement is exempt — you don't pay a rupee of tax on it." A second, equally confident version says the opposite: "The exemption is only ₹3 lakh, so most of your leave encashment gets taxed at slab." Both are wrong for most people reading them. The first is true only for government employees. The second has been out of date since 1 April 2023 — and taxpayers who still believe it are leaving refunds unclaimed.

Here is what the law actually provides, what changed, and how to compute your own number before you sign your full-and-final settlement.

What the law actually says

Leave encashment — the cash paid for unutilised earned leave — is taxed under the salary head, but a specific exemption carves out part or all of it.

Under the Income-tax Act, 1961, the governing provision is Section 10(10AA). Under the Income-tax Act, 2025 (ITA 2025), the same relief sits in the exempt-income schedule (Schedule II) dealing with retirement benefits, with no change of substance — the drafting was consolidated, not altered. When you file, cite the provision your form asks for; the arithmetic is identical either way.

The provision splits into two limbs:

Limb one — Section 10(10AA)(i): government employees. Leave encashment received on retirement or superannuation by an employee of the Central Government or a State Government is fully exempt. There is no monetary ceiling, no leave-days cap, no averaging. The entire amount is exempt.

Note the boundary carefully. "Government employee" here means Central or State Government service. Employees of public sector undertakings, nationalised banks, statutory corporations, and local authorities are not covered by limb one — a point Indian courts have upheld repeatedly. A PSU officer retiring after 34 years is taxed under limb two, not limb one, however governmental the workplace feels.

Limb two — Section 10(10AA)(ii): all other employees. For non-government employees, the exemption on retirement or resignation is the least of these four figures:

• The actual leave encashment received;
• Ten months' average salary — average of the last 10 months' salary immediately preceding retirement;
• The cash equivalent of unutilised earned leave, computed at a maximum of 30 days of leave for every completed year of service;
• The statutory ceiling of ₹25,00,000.

"Salary" for this computation means basic salary plus dearness allowance (to the extent it forms part of retirement benefits) plus commission based on a fixed percentage of turnover. It does not include HRA, special allowance, LTA, bonus, or employer PF contribution. Getting this definition wrong is the single most common error in self-computation, and it always inflates the expected exemption.

The number that changed — and why the ₹3 lakh figure survives online

The ₹25 lakh ceiling replaced a ceiling of ₹3,00,000 that had stood since 2002. The change was announced in Budget 2023 and given effect by CBDT Notification No. 31/2023 dated 24 May 2023, applicable to leave encashment received on or after 1 April 2023.

That is a more than eight-fold increase, and it is the reason so much online content is stale. Articles, HR handbooks, payroll templates and even some employer computations written before mid-2023 still carry ₹3 lakh. Worse, the Income Tax Department's CPC processing system applied the old ₹3 lakh cap to some returns after the change, generating intimations under Section 143(1) that disallowed the correct exemption. Appellate tribunals — including a well-known Dehradun ITAT ruling — have held that CPC cannot apply the superseded limit where the notification clearly grants ₹25 lakh.

If you received leave encashment after 1 April 2023 and were allowed only ₹3 lakh, that is a live grievance, not a closed matter.

The lifetime cap most people miss

The ₹25 lakh is a lifetime aggregate, not a per-employer figure. If you claimed ₹9 lakh of exemption when you left Employer A in 2024, only ₹16 lakh of headroom remains for every subsequent employer for the rest of your working life. Employers do not know what you claimed elsewhere; the onus of tracking the cumulative figure is entirely yours, and a mismatch surfaces at assessment, not at payroll.

Encashment while still in service is fully taxable

The exemption applies only to leave encashment received at the time of retirement, superannuation, or resignation. If you encash leave during continuing employment — the annual "sell back 10 days of leave" arrangement many companies run — that receipt is fully taxable as salary, with no exemption at all. Relief under Section 89 read with Rule 21A may be available in limited circumstances, but the Section 10(10AA) exemption is simply not available for in-service encashment.

Practical implications

Case 1 — Private sector, long service, large payout. Rohit retires in September 2026 after 28 completed years at a private company. His last 10 months' average of basic plus DA is ₹2,10,000 per month. He has 640 days of unutilised earned leave and receives ₹44,80,000 as leave encashment.

The four figures are: actual received ₹44,80,000; ten months' average salary ₹21,00,000; cash equivalent capped at 30 days per completed year — that is 28 × 30 = 840 days, and since his actual 640 days is lower, the cap does not bite, so ₹2,10,000 ÷ 30 × 640 = ₹44,80,000; and the ceiling ₹25,00,000.

The least of these is ₹21,00,000. That much is exempt. The balance ₹23,80,000 is taxable as salary in Tax Year 2026-27. Notice that the binding constraint here was not the ₹25 lakh ceiling at all — it was the ten-months'-average-salary limb. That happens far more often than people expect.

Case 2 — Leave balance exceeds the 30-day cap. Meera retires after 22 completed years with 780 days of accumulated leave (her employer allowed accumulation beyond 30 days a year). The statutory cap allows only 22 × 30 = 660 days. The 120 excess days are stripped out of the computation entirely, regardless of what the employer actually paid. Employers with generous accumulation policies routinely produce Form 16 figures that overstate the exemption for exactly this reason.

Case 3 — Central Government. Suresh retires from a Central Government department and receives ₹31,00,000. Limb one applies: fully exempt, no computation, no ceiling.

Case 4 — PSU. Anand retires from a public sector bank with ₹29,00,000. Despite the government ownership, limb two applies. His exemption is capped by the least-of-four test and can never exceed ₹25,00,000.

Case 5 — Resignation, not retirement. Kavya resigns at 41 to move abroad and receives leave encashment in her final settlement. The exemption does apply — Section 10(10AA)(ii) covers "retirement whether on superannuation or otherwise", and resignation qualifies. This is another point on which employer payroll teams frequently err in the employee's disfavour.

Old regime versus new regime

The Section 10(10AA) exemption is available under both the old and the new (default) regime. It is a retirement-benefit exemption, not a deduction under Chapter VI-A, and it was not withdrawn when the new regime was made the default. Do not let a payroll team tell you that opting for the new regime forfeits it.

Step-by-step: what to do

• Establish which limb applies to you. Central or State Government service means full exemption. Everything else — PSU, bank, autonomous body, private company — means the least-of-four test.
• Pull your last 10 months' salary breakup. Take basic salary plus DA (retirement-benefit portion) plus turnover-linked commission for the 10 months immediately before your last working day. Divide the total by 10. That is your average monthly salary.
• Count completed years of service. Completed years only — 27 years and 9 months counts as 27. Multiply by 30 to get your maximum eligible leave days.
• Compute the cash equivalent. Take the lower of (actual unutilised leave days) and (completed years × 30). Multiply by average monthly salary ÷ 30.
• Compute all four figures and take the lowest. Actual received; ten months' average salary; cash equivalent from step 4; ₹25,00,000.
• Subtract prior exemptions claimed in earlier jobs. The ₹25 lakh is lifetime. Reduce your available ceiling by whatever you have already claimed.
• Cross-check your Form 16 (now Form 169 series under ITA 2025) against your own computation. If the employer's exempt figure is lower than yours, ask for a revised computation before the TDS return is filed. If it is higher, correct it in your return — the liability is yours, not the employer's.
• Report it correctly in the return. The exempt portion goes in the exempt-income schedule of your ITR; the taxable balance goes into salary income. Do not simply omit the exempt part — omission triggers a mismatch against the Form 26AS (now Form 168 under ITA 2025) and AIS data the department already holds.
• If you were allowed only ₹3 lakh for a post-April-2023 receipt, file a rectification application under Section 154 against the Section 143(1) intimation, attaching CBDT Notification No. 31/2023. If the rectification window has closed, examine a condonation application under Section 119(2)(b).
• If the amount is large, model your tax year. Leave encashment lands in a single tax year and can push you into the top slab plus surcharge. Where the retirement date is negotiable, shifting it across 31 March can matter materially.

FAQ

Is leave encashment received while I am still working exempt?
No. In-service encashment is fully taxable as salary. The Section 10(10AA) exemption applies only to encashment received on retirement, superannuation, or resignation.

I worked at three companies and claimed exemption at each. Do I get ₹25 lakh each time?
No. The ₹25,00,000 is a lifetime aggregate across all employers. Every rupee claimed earlier reduces the ceiling available for your final employer. Keep a running record — nobody else maintains it for you.

My employer's Form 16 shows a bigger exemption than my own calculation. Can I just use their figure?
No. Use the correct figure. Employers commonly ignore the 30-days-per-completed-year cap and the lifetime ₹25 lakh aggregate. The assessment is against you, not your employer, and an inflated exemption becomes an under-reported income addition with interest under Sections 234B and 234C.

I am a nationalised bank employee retiring next year. Am I fully exempt like a government servant?
No. Limb one covers only Central and State Government employees. Bank, PSU, and statutory corporation employees fall under limb two and are capped by the least-of-four test, with ₹25,00,000 as the outer ceiling.

Before you sign your settlement

Leave encashment is one of the few retirement receipts where the arithmetic is fully knowable in advance — and where the employer's number is wrong often enough that checking it is worth an hour of your time. Run the least-of-four test yourself, reconcile it against the exemption you have already used in earlier jobs, and raise any discrepancy before the TDS return goes in rather than after the intimation arrives.

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