Key Takeaways
- Leave encashment received during service is fully taxable as salary income under Section 17(1). No exemption applies.
- Leave encashment at retirement or resignation qualifies for exemption under Section 10(10AA), up to ₹25 lakh for non-government employees (CBDT Notification 31/2023, effective April 1, 2023).
- Government employees get full exemption on leave encashment at retirement.
- The exemption for private employees is the lowest of four amounts: actual amount received, 10 months' average salary, cash equivalent of unutilised leave (capped at 30 days per year of service), and ₹25 lakh.
- The ₹25 lakh limit is a lifetime cap across all employers and all years.
How much leave encashment is tax-free? For non-government employees, leave encashment received at retirement or resignation is exempt up to ₹25 lakh under Section 10(10AA) (CBDT Notification 31/2023, effective April 1, 2023). The exempt amount is the lowest of: the actual leave encashment received, 10 months' average salary, cash equivalent of earned leave at 30 days per completed year of service, and ₹25 lakh. Government employees receive full exemption with no cap.
Looking for expert help with leave encashment tax exemption Section 10(10AA) India? The team at Tax Garden, based in Kondapur, Hyderabad, helps Indian SMEs stay compliant end-to-end: filings, notices, and advisory, all in one place.
When Is Leave Encashment Taxable?
Your company's leave policy probably lets you accumulate earned leave and cash it out. The tax treatment depends entirely on when you receive that payment.
During service: If your employer pays you for unused leave while you're still employed, every rupee of it is salary income under Section 17(1). No exemption. No deduction. It goes straight into your taxable salary, and your employer deducts TDS on it under Section 192.
At retirement or resignation: This is where Section 10(10AA) kicks in. When you receive leave encashment at the time of leaving your job, whether that's superannuation, resignation, or voluntary retirement, part or all of the amount can be exempt from tax.
The distinction matters more than people realise. Say you cash out 15 days of leave in December while still working, and then resign in March and cash out another 45 days. The December payment is fully taxable. Only the March payment qualifies for the Section 10(10AA) exemption.
Comparison
Leave Encashment Tax: Government vs Private Employees
Tax treatment at retirement or resignation
| Parameter | Government Employee | Private Employee |
|---|---|---|
| Exemption at retirement | Fully exempt (no cap) | Exempt up to ₹25 lakh (lowest of 4 limits) |
| During service | Fully taxable as salary | Fully taxable as salary |
| Governing section | Section 10(10AA)(i) | Section 10(10AA)(ii) |
| Lifetime cap | No cap | ₹25 lakh across all employers |
| Leave cap for calculation | Not applicable | 30 days per year of service |
| Salary definition | Not applicable | Basic + DA + turnover-based commission |
Source: Section 10(10AA), Income Tax Act 1961; CBDT Notification 31/2023
How the ₹25 Lakh Exemption Works (Four Limits)
For non-government employees, the exempt amount is not automatically ₹25 lakh. It's the lowest of these four figures:
1. Actual leave encashment received: The amount your employer actually pays you for unutilised earned leave at the time of retirement or resignation.
2. 10 months' average salary: Your average monthly salary (Basic + DA + turnover-based commission only) for the 10 months immediately before retirement, multiplied by 10. HRA, special allowances, and bonuses don't count.
3. Cash equivalent of unutilised leave: Here's the catch. Even if your company credits 45 or 60 days of leave per year, the tax law caps the calculation at 30 days per completed year of service. The formula: (Daily salary) x (Earned leave balance, capped at 30 days per year of service minus leave already availed).
4. ₹25 lakh: The statutory ceiling set by CBDT Notification 31/2023, effective from April 1, 2023. Before this notification, the limit was just ₹3 lakh (unchanged since 2002).
The exemption equals whichever of these four amounts is the smallest. Everything above that is taxable salary.
Step-by-Step Exemption Calculation
Step-by-Step Guide
How to Calculate Section 10(10AA) Exemption
Work through each limit, then pick the lowest
Find actual leave encashment
Take the gross amount your employer pays for unused earned leave at retirement or resignation. This is Limit A.
Calculate 10 months' average salary
Add up Basic + DA + turnover-based commission for the 10 months before your last working day. Divide by 10 to get the monthly average, then multiply by 10. This is Limit B.
Compute cash equivalent of leave
Count completed years of service. Multiply by 30 (max leave days recognised per year). Subtract leave actually taken. Multiply the remaining days by your daily salary (monthly salary ÷ 30). This is Limit C.
Apply the ₹25 lakh statutory cap
Reduce ₹25 lakh by any Section 10(10AA) exemption you have already claimed from a previous employer in any earlier year. The balance is Limit D.
Exemption = lowest of A, B, C, D
Pick the smallest figure. That amount is exempt. The rest (actual leave encashment minus exemption) is taxable salary.
Source: Section 10(10AA)(ii), Income Tax Act 1961; CBDT Notification 31/2023
Worked Example
Ravi resigns from a private company after 12 years of service in June 2026. His leave encashment details:
- Basic salary: ₹80,000/month, DA: ₹10,000/month (total salary for this purpose: ₹90,000/month)
- Total earned leave balance: 420 days (company credits 35 days/year)
- Leave encashment received: ₹12,60,000
Here's how each limit works:
Limit A (Actual amount): ₹12,60,000
Limit B (10 months' average salary): ₹90,000 x 10 = ₹9,00,000
Limit C (Cash equivalent of leave): The tax law caps recognised leave at 30 days per year. For 12 completed years, that's 360 days maximum. Ravi's 420-day balance gets capped to 360 days. Daily salary: ₹90,000 ÷ 30 = ₹3,000. Cash equivalent: 360 x ₹3,000 = ₹10,80,000.
Limit D (Statutory cap): ₹25,00,000 (no prior claims).
Exemption = lowest = ₹9,00,000 (Limit B).
Taxable leave encashment: ₹12,60,000 minus ₹9,00,000 = ₹3,60,000. This ₹3,60,000 gets added to Ravi's salary income and taxed at his applicable slab rate.
Notice how Limit B (10 months' salary) was the binding constraint, not the ₹25 lakh cap. For most employees earning moderate salaries, Limit B or Limit C will typically be the lowest.
How to Report Leave Encashment in Your ITR
Leave encashment goes into Schedule S (Salary) of your ITR form (ITR-1, ITR-2, or ITR-3). Here's how:
Step 1: Your employer includes the full leave encashment in your gross salary in Form 16 (Part B).
Step 2: The exempt portion under Section 10(10AA) appears in the "Allowances exempt under Section 10" section of Form 16.
Step 3: In your ITR, report the full salary (including leave encashment) under Schedule S. Then claim the exempt amount separately under "Allowances to the extent exempt under Section 10" by selecting "Section 10(10AA) - Earned leave encashment on retirement" from the dropdown.
Step 4: Cross-verify that the exempt amount in your ITR matches what your employer has shown in Form 16. If your employer didn't compute the exemption (some don't), calculate it yourself using the four-limit formula and claim it in your ITR.
For employees who changed jobs and received leave encashment from multiple employers, the ₹25 lakh lifetime cap applies across all of them. Reduce the limit by any exemption claimed in earlier years.
What About the Income Tax Act 2025?
The Income Tax Act 2025 replaced the 1961 Act with effect from April 1, 2026. However, the ITR forms for AY 2026-27 (tax year 2025-26) continue to reference Section 10(10AA) from the 1961 Act since the income pertains to a period before the new Act took effect. The substantive rule and the ₹25 lakh exemption limit remain unchanged. For AY 2027-28 onwards, check the corresponding section in the 2025 Act.
Common Mistakes to Avoid
Claiming exemption on leave encashment during service: This is the most frequent error. If you cashed out leave while still employed and claimed Section 10(10AA) exemption on it, expect a notice. The exemption applies only at retirement or resignation.
Ignoring the 30-day cap: Your company may credit 45 or 60 days of earned leave per year. The tax department doesn't care. For exemption purposes, only 30 days per completed year of service counts. Using your company's leave balance instead of the capped figure overstates the exemption.
Forgetting the lifetime cap: If you claimed ₹8 lakh exemption from a previous employer and now claim ₹25 lakh from your current employer, you'll get a notice. The maximum across your entire career is ₹25 lakh total.
Leave Encashment Tax: Frequently Asked Questions
Is leave encashment taxable if I resign (not retire)?
Section 10(10AA) covers leave encashment received 'on retirement, whether on superannuation or otherwise.' The word 'otherwise' includes resignation, termination, and voluntary retirement. The exemption applies regardless of how you leave, as long as the payment is at the time of leaving the job.
What is the leave encashment exemption limit for AY 2026-27?
For non-government employees, the maximum exemption under Section 10(10AA) is ₹25 lakh (CBDT Notification 31/2023, effective April 1, 2023). This is a lifetime cap across all employers. Government employees have no cap.
Can I claim Section 89(1) relief on leave encashment?
Yes, if the leave encashment relates to past years' salary (which it typically does, since earned leave accumulates over multiple years), you can claim relief under Section 89(1) by filing Form 10E. This spreads the tax impact across the years in which the leave was earned, potentially reducing your effective tax rate.
Is leave encashment received by legal heirs of a deceased employee taxable?
Leave encashment received by legal heirs of a deceased employee is not taxable in the hands of the legal heirs. It falls under Section 10(10AA)(i) and is treated as exempt because the employee was deemed to have retired on the date of death.
How do I calculate daily salary for leave encashment exemption?
Daily salary = (Basic Pay + Dearness Allowance + Turnover-based Commission) ÷ 30. HRA, special allowances, house perquisites, and bonuses are excluded from this calculation.
What if my employer didn't show the exempt amount in Form 16?
You can still claim the exemption in your ITR. Calculate the exempt amount using the four-limit formula, report it under 'Allowances exempt under Section 10' in Schedule S, and keep documentation (appointment letter showing leave policy, salary slips, and full-and-final settlement letter) ready for verification.
Tax Garden Handles Your Leave Encashment ITR
If you've received leave encashment this year, whether at resignation or retirement, getting the exemption calculation right is critical. Overclaim it and you'll get a notice. Underclaim it and you pay tax you didn't owe. Tax Garden computes your four-limit exemption, checks your lifetime cap, files Form 10E for Section 89(1) relief if applicable, and reports the correct figures in your ITR.