In this guide
What is leave encashment?
Leave encashment is money an employer pays for earned leave an employee has not used. Its tax treatment depends mainly on when the payment is made and the type of employer.
AY 2026–27 generally covers FY 2025–26, from 1 April 2025 to 31 March 2026. The Income-tax Act, 1961 applies to this assessment year. Income received from 1 April 2026 falls under the Income-tax Act, 2025 and its Tax Year framework. Apply the law and ITR utility for the year in which the income is taxable.
| When leave encashment is received | General tax treatment |
|---|---|
| During employment | Taxable as salary |
| At retirement or qualifying separation: Central or State Government employee | Fully exempt, subject to applicable rules |
| At retirement or qualifying separation: other employee, including a PSU employee | Exemption is the least of four prescribed amounts, subject to the available ₹25 lakh limit |
| On the employee’s death, paid to legal heirs | Generally fully exempt |
The distinction between a Central or State Government employee and other employees is important. Working for a public sector undertaking does not, by itself, make someone a Central or State Government employee for this exemption.
How the ₹25 lakh exemption is calculated
For an employee who is not a Central or State Government employee, the exempt amount is the least of these four amounts:
| Calculation limit | What to use |
|---|---|
| Leave encashment received | The qualifying payment received at retirement or separation |
| Cash equivalent of unutilised earned leave | Eligible unutilised leave multiplied by average monthly salary |
| Ten months’ average salary | Average monthly salary for the ten months before retirement, multiplied by ten |
| Government-notified maximum | ₹25 lakh, reduced by exemption already allowed under this provision |
The ₹25 lakh figure is a ceiling, not an automatic tax-free allowance. The leave balance, salary-based calculations or actual payment may produce a lower exemption. Any amount above the exemption is generally taxable as salary.
The limit increased from ₹3 lakh to ₹25 lakh with effect from 1 April 2023. It is cumulative: if a non-government employee receives qualifying leave encashment from more than one employer in the same financial year, the total exemption cannot exceed the available limit. Exemption already allowed under this provision in earlier years also reduces the amount available.
Work out eligible leave and average salary
1. Check the earned leave balance
Start with the employer’s leave records and service rules. The calculation is for eligible earned leave standing to the employee’s credit at retirement or qualifying separation.
For this tax calculation, earned leave entitlement is limited to 30 days for each completed year of service with the current employer. If the employer credits more than 30 days a year, do not simply use the full leave balance shown in the payroll record. Ask the employer for its tax calculation, including how it treated leave already taken or encashed.
If the balance is given in days, convert it into months using 30 days as one month. For example, 240 eligible days equal eight months.
2. Calculate average monthly salary
Use the average salary drawn during the ten months immediately before retirement. Salary generally includes:
- Basic salary;
- Dearness allowance, to the extent it forms part of retirement benefits; and
- Commission calculated as a fixed percentage of turnover, if applicable.
Do not use take-home pay, total cost to company or an unrelated annual salary figure. Use the relevant salary components for the ten-month period and retain the employer’s calculation.
3. Compare all four limits
Work out each amount separately and select the lowest. The example below shows why the full ₹25 lakh ceiling may not be exempt.
A non-government employee retires in FY 2025–26 and receives ₹18 lakh as leave encashment. Eligible leave is 240 days, or eight months. Average monthly salary for the relevant ten-month period is ₹1.2 lakh.
- Actual amount received: ₹18 lakh
- Eligible leave value: 8 × ₹1.2 lakh = ₹9.6 lakh
- Ten months’ average salary: 10 × ₹1.2 lakh = ₹12 lakh
- Government-notified maximum: ₹25 lakh
The lowest amount is ₹9.6 lakh, so that is the exemption. The remaining ₹8.4 lakh is generally taxable as salary.
Qualifying leave encashment received by a Central or State Government employee at retirement is generally fully exempt. The ₹25 lakh ceiling applies to the calculation for other employees; do not apply it to a qualifying government employee in the same way.
What if the payment is made during employment?
Leave encashment received while the employee is still in service is generally taxable as salary. This can include a periodic payout for accumulated leave while the employee remains at work.
Section 89 relief may be available if encashment of leave salary during service increases the employee’s tax because accumulated leave is paid out in one year. To claim relief, file Form 10E online and follow the relevant return instructions. The Income Tax Department advises filing Form 10E before the ITR; a section 89 claim without the required form may not be allowed during processing.
For a payment made when employment ends, consider the facts and the legal nature of the separation and payment. Do not assume that every payment made around the final working day qualifies for the retirement exemption. Review the employer’s documents and calculation.
How to report leave encashment in your ITR
For income taxable in FY 2025–26, report salary and the exemption in the applicable AY 2026–27 ITR form and utility.
- Check the leave encashment amount and exemption shown in Form 16 and the employer’s final settlement statement.
- Report salary in the salary schedule and enter the eligible exemption in the relevant leave encashment field.
- Include the taxable balance in salary income. Do not reduce salary by the full payment if only part qualifies for exemption.
- Match tax deducted by the employer with Form 26AS and other tax-credit information.
- Choose the ITR form that fits your complete income profile.
An eligible resident individual may use ITR-1 if they meet its conditions. ITR-2 is generally for individuals without business or professional income who are not eligible to file ITR-1. ITR-3 is generally used when the individual has business or professional income. Leave encashment alone does not determine which ITR form to use.
The filing deadline depends on the taxpayer’s category and any applicable extension. Check the Income Tax Department portal for the current AY 2026–27 due date that applies to you. If claiming section 89 relief, file Form 10E before the ITR.
For filing steps, see TaxClear’s ITR filing guide for AY 2026–27. The ITR-1 filing guide for salaried employees explains form eligibility and filing. For another retirement benefit with different rules, see TaxClear’s guide to gratuity tax exemption.
Documents to keep
Keep the records used to calculate the exemption and taxable balance:
- Retirement, resignation or separation letter and final settlement statement;
- Employer leave ledger showing earned leave, leave used and leave encashed;
- Salary records for the ten months before retirement;
- Employer’s calculation of eligible leave days and exemption;
- Form 16 and tax-deduction details;
- Records of any earlier exemption claimed under section 10(10AA), especially if you changed employers or received leave payouts in previous years; and
- Form 10E acknowledgement, if claiming section 89 relief.
These documents do not normally need to be uploaded with the ITR. Keep them in case the return is reviewed or the exemption needs to be explained.
Common errors to avoid
- Assuming the entire ₹25 lakh is automatically exempt.
- Treating a PSU employee as a government employee for this rule.
- Using the gross leave balance without applying the 30-days-per-year limit.
- Including salary components that are not part of the defined average salary.
- Reporting only the taxable balance instead of showing salary and exemption correctly in the return.
- Treating leave encashment received during employment as a retirement payment.
- Forgetting to reduce the ₹25 lakh limit for exemption claimed in earlier years or from another employer.
- Claiming section 89 relief without filing Form 10E.
Frequently asked questions
Is the entire ₹25 lakh leave encashment tax-free?
No. For a non-government employee, ₹25 lakh is only one of four limits. The exemption is the least of the actual payment, eligible leave value, ten months’ average salary and the available ₹25 lakh limit.
Does the ₹25 lakh limit apply to PSU employees?
Generally, yes. The special full exemption is for qualifying Central or State Government employees. PSU employees are treated as non-government employees for this limit.
Is leave encashment on resignation exempt?
The rules cover qualifying leave encashment on retirement, whether on superannuation or otherwise. The tax treatment depends on the nature and documentation of the separation and payment. Check the employer’s calculation rather than assuming every final settlement qualifies.
Is leave encashment received during employment tax-free?
No. It is generally taxable as salary. Section 89 relief may be available in eligible cases, but Form 10E must be filed to claim it.
Do I need to report the exempt amount in my ITR?
Report salary and the exemption in the appropriate salary schedule. The exempt amount is separate from the taxable balance and should not be left out simply because tax was not withheld on it.
Does the ₹25 lakh limit reset when I change jobs?
No. The limit is cumulative. Exemption allowed in earlier years or by another employer can reduce the amount still available.
