Leave Encashment Tax Exemption FY 2026-27: Rules, Limit and Calculation
If you are switching jobs, retiring, or simply have unused leaves at the end of the year, the tax treatment of leave encashment matters more than most salaried professionals realise. The rules differ significantly depending on whether you are a government employee or work in the private sector, and whether the encashment happens during service or at the time of leaving.
This guide covers everything you need to know about leave encashment tax exemption for FY 2025-26 and FY 2026-27, including the Rs. 25 lakh limit update, the four-factor formula for private employees, and what to do if your encashment is partially taxable.
What Is Leave Encashment?
Leave encashment is the monetary compensation your employer pays you for unused earned leave that you have accumulated but not taken. Most employers allow employees to carry forward a portion of their earned leave from year to year. At the time of resignation, retirement, or in some cases during employment itself, the employer converts these unused leave days into a cash payment based on your salary.
The tax treatment of this payment depends on three factors: when you receive it, who your employer is, and how much you receive.
Leave Encashment During Service: Fully Taxable
If your employer pays you for unused leave while you are still employed, that amount is fully taxable. It is added to your income under the head “Income from Salary” and taxed at your applicable slab rate.
This applies whether the payment is made as part of an annual leave encashment policy or at any other point during your employment with the same employer.
However, if the lump sum nature of the payment pushes you into a higher slab temporarily, you can claim tax relief under Section 89 of the Income Tax Act. To claim this relief, you must file Form 10E on the income tax portal before filing your ITR. Claiming Section 89 relief without filing Form 10E first will result in a mismatch notice from the department.
Leave Encashment at Retirement or Resignation: Partial or Full Exemption
This is where the real tax benefit lies. When you receive leave encashment at the time of retirement or resignation, the tax treatment is significantly more favourable, especially if you have worked for many years.
Government Employees: Fully Tax-Free
Central government and state government employees receive complete exemption on leave encashment received at the time of retirement. There is no upper limit. The entire amount received is exempt from tax under Section 10(10AA)(i) of the Income Tax Act 1961.
This applies to all forms of retirement including superannuation, voluntary retirement, and compulsory retirement. It also applies to resignation in some cases depending on service rules.
Private Sector Employees: Exempt Up to Rs. 25 Lakh
For non-government employees, the exemption is calculated as the least of the following four amounts:
- Actual leave encashment amount received
- Rs. 25,00,000 (the government-notified maximum limit, effective from 1 April 2023)
- Average salary of the last 10 months (basic pay + dearness allowance + commission based on fixed percentage of turnover)
- Cash equivalent of leave balance: calculated as salary per day multiplied by the number of eligible leave days, where eligible leave days are capped at 30 days per completed year of service
The lowest of these four figures is the exempt amount. Anything above that is taxable as salary income.
Important Update: Rs. 25 Lakh Limit
The exemption limit for private sector employees was raised from Rs. 3 lakh to Rs. 25 lakh with effect from 1 April 2023. This is a lifetime cap across all employers combined, not per employer per year. If you received leave encashment from a previous employer and claimed exemption, that amount reduces what you can claim in future.
Calculation Example: Private Sector Employee at Retirement
Rahul has worked at a private company for 20 years and retires in FY 2025-26. His employer pays him Rs. 18 lakh as leave encashment for 180 days of accumulated leave.
His basic salary + DA in the last 10 months averaged Rs. 80,000 per month.
Now apply the four-factor test:
- Actual amount received: Rs. 18,00,000
- Maximum limit: Rs. 25,00,000
- Average salary of last 10 months: Rs. 80,000 × 10 = Rs. 8,00,000
- Cash equivalent of eligible leave: Rs. 80,000 ÷ 30 days × (20 years × 30 days capped) = Rs. 80,000 ÷ 30 × 600 = Rs. 16,00,000
The least of these four amounts is Rs. 8,00,000 (average salary of last 10 months).
So Rs. 8,00,000 is exempt. The remaining Rs. 10,00,000 (Rs. 18 lakh minus Rs. 8 lakh) is taxable as salary income in FY 2025-26.
Rahul can claim Section 89 relief on the taxable portion since it is a lump-sum receipt that may push him into a higher slab.
Calculation Example: Job Change Mid-Career
Priya resigns from her private sector job after 8 years. Her employer pays Rs. 3.5 lakh as leave encashment. Her average monthly salary (basic + DA) over the last 10 months was Rs. 60,000.
Apply the four-factor test:
- Actual amount received: Rs. 3,50,000
- Maximum limit: Rs. 25,00,000
- Average salary of last 10 months: Rs. 60,000 × 10 = Rs. 6,00,000
- Cash equivalent of eligible leave: Rs. 60,000 ÷ 30 × (8 × 30) = Rs. 60,000 ÷ 30 × 240 = Rs. 4,80,000
The least of these four is Rs. 3,50,000 – which is the actual amount received. So the entire Rs. 3.5 lakh is exempt from tax. Priya pays zero tax on her leave encashment.
Leave Encashment Tax Exemption Received by Legal Heirs: Fully Exempt
If an employee passes away during service, any leave encashment paid to the legal heirs by the employer is completely exempt from tax with no upper limit. This applies to both government and private sector employees.
New Income Tax Act 2025: Section Number Change
Under the new Income Tax Act 2025, which came into effect from 1 April 2026, Section 10(10AA) has been renumbered. However, for your July 2026 ITR filing (covering FY 2025-26 income), you will still use the old Act 1961 and reference Section 10(10AA) as before. The new numbering applies from FY 2026-27 onwards.
The exemption rules and the Rs. 25 lakh limit remain unchanged under the new Act. See the complete guide on Income Tax Act 2025 vs 1961 for all section number changes.
How to Report Leave Encashment in Your ITR
When filing your ITR for FY 2025-26 (due by 31 July 2026), follow these steps:
- Get your Form 16 or salary certificate from your employer. Leave encashment received during service will appear in your gross salary. Leave encashment at retirement or resignation may appear separately.
- Calculate the exempt portion using the four-factor formula above. The employer’s Form 16 may already reflect the exempt portion, but verify it yourself.
- Enter the taxable portion under “Income from Salary” in your ITR.
- If claiming Section 89 relief on the taxable portion, file Form 10E on the income tax portal before submitting your ITR. Do not skip this step.
- Do not double-count – if your employer has already shown the exempt amount correctly in Form 16, do not manually add it back as income.
Common Mistakes with Leave Encashment Taxation
Mistake 1: Assuming all leave encashment is tax-free. It is only tax-free at retirement or resignation and only up to the formula-calculated exempt amount. Encashment during service is fully taxable.
Mistake 2: Forgetting the Rs. 25 lakh is a lifetime limit. If you changed jobs multiple times and received leave encashment each time, the total exemption across all employments cannot exceed Rs. 25 lakh. Keep a record of what you have already claimed.
Mistake 3: Including only basic salary in the formula. The correct base is basic pay plus dearness allowance plus commission linked to a fixed percentage of turnover. HRA, special allowances, and other components are not included.
Mistake 4: Claiming Section 89 relief without filing Form 10E first. The portal will flag this as a defect in your return. Always file Form 10E before submitting the ITR.
Mistake 5: Confusing leave types. Only earned leave or privilege leave typically qualifies for encashment. Casual leave and sick leave generally cannot be encashed, though employer policies vary.
Leave Encashment vs Gratuity: Key Difference
Both are retirement benefits paid by employers, but they follow different tax rules. Leave encashment is calculated on unused leave days and has a Rs. 25 lakh exemption cap for private employees. Gratuity is calculated on years of service and salary, and has its own separate exemption limit. Both can be received at the same time at retirement, and both exemptions are calculated independently – you do not have to choose one over the other. See the complete guide on gratuity tax exemption 2026 for the detailed rules.
Frequently Asked Questions
Is leave encashment tax-free in the new tax regime?
Yes. The leave encashment exemption under Section 10(10AA) is available under both the old and the new tax regime. This is one of the exemptions that the new regime has retained. Unlike Section 80C deductions which are only available under the old regime, leave encashment exemption applies regardless of which regime you choose. Check the income tax slabs FY 2026-27 to understand how the rest of your income is taxed under each regime.
What if I received leave encashment from two employers in the same year?
The Rs. 25 lakh lifetime exemption cap applies to the combined amount received from all employers in the same year and across all previous employments. If you received Rs. 15 lakh from employer A and Rs. 12 lakh from employer B in the same year, the total exempt amount cannot exceed Rs. 25 lakh across both.
Can a senior citizen claim additional benefits on leave encashment?
The leave encashment exemption rules are the same regardless of age. Senior citizens do not get a higher exemption limit on leave encashment. However, they do benefit from a higher basic exemption limit under the old tax regime, which reduces the tax payable on any taxable portion. Read the income tax for senior citizens FY 2026-27 guide for complete details on their overall tax position.
Is leave encashment included in Form 16?
Leave encashment received during service is included in gross salary in Part B of Form 16. Leave encashment at retirement may be shown separately with the exempt portion identified. If you are unsure about how it has been reflected, ask your employer’s payroll or HR team for a detailed break-up before filing your ITR.
What is the last date to file ITR if I received leave encashment?
The normal ITR filing deadline applies. For FY 2025-26, the due date is 31 July 2026 for salaried individuals without audit. Receiving leave encashment does not change your filing deadline, but it may change which ITR form you need to use if it results in higher income requiring ITR-2.
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