Leave Encashment
Leave encashment is what an employee gets paid for leave they earned but never took. It sounds simple until the tax question comes up, and that’s where most explanations go wrong: the exemption depends heavily on when you’re encashing it and who you work for, not just how many days are sitting unused.
The distinction that actually matters: during service vs at exit
Leave encashed while still employed, an annual “sell back your unused leave” policy some companies run, is fully taxable as salary income in the year it’s paid. There’s no special exemption for it.
Leave encashed at retirement, resignation, or termination is a different matter. This is where Section 10(10AA) of the Income Tax Act applies, and it’s the distinction most generic explanations of leave encashment skip entirely.
The exemption for non-government employees
Government employees get full exemption on leave encashment at retirement, no cap. For everyone else, the exempt amount is the least of four figures:
- The actual leave encashment amount received
- 10 months’ average salary, based on your average basic plus DA over the 10 months immediately before you leave
- Cash equivalent of unused leave, capped at 30 days for each completed year of service
- ₹25,00,000, a lifetime aggregate limit across every employer you’ve ever claimed this exemption from, not ₹25 lakh fresh at each job
The ₹25 lakh figure comes from CBDT Notification No. 31/2023, dated 24 May 2023, effective from 1 April 2023. Before that, the limit had been ₹3 lakh since 2002, so this was a significant jump, not a minor inflation adjustment. Whatever exceeds the least of these four amounts is taxed as regular salary income.
A worked example
An employee resigns after 12 years, with average basic plus DA over the last 10 months of ₹80,000 a month, and 240 days of unused leave standing to their credit, capped at 30 days per year of service, so 360 days worth is the theoretical maximum but only 240 actually accrued. The employer pays out the full ₹240 days at that rate, roughly ₹6,40,000.
| Amount | Value |
|---|---|
| Actual encashment received | ₹6,40,000 |
| 10 months’ average salary | ₹8,00,000 |
| Leave cash equivalent (capped at 30 days/year × 12 years) | ₹9,60,000 |
| Statutory cap | ₹25,00,000 |
The least of the four is the actual amount received, ₹6,40,000, so the entire payout is exempt in this case. The cap only starts to bind for much larger payouts, typically senior employees with long tenure and a high accumulated leave balance.
If the employee dies in service
Leave encashment paid to legal heirs on an employee’s death is fully exempt from tax, for both government and non-government employees, with no cap. This is a separate provision from the retirement exemption above and is worth knowing specifically because it’s easy to assume the same ₹25 lakh limit applies; it doesn’t in this case.
How the payout itself is usually calculated
Most employers use a simple per-day rate: (basic + DA) ÷ 26 or ÷ 30, depending on company policy, multiplied by the number of unused leave days being encashed. Only earned or privilege leave is typically eligible; casual leave and sick leave are commonly excluded from encashment policy entirely, forfeited if unused rather than paid out. Check your specific company’s leave policy rather than assuming all leave types are treated the same.
Frequently asked questions
Is leave encashment during service ever tax-free?
No. The Section 10(10AA) exemption applies specifically to encashment at retirement, resignation or termination. Encashment while still employed is added to salary and taxed at your normal slab rate.
Does the ₹25 lakh limit reset if I change jobs?
No. It’s a lifetime aggregate limit across all employers, tracked cumulatively, not a fresh allowance at each new job.
Can casual leave or sick leave be encashed?
Usually not. Most companies restrict encashment to earned or privilege leave and let unused casual or sick leave lapse at year end, though this is set by company policy rather than a single national rule.
Is the 30-day-per-year cap on the amount, or on the number of days?
It caps the number of days used in the calculation, 30 per completed year of service, not the rupee amount directly. A longer tenure raises this cap proportionally.
Does this exemption apply to leave encashed during maternity leave?
No, that’s a different kind of leave with its own rules; see our guide to maternity leave for how that’s handled separately.
Who typically pays out faster, and is there a legal deadline?
There’s no single statutory deadline specific to leave encashment the way there now is for overall final wages; see our full and final settlement process guide for the current 2-working-day rule that now governs the broader exit payout leave encashment is usually bundled into.
Payment terms should be clearly stated in your employee handbook, alongside related policies like bereavement leave. Calculating leave encashment correctly at scale, across employees with different joining dates, tenures and leave policies, is where HR software earns its keep over manual spreadsheets.
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