Leave encashment received at retirement qualifies for income-tax exemption even under the new tax regime, subject to the conditions of Section 10(10AA).
For eligible government employees, the entire amount is fully exempt. For non-government employees, the exemption is capped at ₹25 lakh and determined by a prescribed calculation.
Leave encashment received during employment, however, remains fully taxable as salary income regardless of the tax regime chosen.
The new tax regime under Section 115BAC does not withdraw this retirement-specific exemption. This distinction matters because many taxpayers assume that opting for the new regime eliminates all salary-related exemptions—which is not accurate.
This article explains the tax treatment of leave encashment for FY 2025-26 (AY 2026-27), clarifies how the rules differ for government and non-government employees, and separately addresses the tax treatment of gratuity as a distinct retirement benefit.
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What Is Leave Encashment and When Is It Taxable?
Leave encashment refers to the monetary compensation an employer pays for eligible earned leave that an employee has not used.
The tax treatment depends primarily on when the payment is received and the employee’s category, not on which tax regime the employee has opted for.
Leave Encashment During Employment
Leave encashment received while an employee continues in service is fully taxable as salary income. The retirement-related exemption under Section 10(10AA) does not apply in this situation.
For example, if an employee receives ₹1,00,000 by encashing accumulated leave while still working, the amount is generally included in taxable salary and taxed at the applicable slab rates.
Choosing the new tax regime does not turn an in-service leave encashment payment into a tax-free receipt.
Leave Encashment at Retirement or Separation
A different rule applies when eligible leave encashment is received in connection with retirement, superannuation, resignation, or other qualifying cessation of employment.
Section 10(10AA) provides the relevant exemption, with conditions differing based on whether the employee is a government employee or a non-government employee.
Is Leave Encashment Exempt Under the New Tax Regime?
Yes. An eligible retirement-related leave encashment exemption can still be claimed under the new tax regime.
The exemption under Section 10(10AA) should not be confused with deductions such as Section 80C, which are generally restricted under the new regime.
The three concepts should be kept separate:
- Exemption: A qualifying amount is excluded from taxable income under a specific provision.
- Deduction: An eligible amount is subtracted from income while calculating taxable income.
- Rebate: A tax rebate, such as Section 87A for eligible taxpayers, reduces tax payable after the tax calculation.
The new tax regime under Section 115BAC primarily affects deductions (Chapter VI-A) and certain allowances like HRA and LTA.
Retirement-related exemptions under Section 10, including leave encashment and gratuity, remain available.
A taxpayer should not assume that opting for the new regime eliminates every exemption available under the Income-tax Act.
Leave Encashment Exemption for Government Employees
Eligible Central and State Government employees receive the most favourable treatment for leave encashment under Section 10(10AA)(i).
Where the statutory conditions are satisfied, leave encashment received at qualifying retirement is fully exempt, without any monetary ceiling applicable to non-government employees.
The important point is that this is not a blanket exemption for every payment described as leave encashment. The circumstances of the payment and the employee’s status need to satisfy the provision.
An employee should distinguish between qualifying retirement-related leave encashment and an amount received while continuing in employment.
Leave Encashment Exemption for Private and Other Non-Government Employees
For non-government employees, Section 10(10AA)(ii) applies a more restrictive calculation. The exempt amount is the least of four amounts:
- Actual leave encashment received
- ₹25 lakh — the maximum statutory ceiling (lifetime aggregate)
- Average salary of the last 10 months immediately preceding retirement
- Cash equivalent of unutilised earned leave, subject to a maximum accumulation of 30 days per completed year of service
For this calculation, “salary” includes basic salary, dearness allowance (to the extent it forms part of retirement benefits), and commission based on a fixed percentage of turnover. Other allowances and perquisites are excluded.
The ₹25 lakh limit was increased from ₹3 lakh by CBDT Notification No. 31/2023, effective from April 1, 2023.
This ceiling is a lifetime limit if exemption has been claimed from a previous employer, the available limit is reduced accordingly.
How the Exemption Is Calculated
Consider a non-government employee who receives ₹12,00,000 as eligible leave encashment on retirement. Assume:
- Average salary for the relevant 10-month period: ₹80,000 per month
- Eligible unutilised earned leave: 300 days
- Completed service: 25 years
The four figures to compare are:
| Calculation | Amount |
|---|---|
| Actual leave encashment received | ₹12,00,000 |
| Statutory maximum ceiling | ₹25,00,000 |
| 10 months’ average salary | ₹8,00,000 |
| Cash equivalent of eligible leave (300 days, within 30 × 25 = 750-day limit) | ₹8,00,000 |
| Exempt amount (least of above) | ₹8,00,000 |
| Taxable balance | ₹4,00,000 |
Here, the ₹8 lakh average-salary figure is the lowest of the four amounts, so ₹8 lakh is the exempt amount. The remaining ₹4 lakh generally forms part of taxable salary.
What Happens to the Amount Above the Exemption?
The portion that does not qualify for exemption is generally taxable as salary income. The taxable balance is considered along with the taxpayer’s other taxable income when determining the final tax liability under the applicable regime.
For salaried taxpayers using the new tax regime for FY 2025-26, the standard deduction of ₹75,000 and the applicable slab rates also need to be considered.
Gratuity Exemption in New Tax Regime
Gratuity is a separate retirement-related employment benefit governed by Section 10(10) rather than Section 10(10AA).
The gratuity exemption in new tax regime remains available where the taxpayer satisfies the conditions of the relevant provision. Choosing the new regime does not, by itself, make an otherwise eligible gratuity exemption taxable.
Government Employees
Gratuity received by eligible Central or State Government employees, local authority employees, and members of the Defence services is fully exempt under Section 10(10)(i). No monetary ceiling applies to this exemption.
Non-Government Employees
For non-government employees, the exemption depends on whether the employer is covered under the Payment of Gratuity Act, 1972:
| Coverage Status | Exempt Amount (Least Of) |
|---|---|
| Covered under the Act | Gratuity received; ₹20 lakh; 15/26 × last drawn salary × years of service |
| Not covered under the Act | Gratuity received; ₹20 lakh; 15/30 × average salary of last 10 months × completed years |
The ₹20 lakh ceiling is a lifetime limit applicable across all employers. Any gratuity received above the exempt amount is taxable as salary income in the year of receipt.
The employer is required to pay gratuity only after an employee has rendered continuous service for not less than five years, except in cases of death or disablement.
It is essential to understand that gratuity and leave encashment are separate tax provisions under separate sections. Claiming an exemption under one does not reduce or affect the exemption available under the other.
An eligible employee can claim both exemptions independently, subject to the respective conditions and ceilings.
Leave Encashment vs Gratuity: Key Differences
| Point | Leave Encashment | Gratuity |
|---|---|---|
| What it represents | Compensation for unutilised earned leave | Reward for long and continuous service |
| Common payment occasion | Retirement, resignation, or during service | Retirement, resignation, death, or disablement |
| Tax treatment during employment | Fully taxable | Not applicable (gratuity is not paid during employment) |
| Government employee treatment | Fully exempt at retirement under Section 10(10AA)(i) | Fully exempt under Section 10(10)(i) |
| Non-government employee treatment | Exempt up to least of four amounts, maximum ₹25 lakh | Exempt up to least of three amounts, maximum ₹20 lakh |
| Relevant exemption conditions | Section 10(10AA); salary includes basic, DA, and commission | Section 10(10); salary includes basic and DA |
Worked Example: How the Taxable Amount Can Be Determined
Consider a non-government employee who retires during FY 2025-26 and receives:
- Leave encashment amount: ₹15,00,000
- Gratuity amount: ₹18,00,000
- Average monthly salary (last 10 months): ₹90,000
- Completed years of service: 30 years
- Eligible earned leave: 400 days
Leave Encashment Exemption Calculation (Section 10(10AA)):
| Component | Amount |
|---|---|
| Actual amount received | ₹15,00,000 |
| Maximum statutory ceiling | ₹25,00,000 |
| 10 months’ average salary | ₹9,00,000 |
| Cash equivalent of eligible leave (400 days, within 30 × 30 = 900-day limit) | 400/30 × ₹90,000 = ₹12,00,000 |
| Exempt amount (least of above) | ₹9,00,000 |
| Taxable leave encashment | ₹6,00,000 |
Gratuity Exemption Calculation (Section 10(10), not covered under the Act):
| Component | Amount |
|---|---|
| Actual gratuity received | ₹18,00,000 |
| Maximum ceiling | ₹20,00,000 |
| 15/30 × average salary × completed years | 15/30 × ₹90,000 × 30 = ₹13,50,000 |
| Exempt amount (least of above) | ₹13,50,000 |
| Taxable gratuity | ₹4,50,000 |
The total taxable amount from these two retirement benefits is ₹6,00,000 + ₹4,50,000 = ₹10,50,000, which is included under “Income from Salary” and taxed at the applicable slab rates for FY 2025-26.
Common Mistakes When Claiming Leave Encashment or Gratuity Exemption
- Assuming all leave encashment is tax-free. Only retirement-related encashment qualifies for exemption; encashment during service is fully taxable.
- Believing the new tax regime removes every exemption. Retirement benefits under Section 10 continue to be available under the new regime.
- Applying government-employee rules to private employees. The full exemption without ceiling applies only to eligible government employees.
- Treating gratuity and leave encashment as the same benefit. They are governed by separate sections with different limits and calculation methods.
- Ignoring the circumstances of receipt. The timing (during service vs. at retirement) determines whether the exemption applies.
- Not tracking the lifetime ceiling. The ₹25 lakh leave encashment limit and ₹20 lakh gratuity limit are lifetime aggregates that reduce with prior claims.
- Incorrectly reporting in the ITR. The exempt portion should be disclosed under Schedule S in the “Allowances to the extent exempt under section 10” column, while the taxable portion is included in gross salary.
Key Takeaways
- Leave encashment received at retirement is exempt under Section 10(10AA) even if the employee has opted for the new tax regime.
- Government employees receive full exemption on retirement leave encashment with no monetary ceiling.
- Non-government employees can claim exemption up to the least of four amounts, with a maximum lifetime ceiling of ₹25 lakh.
- Gratuity exemption under Section 10(10) is separate from leave encashment and carries a ₹20 lakh lifetime ceiling for non-government employees.
- Leave encashment received during employment is fully taxable for all employee categories.
- Both exemptions require proper documentation and accurate reporting in the income tax return.
Frequently Asked Questions
Is leave encashment tax-free under the new tax regime?
Is leave encashment received on retirement exempt from income tax?
Is leave encashment exemption different for private employees?
Is gratuity exempt under the new tax regime?
Can an employee claim both gratuity and leave encashment exemption?
Yes. These are separate benefits under separate sections—Section 10(10) for gratuity and Section 10(10AA) for leave encashment.
An eligible employee can claim both exemptions independently, each subject to its own conditions and ceiling.
