Leave Encashment - Tax Exemption, Calculation & Formula With Example, Rules

Have you heard of the term ‘leave encashment’? 

The concept of leave encashment is quite common among the salaried class. It sounds like even your leaves can bring you some income. 

Continue reading to know more about the meaning and taxability of leave encashment received by employees.

Budget 2023 update 
The leave encashment for non-government employees is exempt up to a certain limit. This limit was Rs.3 lakh since 2002 and is now increased to Rs.25 lakh owing to the general increase in income from salary. 

What is leave encashment?

As per labour law, every salaried person is entitled to a minimum number of paid leave every year. However, it is not necessary that an individual employee utilises all the leave he is entitled to in a year. In fact, most employers allow the employees an option of carrying forward such unutilised paid leaves. 

This would invariably leave the employee with an accumulated unutilised leave balance at the time of retirement or resignation from the company, as the case may be. This compels the employer to compensate the unutilised paid leave of the employees. This concept is better known as leave encashment.

What are the types of leaves?

The different types of leaves are mentioned in the leave policy of a company. The leave policies differ from company to company. Here are the types of leaves generally available for employees: 

• Casual leave: Casual leaves are available for 7 to 10 days. Employees may avail of these leaves for personal reasons. Encashment of this leave varies from one company to another. 
• Earned leave or privilege: An employee can avail of earned leaves with prior notice to the authority. These leaves become eligible for encashment after a specific period. This policy varies from one organisation to another.  
• Medical leaves: If employees cannot perform their duties towards the organisation due to health conditions, they must inform the employer of the leaves. The maximum limit of the number of medical leaves available differs from one firm to another. 
• Holiday leaves: Holiday leaves are granted by employees, and no salary is deducted for these leaves. The maximum number of holiday leaves differs from one company to another. 
• Maternity leaves: Maternity leaves are only available for female employees and can range from 12 to 26 weeks during pregnancy. An employee can ask for an extension, but no payment shall be made for that period. However, these leaves are not available for encashment. 
• Sabbaticals: Employees can take leaves for upskilling and expand their knowledge. They can enrol for a course, and for that period of time, the employer will reimburse those leaves.   

Taxation of Leave Encashment

Leave encashment received during service

Leave encashment received by employees is taxable based on when it is received. If an employee gets leave encashment while on his job, that amount becomes fully taxable and forms part of ‘Income from Salary'. However, you can claim some tax benefits under Section 89 of the Income Tax Act. You must fill up Form 10E to claim the tax relief for leave encashment. You can fill up and submit this form online on the income tax portal. 

Leave encashed at the time of retirement or resignation

Here are the following conditions under which you can claim partial or complete exemption of leave encashment received at the time of retirement: 

Leave Encashment Calculation

The formula for computing leaves encashment exemption of non-government employees:

*Proposed limit increase from Rs 3 lakh to Rs 25 lakh has been incorporated.

*Salary for this purpose includes basic salary, dearness allowance and commission based on a fixed percentage of turnover secured by the employee **Specified amount of Rs 25,00,000 is the aggregate amount allowed as an exemption irrespective of the frequency of leave encashment received by the employee by various employers. If an employee has utilised Rs 5,00,000 already at the time of first resignation, he is only entitled to use the balance of Rs 20,00,000 for the exemption computation next time. Hence, the overall employee is allowed a total exemption of only Rs 25,00,000 with respect to leave encashed from all employers.

Note: 1. If leave encashment is received from two or more employers in the same previous year, then the maximum amount of exemption is capped at Rs.25,00,000.

2. Exemption under section 10(10AA) would be available to an assessee irrespective of the regime under which he pays tax. 

Leave Encashment Exemption Illustration

Let us understand leave encashment exemption with the help of an illustration:

*Proposed limit increase from Rs 3 lakh to Rs 25 lakh has been incorporated.

Mr A is retiring after 15 years of service. 
Mr A was entitled to 35 days of paid leave per annum from his employer, i.e., overall 525 days of leave during his entire service (35*15).
Out of the same, Mr A has already utilised 200 days of paid leave and is left with 325 days of unutilised leave. Mr A was drawing basic salary + DA of Rs 33,000 per month at the time of retirement and received Rs 3,57,500 as leave encashment calculated based on 325 days * Rs. 1,100 (salary per day = Rs.33,000/30 days).

Based on the employer’s leave encashment policy and the income of an individual, tax planning can be made by deciding whether it is beneficial to encash leave year on year or to receive a lump sum at the time of retirement or resignation. 

One may consider the cost of inflation as well before deciding on the same.