Leave encashment: rules, formula and tax in 2026

Leave encashment is the payment an employee receives for earned leave they did not take. It shows up at three moments: at year end if the policy encashes the excess over the carry-forward cap, during service if the policy allows a voluntary encashment, and at exit, when the whole unused balance is settled. The rules on when it is owed come mostly from your own policy and the state law that applies to you. The tax rules come from the Income-tax Act, and those were renumbered this April.

When encashment is owed

• On exit, the balance of earned or privilege leave must be paid. Every state Shops and Establishments Act and the Code on Wages treat it as wages due on separation, and the Code on Wages requires wages due on resignation or termination to be paid within two working days of the last day. In practice most companies pay it in the full and final settlement; the two-day rule is the standard you should plan against.
• At year end, encashment is owed only if your leave policy says so. A policy that lapses excess leave is lawful provided the statutory minimum carry-forward under your state's Act is respected. A policy that encashes the excess creates a predictable December payout.
• During service, encashment is a policy choice, not a legal right. Most companies either prohibit it or allow it once a year above a minimum retained balance.

Casual and sick leave are not encashable anywhere in common practice; only earned or privilege leave is.

The formula

Encashment = leave days × daily rate, where daily rate = monthly base ÷ divisor.

Two choices decide the amount, and both must be written into the policy because they change the payout materially:

Worked example. An employee leaves with 24 days of earned leave. Monthly basic is ₹45,000. On basic with a divisor of 30, the daily rate is ₹1,500 and the payout is ₹36,000. On basic with a divisor of 26, the daily rate is ₹1,730.77 and the payout is ₹41,538. On gross of ₹90,000 with a divisor of 30, the payout is ₹72,000. The leave encashment calculator runs these variants side by side.

Under the Code on Wages, "wages" for a payment like this means basic plus DA plus retaining allowance, with the rule that excluded allowances cannot exceed half of total remuneration. If your policy encashes on basic and the basic is below half of gross, check whether the Code's definition pushes the base up for the statutory minimum.

Tax during service

Encashment received while still employed is fully taxable as salary in the year it is paid. There is no exemption. Deduct TDS on it like any other salary component, and show it as a separate line on the payslip.

Tax on exit or retirement

For a private-sector employee, encashment received on leaving is exempt up to the least of four amounts:

1. The amount actually received.
2. Ten months' average salary, taking the average of the last ten months before leaving. Salary here means basic plus DA (if it counts for retirement benefits) plus commission as a fixed percentage of turnover.
3. ₹25 lakh, the ceiling notified in 2023 and carried forward unchanged.
4. The cash equivalent of unused leave computed at a maximum of 30 days of leave for every completed year of service, at the same average salary.

The exemption lived in Section 10(10AA) of the Income-tax Act 1961. From 1 April 2026 it is in Section 19 of the Income-tax Act 2025, with the substance unchanged. Payroll software and older HR notes still cite 10(10AA); the number on your Form 130 computation (the successor to Form 16) will be the new one.

The ₹25 lakh limit is a lifetime figure across employers. If an employee has claimed ₹10 lakh of exemption at a previous job, only ₹15 lakh remains. You will not know their history, so ask, document the answer, and apply the exemption on the balance they declare.

Worked example. An employee retires after 20 years with 300 days of unused earned leave, and average salary of ₹60,000 a month. Amount received on basic with a divisor of 30 is ₹6,00,000. Ten months' average salary is ₹6,00,000. The 30-days-per-year cap gives 600 days, which exceeds the 300 actual days, so limb four equals the ₹6,00,000 received. The exemption is the least of these and ₹25 lakh, so the entire ₹6,00,000 is exempt. Had the policy paid on gross and produced ₹12,00,000, only ₹6,00,000 would be exempt and TDS would apply to the rest.

Encashment paid to a government employee on retirement is fully exempt; the four-limb test applies only to everyone else.

What payroll should do

• Keep leave balances in the same system as payroll, so the exit balance is a lookup rather than a reconciliation. Disputed balances are the most common reason F&F misses the deadline.
• Compute encashment on the policy base and divisor, not on whatever the previous HR person used.
• On exit, run the four-limb exemption test, apply TDS to the excess only, and attach the working to the settlement sheet.
• Record the exempt amount in the employee's final tax computation so their Form 130 is right.

Sources

• Leave encashment under the Income-tax Act 2025: exempt limit (TaxClue)
• Leave encashment exemption: the ₹25 lakh limit explained (TaxGuru)
• The Code on Wages, 2019 as amended (India Code)

This article describes general legal provisions and common practice, not legal advice. Encashment entitlements depend on your leave policy and the state law applicable to your establishment, and the tax treatment on the employee's own history; confirm specifics with a professional.