Leave Encashment: Calculation Rules and Tax Treatment
Leave encashment is usually (basic plus DA) ÷ 30 × the days encashed. Tax depends on timing: encashment during employment is fully taxable, government employees' encashment at retirement is exempt, and private-sector employees get an exemption at retirement or resignation up to a statutory limit. Applying the retirement exemption to in-service encashment is the common mistake.
Leave encashment is a cash payment for earned leave an employee has not used. The calculation is simple. The tax is the part that goes wrong, because it depends on when the money is paid and on who the employee is.
How the payout is calculated
A common formula is: (basic salary + dearness allowance) ÷ 30 × the number of leave days encashed. Some employers divide by 26, so check which your policy uses. Policy also decides how many days can be encashed, and whether it happens every year or only at exit.
Example
An employee with a basic plus DA of ₹30,000 a month has 20 days of unused earned leave. The daily rate is ₹30,000 ÷ 30 = ₹1,000, so the payout is ₹20,000.
Tax treatment
| Situation | Treatment |
|---|---|
| Encashment during employment | Fully taxable as salary |
| Government employees, at retirement | Exempt |
| Private-sector employees, at retirement or resignation | Exempt up to a statutory limit, which is currently ₹25 lakh over a lifetime, subject to other conditions |
The exemption is the least of the actual amount received, a cap based on average salary and unused leave, and the overall limit, so work through each condition. Limits are revised, so confirm the current figure.
The most common mistake
Applying the retirement exemption to leave encashed while the employee is still working. That payment is taxable in full, with no exemption.
Policy points to settle
- ✓How many days can be carried forward, and how many can be encashed
- ✓Whether encashment is allowed during service or only at exit
- ✓Which salary components form the base
- ✓Whether sick or casual leave can be encashed, which is uncommon
Payroll steps
- Check the leave balance on the last working day.
- Calculate the payout using the base and divisor in your policy.
- Decide whether the payment is taxable or exempt, based on the reason for exit and the employee's category.
- Include it in the final settlement and in the TDS calculation.
- Keep the working with the employee's file.
Manual risk
Where payroll is handled by hand, people often reuse one formula for every exit. The rule changes with the event, so the system or the checklist has to ask the reason for leaving before it applies the exemption.
Written by
HR Manager, Airwix Technologies (Sleet)
Nihit Dobariya is the HR Manager at Airwix Technologies in Ahmedabad, where he runs HR and payroll for the team behind Sleet. He writes about payroll, PF and ESIC, professional tax, the labour codes and everyday HR practice for Indian employers, and checks each rule against the official notification before it is published.
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