Leave Encashment Tax in India (AY 2026-27): Section 10(10AA), the ₹25 Lakh Cap, and the Govt vs Non-Govt Split

The leave encashment exemption is one of the more useful tax breaks in Indian salary code, and one of the most misremembered. Many salaried employees still operate under the old ₹3 lakh cap that prevailed for two decades. Budget 2023 raised it to ₹25 lakh — an 8x increase that materially changes how much of your accumulated leave is sheltered from tax at retirement.

This guide walks through the framework: government vs non-government rules, retirement vs in-service treatment, the four-step exemption formula, the ₹25 lakh lifetime aggregate, and the reporting friction that often causes payroll to under- or over-tax the encashment.

The two-line summary

• Leave encashment AT retirement (or resignation that ends employment):
  • Government employees: fully exempt under Section 10(10AA)(i).
  • Non-government employees: exempt up to the lesser of (actual amount, 10-month average salary, cash equivalent of unused leave capped at 30 days per year of service, ₹25 lakh lifetime).
• Leave encashment DURING service: fully taxable as salary at slab rate — no exemption.
• Leave encashment to family on death: fully exempt, no cap.

The rest of this guide is the detail behind each line.

Government employees — full exemption

For employees of the Central Government, State Government, and government-related undertakings, leave encashment received at retirement is fully exempt under Section 10(10AA)(i). No cap, no formula, no four-step computation. The employer issues the encashment, the employee receives it, the entire amount is excluded from taxable income.

What counts as a "government employee" for this purpose:

• Central / State Government direct employees.
• Members of the All India Services (IAS, IPS, IFS).
• Employees of statutory corporations established by Central or State legislation.

What does NOT qualify:

• Employees of public-sector undertakings (PSUs) that are companies (e.g., ONGC, BHEL employees are technically not government employees for this exemption — they're treated as non-government, subject to the ₹25 lakh cap).
• Employees of nationalised banks (treated as non-government for leave encashment purposes).
• Employees of autonomous bodies set up by government but operating as societies / trusts.

The PSU and nationalised-bank distinction matters at retirement — many PSU retirees assume "government" treatment and discover at filing that the ₹25 lakh cap applies.

Non-government employees — the four-step formula

For private-sector and PSU employees, the Section 10(10AA)(ii) exemption is the LEAST of four amounts:

(a) Actual leave encashment received

The cash amount paid by the employer at the time of separation. This is the simplest figure — it's on the FNF document.

(b) 10 months × average salary of last 10 months

"Salary" for this purpose is defined narrowly:

• Includes: Basic salary, dearness allowance (DA) that forms part of retirement benefits, commission as a fixed percentage of turnover.
• Excludes: HRA, special allowances, conveyance, bonus, one-time payments, perquisites.

Take the average of basic + DA-retirement + qualifying commission for the 10 months immediately preceding retirement. Multiply by 10. That's leg (b).

(c) Cash equivalent of unused leave, capped at 30 days per year of service

This is the most computationally involved leg. The formula:

Cash equivalent = Unused leave days × (Average monthly salary / 30)

Where:

• "Unused leave days" = leave standing to your credit at retirement.
• "Average monthly salary" uses the same definition as in (b) — basic + DA-retirement + qualifying commission.
• Unused leave days are capped at 30 days × completed years of service.

The 30-day cap is the trap. If your company allows you to accumulate 45 days of leave per year (some PSUs do), and you've worked 25 years, you might actually have 1,125 days of leave standing to credit. But for Section 10(10AA), only 30 × 25 = 750 days are eligible for exemption. The rest is fully taxable as part of leave encashment income.

(d) ₹25 lakh lifetime aggregate cap

The hard rupee ceiling. This is a lifetime aggregate across all employers — not per FY, not per employer.

The least of all four wins

The exemption is the smallest of (a), (b), (c), and (d). The remaining (actual leave encashment minus exemption) is taxable as salary income.

Worked example — non-government retirement

A Bangalore IT manager retires after 30 years of service. Final 10-month average salary (basic + DA): ₹2,00,000 per month. Leave standing to credit: 720 days. Actual leave encashment paid: ₹40,00,000.

Exemption legs:

• (a) Actual encashment: ₹40,00,000.
• (b) 10 months × average salary: 10 × ₹2,00,000 = ₹20,00,000.
• (c) Cash equivalent of unused leave (capped): Unused leave eligible = min(720, 30 × 30) = 720 days. Cash equivalent = 720 × (₹2,00,000 / 30) = ₹48,00,000.
• (d) Lifetime cap: ₹25,00,000.

Exemption = LEAST of four = ₹20,00,000 (leg b).

Taxable portion: ₹40,00,000 − ₹20,00,000 = ₹20,00,000, taxed at slab rate.

Notice how leg (b) was the binding constraint — not the ₹25 lakh cap. This is common at retirement: high-tenure employees with significant leave but moderate final salary often hit the 10-month-salary leg before the ₹25 lakh ceiling.

A different worked example — high salary, low leave

A senior executive retires after 8 years. Final 10-month average salary: ₹6,00,000 per month. Leave standing to credit: 100 days. Actual leave encashment paid: ₹19,00,000.

Exemption legs:

• (a) Actual: ₹19,00,000.
• (b) 10 × ₹6,00,000: ₹60,00,000.
• (c) Cash equivalent (capped at 30 × 8 = 240 days, so 100 days fully eligible): 100 × (₹6,00,000 / 30) = ₹20,00,000.
• (d) Lifetime cap: ₹25,00,000.

Exemption = LEAST = ₹19,00,000 (leg a). The full encashment is exempt.

Different binding leg, different result.

In-service leave encashment — fully taxable

If you cash out leave while still working at the same company — common in companies that have annual "leave purchase" or quarterly "encashment days" programs — Section 10(10AA) does NOT apply. The amount is treated as a regular salary payment in the FY of receipt, taxed at your slab rate.

This is the most common payroll-level error: companies sometimes apply Section 10(10AA) to in-service encashment too, generating an exemption the employee isn't entitled to. When discovered in scrutiny, the employer's TDS shortfall and the employee's under-payment both become payable, with interest.

The lifetime aggregate ₹25 lakh cap

The ₹25 lakh cap applies across all your retirement / superannuation events combined — not per employer, not per FY. Three patterns:

Pattern 1 — Single retirement event

You retire from one employer with ₹15 lakh of exempt leave encashment. The cap is reduced to ₹25L − ₹15L = ₹10L for any future event. If you never have another retirement event, the remaining cap is unused.

Pattern 2 — Two-job retirement / resignation career

You leave Employer A at age 45 with ₹12 lakh leave encashment (claim ₹12L exemption). You retire from Employer B at age 60 with ₹20 lakh leave encashment. Lifetime cap remaining at the second event: ₹13L. Exemption at second event = LEAST(₹20L actual, ..., ₹13L cap) — capped at ₹13L. Remaining ₹7L is taxable.

Pattern 3 — Old cap at first event, new cap at second

You retired in 2018 and claimed ₹3 lakh exemption at the then-prevailing cap. You retire again in 2026 — your remaining cap is ₹25L − ₹3L = ₹22L. The cap is computed as a lifetime aggregate against the current ₹25 lakh ceiling, NOT the cap that prevailed at the first event.

This is a meaningful planning point: anyone who claimed leave encashment exemption pre-2023 has a substantial residual cap available now.

Death-in-service: full exemption

If an employee dies in service and the employer pays leave encashment to legal heirs (typically the spouse), the entire amount is exempt under the proviso to Section 10(10AA)(i). The ₹25 lakh cap does not apply. The exemption is claimed in the legal heir's return (or in the deceased's final return if paid before death).

This is a humane carve-out that survives the 2023 cap revision unchanged.

The reporting friction — Form 16 and ITR

Most non-government employer payrolls handle leave encashment correctly: they compute the exemption using the four-step formula, deduct from the taxable salary in Form 16, and report only the taxable portion as Section 17(1) income. But three error patterns recur:

Error 1 — Payroll uses outdated ₹3 lakh cap

Some companies — particularly smaller ones with manual payroll — haven't updated their payroll software for the 2023 cap revision. They apply the old ₹3 lakh limit and over-tax the employee. The fix: file the return with the correct ₹25 lakh cap, claim the larger exemption, and attach a note explaining the deviation. Be prepared with documentation in case of 143(1).

Error 2 — Payroll ignores the lifetime aggregate

Most payrolls don't know your prior-employer encashment history. They apply the full ₹25 lakh cap to the current event, even if you previously claimed a meaningful exemption. The under-paid tax becomes payable when you file or when CPC reconciles against your prior returns.

Error 3 — Payroll applies the formula to in-service encashment

In-service leave purchase or quarterly cash-outs are sometimes erroneously treated as Section 10(10AA) events. The exemption is claimed but not allowable. Verify in your Form 16 — if leave encashment shows an exemption line in a year where you didn't separate from service, the exemption is wrong and your tax is under-paid.

Run your salary tax computation

Where this fits

For the broader retirement-benefit framework (gratuity in particular), the salary tax optimisation guide covers gratuity calc treatment and the gratuity calculator at /gratuity-calculator handles the parallel exemption computation.

For pre-filing reconciliation that catches payroll errors on leave encashment, see the AIS / 26AS / Form 16 reconciliation guide.

For broader job-transition tax considerations including notice period buyouts, see How to evaluate a job offer beyond CTC and Notice period buyout tax in India.

A note on the gratuity-leave-encashment interaction

The ₹25 lakh leave encashment cap and the ₹20 lakh gratuity cap (under Section 10(10)(iii)) are independent. Both apply at the same retirement event. A retiring non-government employee with both gratuity and leave encashment can claim:

• Gratuity exemption: lesser of actual gratuity, ₹20 lakh, or 15-days-salary-per-year formula.
• Leave encashment exemption: lesser of actual encashment, 10-month average salary, 30-day-per-year cash equivalent, or ₹25 lakh.

The two are computed separately, applied to separate amounts in the FNF, and reported on different lines in the ITR. Be deliberate at filing — payrolls sometimes muddle the two.

Honest disclosure

The Section 10(10AA) framework is well-established and the ₹25 lakh cap is uncontroversial as of AY 2026-27. The errors that produce over- or under-payment are operational (payroll software, lifetime-aggregate tracking) rather than legal. Where the encashment amount is large (₹15 lakh+) and you've had prior retirement events, a CA review of the lifetime aggregate calculation is worth the fee.

This article is a framework reference and does not constitute tax advice for any specific transaction.