Leave Encashment in India 2026: Rules, Tax & Calculation Guide

A senior accountant in your factory walks up on the 28th of the month and says he’s resigning — last working day is the 15th, and he has 47 unused earned leaves on the books. Two questions land on your table by lunch: how much do we pay him for those leaves, and how much TDS gets deducted? If your gut says “45,000-ish, let me check Excel”, you’re already in trouble — because the answer depends on the leave-policy ceiling, the salary heads you include, and whether his lifetime Section 10(10AA) bucket has any room left.

Leave encashment is one of those payroll items that looks tiny on a payslip but creates the biggest mess in full-and-final settlements. Here is the rule-by-rule guide for HR managers in India in 2026 — calculation, tax, common mistakes, and the exact words to put in your leave policy.

What is leave encashment?

Leave encashment is the cash payout an employee receives in exchange for unused earned or privilege leave that has accumulated to their credit. It is triggered in three situations: at resignation, at retirement or superannuation, and (in some companies) at the end of each calendar year as part of an annual encashment policy. The amount is treated as salary income, but the tax treatment changes sharply depending on when the payout happens.

Which leaves can be encashed in India?

Only earned leave (EL) and privilege leave (PL) are encashable in the private sector. Casual leave, sick leave, maternity leave, paternity leave and compensatory off are not encashable under Indian labour law. The reason is simple — these leaves exist for specific purposes (rest, illness, childcare) and lapse if unused.

Each state runs its own Shops and Establishments Act, so the EL entitlement differs:

State / Statute	Earned leave per year	Max carry-forward
Factories Act, 1948 (Sec. 79)	1 day for every 20 worked (~12/yr)	30 days
Maharashtra S&E Act	21 days	45 days
Karnataka S&E Act	21 days (after 12 months)	30 days
Delhi S&E Act	15 days	45 days
Tamil Nadu S&E Act	12 days	No carry-forward

If your company sits across multiple states — say a Delhi HQ with a Pune branch and a Chennai service centre — your leave policy must be the maximum of the statute and your internal rule. You cannot drop below the statutory floor of the state where the employee actually works.

How to calculate leave encashment: the formula

The standard formula used across Indian SMEs is:

Leave Encashment = [(Basic Salary + DA) ÷ 30] × Number of unused EL/PL days

Three things trip people up here:

1. Use 30 as the denominator, not 26 or the actual days in the month. The Income Tax Department, EPFO interpretation and standard payroll convention all use 30. Some HR teams divide by 26 (excluding Sundays) — that inflates the payout by ~15% and creates audit issues.
2. Only Basic + DA goes into the numerator. Not HRA, not special allowance, not LTA, not conveyance. If your CTC is structured with a fat HRA component and a thin Basic, your leave encashment liability shrinks — which is legal, but employees will push back.
3. “Unused leaves” means the balance on the last working day, after deducting any negative balance or LWP adjustments in the final month.

Worked example

Take Priya, an HR executive in Pune resigning on 31 May 2026:

• Basic = ₹28,000 / month
• DA = ₹2,000 / month (factory unit, so DA applies)
• Unused EL on 31 May 2026 = 34 days

Leave encashment = [(28,000 + 2,000) ÷ 30] × 34 = ₹1,000 × 34 = ₹34,000.

Because Priya is still in active employment (not retiring), the entire ₹34,000 is added to her salary income for FY 2026-27. Section 10(10AA) does not apply mid-career — only at separation/retirement, and even then only for the qualifying portion.

Leave encashment tax rules in 2026: Section 10(10AA) and the ₹25 lakh limit

This is where most HR teams over-pay tax on behalf of departing employees. The rules:

Government employees

Leave encashment received at retirement or resignation is fully exempt — no upper cap. This covers central government, state government, and statutory body employees.

Non-government employees (private sector, PSUs, banks)

At retirement, resignation or superannuation, Section 10(10AA)(ii) grants exemption equal to the least of the following four:

1. Actual leave encashment received
2. ₹25,00,000 (lifetime aggregate, all employers combined)
3. 10 × average monthly salary (Basic + DA + commission, of last 10 months)
4. Cash equivalent of unused leave, capped at 30 days per completed year of service

The ₹25 lakh ceiling was raised from the earlier ₹3 lakh limit (frozen since 31 May 2002) via CBDT Notification No. 31/2023 dated 24 May 2023, effective 1 April 2023. The exemption is a lifetime aggregate — so if an employee received ₹8 lakh exempt at a previous employer in 2024 and is now claiming ₹20 lakh, only ₹17 lakh can be exempted further.

Encashment during active employment

If your company runs an annual leave-encashment scheme (say, every December for leaves above 20 days), the entire payout is fully taxable as salary. Section 10(10AA) only kicks in at retirement, resignation or superannuation — not during continuing service. TDS must be deducted at the employee’s slab rate, and the amount must reflect in Form 16 Part B under “Salary as per Section 17(1)”.

Tax regime impact

Both the old regime and the new regime allow the Section 10(10AA) exemption. The Budget 2023 reform specifically protected leave encashment exemption when it tightened the new regime. So an employee opting for the new regime does not lose this benefit.

Common mistakes HR managers make

From audit conversations across factories, retail chains and IT SMEs, these are the five errors that keep repeating:

1. Encashing casual or sick leave. An employee threatens to escalate, the HR caves, and ₹15,000 of CL gets encashed at exit. It’s not legal, and it sets a precedent for every future FnF.
2. Including HRA or special allowance in the calculation base. The formula is Basic + DA only. Bonus, LTA, conveyance, medical reimbursement and HRA are excluded by statute. Including them creates over-payment and inflates PF wage interpretation.
3. Using 26 days as the divisor. Use 30. The 26-day divisor is for daily-wage calculation under the Minimum Wages Act, not for leave encashment.
4. Treating the ₹25 lakh exemption as per-employer. It is a lifetime aggregate. Ask the resigning employee for a self-declaration on any prior leave-encashment exemption claimed. Without it, you risk under-deducting TDS and the Form 24Q reconciliation gets flagged.
5. Carrying forward more leave than statute allows. The Factories Act caps adult-worker carry-forward at 30 days; Maharashtra S&E at 45. If your HRMS shows employees with 80 or 100 EL balance after 4 years, you have a policy bug that will show up as a fat encashment liability on the balance sheet.

FAQ

Is leave encashment taxable in India in 2026?

Yes, leave encashment is taxable as salary income — but the tax treatment changes based on when it is paid. During active employment, it is fully taxable. At retirement or resignation, Section 10(10AA) exempts up to ₹25 lakh (lifetime) for non-government employees, and the full amount for government employees.

Can casual leave or sick leave be encashed?

No. Indian labour law allows only earned leave (EL) and privilege leave (PL) to be encashed. Casual leave, sick leave, maternity leave, paternity leave and compensatory off lapse if unused — they cannot be converted to cash at exit, retirement or year-end.

What is the maximum number of leaves an employee can carry forward?

The cap depends on the governing statute. Under the Factories Act 1948 (Section 79), adult workers can carry forward up to 30 days. State Shops and Establishments Acts vary — Maharashtra and Delhi allow 45 days; Karnataka 30; Tamil Nadu does not permit carry-forward. Your leave policy must respect the floor of the state where the employee works.

Is the ₹25 lakh exemption available in the new tax regime?

Yes. Section 10(10AA) exemption applies under both the old and the new tax regime. The Budget 2023 reform that raised the limit from ₹3 lakh to ₹25 lakh specifically preserved this exemption when the new regime was tightened.

How does TDS work on leave encashment at resignation?

Compute the exempt amount under Section 10(10AA), deduct it from the gross leave encashment, and add the taxable portion to the employee’s salary for that month. Apply the average monthly TDS rate on the resulting total. Report the taxable portion under Section 17(1) of Form 16 Part B and reflect the exempt portion in the relevant exemption row.

If an employee resigns mid-year, are they entitled to a pro-rated EL?

Yes — most policies and state statutes grant earned leave on a pro-rata basis based on actual days worked in the calendar year up to the last working day. The standard formula is (EL annual entitlement × days worked in year) ÷ 365, rounded down to whole days. Any negative leave balance (leaves taken in excess) is recovered from the FnF payout at the same per-day rate.

Get leave encashment right in every FnF

The fastest way to stop tripping over this is to let your HRMS run the formula and the Section 10(10AA) check automatically, every time. EZHRM’s leave management module tracks EL/PL balances state-wise, enforces carry-forward caps, and our payroll engine generates the encashment line item with TDS pre-computed for full-and-final settlement.