An employee resigns after six years, your executive runs the F&F, and the statement shows ₹1.72 lakh payable. Then the employee asks the question that stops everyone cold: “How much TDS are you cutting, and on which part?” If the answer is “on the whole amount,” you have a problem — and so does the employee’s ITR.
TDS on full and final settlement is not one deduction on one number. Each component carries its own treatment under the Income Tax Act, and getting the split wrong is among the most common payroll errors in Indian SMEs. Here is the component-wise position for FY 2026-27, with the limits, the rounding rules, and a worked example your team can copy.
TL;DR
- TDS on full and final settlement applies component-wise under Section 192, not on the gross F&F figure.
- Gratuity is exempt up to a lifetime ₹20 lakh under Section 10(10); leave encashment is exempt up to a lifetime ₹25 lakh for non-government employees under Section 10(10AA).
- Pro-rated salary, performance bonus, and any excess over the exemption caps are fully taxable at slab rates.
- Notice period recovery is a contested deduction — most employers do not reduce taxable salary by the recovered amount, and issue Form 16 accordingly.
What is TDS on full and final settlement?
TDS on full and final settlement is the tax an employer deducts at source under Section 192 on the taxable portion of an exiting employee’s final dues. An F&F payout bundles four or five components, and the Act treats each separately — some fully taxable as salary, some exempt up to a statutory ceiling, and one (notice recovery) in a grey zone that has produced conflicting tribunal rulings.
Practically: split the settlement into components, apply the correct exemption to each, add the taxable balance to year-to-date salary, and only then compute TDS. If you are still building the statement itself, the Full & Final Settlement Calculator produces the component breakup this tax exercise needs.
Component-wise tax treatment of an F&F settlement (FY 2026-27)
Keep this table open during exit processing.
| F&F Component | Tax Treatment | Section / Limit |
|---|---|---|
| Pro-rated salary for the last month | Fully taxable | Salary income, Sec 192 |
| Gratuity (private sector, covered by the Act) | Exempt up to the least of three tests | Sec 10(10) — cap ₹20,00,000 lifetime |
| Leave encashment on exit (non-govt employee) | Exempt up to the least of four tests | Sec 10(10AA) — cap ₹25,00,000 lifetime |
| Statutory bonus under the Payment of Bonus Act | Fully taxable | Salary income, taxed on receipt |
| Performance bonus / incentive | Fully taxable | Salary income, taxed on receipt |
| Retrenchment compensation | Exempt up to ₹5,00,000 | Sec 10(10B) |
| VRS compensation | Exempt up to ₹5,00,000 | Sec 10(10C) |
| Notice period recovery (deduction) | Contested — usually not reduced from taxable salary | No express provision |
| Advances, asset or loan recovery | Pure recovery — no tax effect | — |
Gratuity and leave encashment: two caps, two different numbers
Ask ten HR managers what the leave encashment exemption limit is and at least four will say ₹3 lakh. That number is years out of date. The CBDT raised the Section 10(10AA) ceiling for non-government employees from ₹3 lakh to ₹25 lakh via Notification No. 31/2023, effective 1 April 2023, and it stands unchanged for FY 2026-27.
Gratuity — Section 10(10)
For an employee covered by the Payment of Gratuity Act 1972, the exemption is the least of: actual gratuity received, ₹20 lakh, or (Basic + DA) × 15/26 × completed years of service. Two rules trip people up. The ₹20 lakh cap is a lifetime limit across all employers, not per job. And a part-year counts as a full year only if it exceeds six months — 6 years 4 months is 6 years, but 6 years 7 months is 7. That rounding call alone can move the figure by ₹20,000. Run it through the Gratuity Calculator.
Leave encashment — Section 10(10AA)
For a non-government employee encashing leave at exit, the exemption is the least of four tests: actual amount received, ₹25 lakh lifetime, ten months’ average salary of the last ten months, or the cash value of earned leave capped at 30 days per completed year of service.
The distinction that matters: leave encashed during employment is fully taxable, no exemption at all. Only encashment on retirement or resignation qualifies. If you allow mid-year encashment, that money enters taxable salary in the month paid. The Leave Encashment Calculator handles both cases.
Notice period recovery: the deduction that confuses everyone
When an employee does not serve full notice, you recover salary for the shortfall days. The natural assumption is that taxable salary should drop by the same amount. The Act does not say so expressly, and this is where positions diverge.
Tribunals have in several cases allowed the employee to reduce salary income by notice pay recovered, reasoning that salary never accrued for days not worked. Revenue’s position has generally been that salary accrued and was then applied to discharge a contractual liability — an application of income, not a diminution of it. Since short deduction exposes the employer under Section 201 while over-deduction only costs the employee a refund claim, most Indian employers take the conservative route: compute TDS on gross taxable salary without reducing for the recovery.
Whatever line you take, write it into the exit policy and apply it to every employee in the year — inconsistency is what draws scrutiny. If you are sizing the recovery itself, the Notice Period Recovery Calculator works off your basis of computation, calendar days or working days, which produce different numbers.
How to compute F&F TDS: a 6-step checklist
- Split the settlement into components. Pro-rated salary, leave encashment, gratuity, bonus, recoveries — each on its own line. Never work off a net figure.
- Apply exemptions component-wise. Section 10(10) for gratuity, 10(10AA) for leave encashment, 10(10B)/10(10C) for retrenchment or VRS. Ask for a declaration of prior-employer exemptions, since both caps are lifetime.
- Add the taxable balance to year-to-date salary. Salary already paid this financial year plus the taxable F&F components gives total salary income.
- Apply the regime and deductions. Standard deduction is ₹75,000 under the new regime, ₹50,000 under the old. Honour the regime already declared — do not switch it at exit.
- Compute tax, subtract TDS already deducted. The balance is what you deduct. If prior deductions exceed the liability, deduct nil — you cannot refund TDS already deposited.
- Report in Form 24Q and issue Form 16. Exempt components go in the exempt-allowance annexure, not gross salary. This is the step most often botched.
Worked example: 6 years 4 months of service
Priya resigns from a Gurugram manufacturing firm. Gross ₹90,000, Basic ₹36,000. She works 18 days in her final month, has 22 earned leaves pending, and falls 15 days short on notice.
| Component | Amount | Taxable? |
|---|---|---|
| Pro-rated salary — (90,000 ÷ 26) × 18 | ₹62,308 | Fully taxable |
| Leave encashment — (36,000 ÷ 26) × 22 | ₹30,462 | Exempt — well under ₹25L |
| Gratuity — 36,000 × 15 ÷ 26 × 6 | ₹1,24,615 | Exempt — well under ₹20L |
| Notice recovery — (90,000 ÷ 30) × 15 | (₹45,000) | Not reduced (conservative view) |
| Net payable | ₹1,72,385 | Taxable addition: ₹62,308 |
Note the gap. The settlement is ₹1.72 lakh, but only ₹62,308 enters taxable salary. Deduct TDS on the full ₹1.72 lakh and you have over-deducted on ₹1.1 lakh of exempt money — which the employee then chases you about for months. Her 6 years 4 months rounds down to 6 completed years, since the part-year does not exceed six months.
What HR managers get wrong about F&F tax
- Treating ₹25 lakh as a government-employee limit. Government employees get unlimited exemption on leave encashment. The ₹25 lakh cap is specifically the non-government ceiling. Plenty of HR blogs state this backwards.
- Forgetting the caps are lifetime. An employee who claimed ₹18 lakh of gratuity exemption at a previous employer has only ₹2 lakh of headroom left. Collect a written declaration at exit.
- Putting exempt gratuity into gross salary in Form 16. It belongs in the exempt-allowances section; reporting it as gross salary triggers a mismatch against the employee’s ITR.
- Switching tax regime at exit. The regime declared at the start of the year governs the whole year’s TDS. Changing it in the final month creates a reconciliation mess.
- Missing the state payment deadline. Several Shops & Establishments Acts require final wages within two working days of the last day. Tax complexity is not a defence for delay.
Frequently asked questions
Is TDS deducted on the entire full and final settlement amount?
No. TDS under Section 192 applies only to the taxable portion. Pro-rated salary and bonus are fully taxable, while gratuity and leave encashment are exempt up to ₹20 lakh and ₹25 lakh respectively for non-government employees. Deducting on the gross F&F figure over-deducts tax and forces the employee into a refund claim.
Is gratuity taxable in an F&F settlement?
Gratuity is exempt under Section 10(10) up to the least of the actual amount received, ₹20 lakh, or (Basic + DA) × 15/26 × completed years of service. The ₹20 lakh ceiling is a lifetime limit across all employers, so ask the employee to declare any exemption already claimed elsewhere before you finalise the computation.
How is leave encashment taxed when an employee resigns?
Leave encashment received at the time of resignation or retirement is exempt for non-government employees under Section 10(10AA), up to the least of four tests, with a lifetime ceiling of ₹25 lakh. Leave encashed while still in service does not qualify for any exemption and is fully taxable as salary in the month of payment.
Does notice period recovery reduce taxable salary?
There is no express provision in the Income Tax Act. Tribunals have allowed the reduction in several cases, but most employers do not reduce taxable salary by notice pay recovered, because short deduction exposes the employer under Section 201. Fix a position in your exit policy and apply it consistently to every employee.
Which form reports F&F TDS?
F&F TDS is reported in the quarterly Form 24Q return for the quarter of payment, and appears in the employee’s Form 16 for that financial year. Exempt components such as gratuity and qualifying leave encashment must be shown in the exempt-allowance annexure, not folded into gross salary.
Getting this right without a spreadsheet
Most F&F errors are not judgement calls — they are arithmetic and reporting slips that happen because a resignation lands in the same week as payroll cut-off. Run the settlement through the F&F Settlement Calculator, and EZHRM’s TDS & Form 16 module carries those components through to Form 24Q without re-keying.
Explore the rest of our free HR calculators, browse more HR guides, or see how EZHRM payroll handles exits end to end. For the statute itself, refer to the Income Tax Department and the Ministry of Labour & Employment.
General guidance for HR and payroll teams, not tax advice. Positions on notice pay recovery vary — consult your tax advisor.