Tax on Gratuity and Leave Encashment

When you leave a job — whether you retire, resign, or move on after years of service — two payments often land in your final settlement that people rarely understand from a tax point of view: gratuity and leave encashment. Both are rewards for long service, and both enjoy generous tax exemptions. But those exemptions are capped, calculated through specific formulas, and differ sharply between government and private employees. Getting the calculation wrong means either paying tax you did not owe, or being surprised by a tax bill on what you assumed was tax-free money. This guide walks through exactly how gratuity and leave encashment are taxed for FY 2025-26, with the formulas and a full worked example.

Gratuity: The Basics

Gratuity is a lump sum an employer pays an employee as a reward for long service, typically when the employee leaves. Under the Payment of Gratuity Act, an employee generally becomes eligible after completing five years of continuous service with an employer (the five-year condition is waived in cases of death or disability).

For tax purposes, employees fall into three buckets, but the practical split is between government and everyone else:

Government employees: Gratuity received on retirement or death is fully exempt from tax. There is no upper limit.

Non-government employees covered by the Payment of Gratuity Act: Exempt up to the least of three amounts (explained below), subject to the lifetime ceiling of ₹20 lakh.

Non-government employees not covered by the Act: A slightly different formula applies, but the ₹20 lakh lifetime ceiling is the same.

The ₹20 lakh figure is a lifetime limit across all employers, not a fresh allowance at each job. This is one of the most overlooked points and a frequent source of error.

How the Gratuity Exemption Is Calculated

For a non-government employee covered by the Payment of Gratuity Act, the exempt gratuity is the least of these three:

1. ₹20,00,000 (the statutory ceiling)
2. Actual gratuity received
3. 15/26 × last drawn salary × number of completed years of service (here "salary" means basic plus dearness allowance, and a part-year of more than six months counts as a full year)

The fraction 15/26 represents 15 days' salary for every completed year, treating a month as 26 working days.

For an employee not covered by the Act, the third figure is computed slightly differently — half a month's average salary (of the last 10 months) for each completed year — but the ₹20 lakh and "actual received" limits still apply, and the least of the three is exempt.

Whatever portion of gratuity exceeds the exempt amount is added to your salary income and taxed at your slab rate.

Leave Encashment: The Basics

Most jobs allow you to accumulate unused paid leave. When you leave, the employer pays you for the leave you never took — this is leave encashment. Its tax treatment depends entirely on when you receive it:

Leave encashment during service (for example, annually selling back leave while still employed): fully taxable as salary. No exemption.

Leave encashment on retirement or resignation:

• Government employees: fully exempt, no limit.
• Non-government employees: exempt up to the least of four amounts, subject to a lifetime ceiling of ₹25 lakh.

That ₹25 lakh ceiling is a recent and significant change. For years the cap stood at just ₹3 lakh — a figure set decades ago and long out of step with salaries. It was raised to ₹25 lakh with effect from FY 2023-24, a major relief for retiring private sector employees. As with gratuity, this is a lifetime limit across all employers.

How the Leave Encashment Exemption Is Calculated

For a non-government employee, the exempt leave encashment on leaving the job is the least of these four:

1. ₹25,00,000 (the statutory ceiling)
2. Actual leave encashment received
3. 10 months × average monthly salary (average of the last 10 months' basic + DA)
4. Cash equivalent of unused leave, calculated at a maximum of 30 days of leave for each completed year of service, valued at the average monthly salary

The fourth limit caps the credited leave the law recognises at 30 days per completed year, even if your company allowed you to accumulate more.

A Full Worked Example

Let us follow Sunita, who retires from a private company in Hyderabad after 28 years and 8 months of service in FY 2025-26. Her last drawn basic salary plus DA is ₹80,000 per month, and her average monthly salary over the last 10 months is also ₹80,000. On retirement she receives:

• Gratuity: ₹18,00,000
• Leave encashment: ₹14,00,000 (she had 320 days of accumulated leave)

She has never claimed either exemption before, so her full lifetime caps are available. She is a non-government employee covered by the Payment of Gratuity Act.

Gratuity exemption — least of three:

• ₹20,00,000 (ceiling)
• ₹18,00,000 (actual received)
• 15/26 × ₹80,000 × 29 years (28 yrs 8 months rounds up to 29) = ₹0.5769 × ₹80,000 × 29 = ₹13,38,461

The least is ₹13,38,461. Taxable gratuity = ₹18,00,000 − ₹13,38,461 = ₹4,61,539 (added to her salary, taxed at slab rate).

Leave encashment exemption — least of four:

• ₹25,00,000 (ceiling)
• ₹14,00,000 (actual received)
• 10 × ₹80,000 = ₹8,00,000 (ten months' salary)
• Cash equivalent of leave at 30 days/year: 30 × 29 = 870 days available under the cap, but she had 320 days; valued at ₹80,000 ÷ 30 × 320 = ₹8,53,333

The least is ₹8,00,000 (the ten-months figure). Taxable leave encashment = ₹14,00,000 − ₹8,00,000 = ₹6,00,000 (added to salary, taxed at slab rate).

Summary:

Component	Received	Exempt	Taxable
Gratuity	₹18,00,000	₹13,38,461	₹4,61,539
Leave encashment	₹14,00,000	₹8,00,000	₹6,00,000
Total	₹32,00,000	₹21,38,461	₹10,61,539

So of ₹32 lakh in terminal benefits, ₹21.38 lakh is tax-free and ₹10.61 lakh gets added to Sunita's taxable income for the year and taxed at her slab rate. Notice that the ten-months-salary limit, not the ceiling, restricted her leave encashment exemption — a common outcome. You can estimate the tax on the taxable portion using the income tax calculator.

The Lifetime Cap Trap

Both exemptions are lifetime limits across all employers. This catches people who change jobs.

Suppose someone exempted ₹10 lakh of gratuity when leaving an earlier employer. At a later retirement, even if the formula would allow ₹15 lakh, they can exempt only the remaining ₹10 lakh (₹20 lakh ceiling minus the ₹10 lakh already used). The same applies to the ₹25 lakh leave encashment cap.

This means you must keep records of exemptions claimed across your entire career. When you join a new employer or retire, declare prior exempt amounts so the new employer computes the remaining exemption correctly. Failing to do this can lead to over-exemption, which the tax department may later reverse with interest.

Other Terminal Benefits in the Same Settlement

When you leave a job, gratuity and leave encashment usually arrive alongside other lump sums, and it helps to know how each is treated so you do not confuse them:

Provident fund (EPF): Your accumulated EPF balance is fully exempt on withdrawal if you have rendered continuous service of five years or more. If you withdraw before five years, the employer's contribution and the interest become taxable, and TDS may apply. So the EPF lump sum in a retirement settlement is generally tax-free for long-tenured employees.

Pension commutation: If you commute (take as a lump sum) part of your pension, the commuted portion is exempt for government employees, and partly exempt for others depending on whether you also receive gratuity. Uncommuted (monthly) pension is fully taxable as salary.

Retrenchment compensation and VRS: Compensation on retrenchment is exempt up to a specified limit, and amounts received under an approved Voluntary Retirement Scheme are exempt up to ₹5,00,000. These are separate exemptions from gratuity and leave encashment, with their own ceilings.

The point is that a single full-and-final settlement can contain several components, each governed by its own rule. Read the breakup carefully rather than treating the whole settlement as one taxable or one exempt figure.

Death Gratuity and the Year of Taxation

Two timing points matter. First, gratuity received by the legal heirs of a deceased employee is treated favourably — gratuity on the death of an employee is exempt, and the family is not burdened with tax on this terminal benefit. The five-year service condition is also waived in cases of death or disability, so the eligibility itself is not denied.

Second, these lump sums are taxed in the financial year in which they are received. Because gratuity and leave encashment land in a year that may already include several months of salary, the combined income can push you into a higher slab for that one year. This is why the year you leave a job is often a high-income year, and why it is worth running the numbers early. If you are also drawing salary from a new employer in the same year, the two incomes stack, and proper tax planning for that transition year can make a real difference.

Regime Note and Where This Fits

Helpfully, the gratuity and leave encashment exemptions are available under both the old and new tax regimes. Unlike most deductions that vanish in the new regime, these terminal-benefit exemptions survive. So your choice of regime does not affect how much of your gratuity or leave encashment is exempt — it only affects the slab rate applied to the taxable portion. To decide which regime to file under, see our old vs new tax regime guide.

For the year you leave a job, these lump sums sit alongside your regular salary on your Form 16, and the TDS your employer deducts should already account for the exempt portions — see TDS on salary explained. If you are planning your exit, factoring these into your wider tax planning is worthwhile, especially since the year of receipt can be a high-income year.

Common Mistakes

Assuming the entire gratuity is tax-free. Only the exempt portion (least of three) is free of tax. Anything above it is fully taxable. People who receive ₹25 lakh gratuity and assume it is all exempt because it is "below" some figure they half-remember are often wrong — the formula, not just the ceiling, governs.

Treating each job's exemption as fresh. The ₹20 lakh and ₹25 lakh caps are lifetime, cumulative across employers. Exemptions claimed earlier reduce what remains. This is the single biggest error among people who switch jobs.

Thinking annual leave encashment is exempt. Leave encashed while in service is fully taxable. Only encashment on leaving the job qualifies. Many employees confuse the two.

Forgetting that the cap was raised to ₹25 lakh. Some people still believe leave encashment exemption is capped at the old ₹3 lakh figure. For FY 2023-24 onwards it is ₹25 lakh for non-government employees — a far more generous limit.

Not declaring prior exemptions to a new employer. When you join a new company mid-career, the employer needs to know how much exemption you have already used, especially relevant if you receive another terminal payment. Omitting this leads to incorrect TDS and a mismatch.

What to Do Next

1. When you leave a job, ask HR for a clear breakup of your gratuity and leave encashment, including the days of leave and the salary figures used.
2. Compute the exempt portion yourself using the least-of-three (gratuity) and least-of-four (leave encashment) formulas, and check the taxable balance against your Form 16.
3. Account for any exemptions you claimed at earlier jobs — subtract them from the ₹20 lakh and ₹25 lakh lifetime ceilings before computing the current exemption.
4. Estimate the tax on the taxable portion using the income tax calculator, and confirm the regime you intend to use.
5. Keep your relinquishment letter, settlement statement, and exemption working filed using a tax document checklist, so the figures are defensible if questioned.

Gratuity and leave encashment are rewards for years of work, and the tax law treats them kindly — but only within defined limits and through specific formulas. Know the least-of formulas, remember that the caps are lifetime and not per job, and recall that the leave encashment ceiling is now a generous ₹25 lakh. Do that, and you will know to the rupee how much of your final settlement reaches you tax-free.

Disclaimer: This article is for educational purposes only and is not tax advice. Tax rules change frequently — verify current provisions on the official income tax portal or with a qualified CA before filing.