Leave Encashment

Leave encashment converts an employee's unused leave balance into money. Rather than letting accrued days lapse, the employer pays their salary value.

It arises in two situations that behave very differently. During service, some employers allow employees to encash part of a balance each year, often to stop leave accumulating beyond a carry-forward cap. On exit, the accumulated balance is settled in cash as part of the final payout, whether the employee resigns, retires or is terminated.

The distinction matters mainly because the tax treatment of the two is not the same.

In most Indian organisations only earned leave, also called privilege or annual leave, is encashable. It accrues in proportion to days worked and typically carries forward up to a cap.

Statutory minimums for accrual and carry-forward come from two places, and one of them changed recently. For factories the source used to be the Factories Act, 1948; that Act was repealed on 21 November 2025 by section 143 of the Occupational Safety, Health and Working Conditions Code, 2020, and the position for factories now sits in the Code. For other workplaces the source is the applicable state shops and establishments legislation, which the Code does not repeal and which continues to apply on its own terms. No accrual or carry-forward figure is stated here, from either source, because the Code's leave provisions have not been checked against the enacted text. An employer can be more generous than the statutory floor but not less, which is why a national employer often runs different leave rules by state.

The standard approach values a leave day at the employee's most recent basic salary plus dearness allowance, divided by the number of days in the month, then multiplied by the encashable balance.

Here is a worked example. An employee with basic salary of 45,000 rupees and dearness allowance of 5,000 rupees has 24 days of earned leave outstanding. Treating a month as 30 days, a day is worth 50,000 divided by 30, or about 1,667 rupees. The encashment is roughly 40,000 rupees.

Two policy choices change the result and should be written down rather than left to the payroll team. The first is the divisor: 30 days, 26 working days and the actual days in the month all appear in practice, and they give materially different answers. The second is the salary base: some employers include allowances beyond basic and dearness allowance, which raises the payout and needs to be applied consistently.

Timing drives the treatment, and the governing provision changed with the tax year.

Encashment received during employment is fully taxable as salary in the year of receipt, and tax is deducted at source in the usual way. There is no exemption for it, even where the employer forces encashment because a carry-forward cap has been reached.

Encashment received on retirement is treated differently, and from tax year 2026-27 it sits in the section 19(1) Table of the Income-tax Act, 2025 rather than in a section 10 exemption. Serial number 13 covers a Central or State Government employee, for whom the entire amount is deductible.

Serial number 14 covers everyone else, and it is a four-way minimum rather than a single ceiling. The deduction is the least of: the cash equivalent of the earned leave at credit at retirement, where the entitlement counted may not exceed thirty days for every year of actual service; ten times the average monthly salary for the ten months immediately preceding retirement; an amount the Central Government may notify having regard to the limit for its own employees; and the actual payment received.

Two of those four are computable from the employee's own record and two are not. The thirty day cap and the ten month average are arithmetic. The notified amount has to be taken from the notification in force, and this entry does not state a figure for it.

The notified limit has historically operated as a lifetime limit rather than a per-employer one, so an employee who used part of it at an earlier job could claim only the balance. That is not verifiable by a later employer and is routinely missed at final settlement. Confirm the current notified amount and whether the lifetime basis carries into the 2025 Act regime before applying either.

On exit, encashment forms part of the full and final settlement alongside unpaid salary, gratuity, notice pay adjustments and recoveries. Most employers settle within 30 to 45 days of the last working day, and several state shops and establishments rules set outer limits for paying final dues.

During service, encashment is usually processed at a fixed point in the leave year, often just before balances would otherwise lapse. Employers commonly cap how many days can be encashed in a year so that leave keeps functioning as rest rather than becoming a salary supplement.

Disputes at exit almost always trace back to something the policy left unsaid. A workable policy answers each of these in writing.

• Which leave types are encashable, and whether that changes on exit.
• The salary components used, and the divisor applied to reach a daily rate.
• The carry-forward cap and what happens to days above it.
• Any annual limit on encashment during service.
• Whether encashment applies on termination for cause, and on death, where it is paid to the nominee.
• The leave cut-off date used for a leaver, since leave taken during notice changes the balance.

The last point causes the most friction. An employee who takes leave during the notice period reduces the balance being encashed, and that is worth stating before someone plans their exit around it.