Leave is an important employee benefit. It helps people rest, recharge, and maintain work-life balance. But what happens when an employee does not use all their leave? This is where leave encashment comes in.
Leave encashment allows employees to convert unused paid leave into money. Instead of losing unused leave days, employees receive a cash payout based on their salary and company policy.
In this glossary, we explain leave encashment meaning, how it works, how it is calculated, tax rules in India, and why it matters for both employees and HR teams.
What Is Leave Encashment?
Leave encashment refers to the money an employee receives in return for unused paid leaves during the year. According to labor laws, salaried employees are entitled to a certain number of paid vacation days, which are determined by the employer.
Additionally, many companies allow employees to carry forward unused paid leaves to the following year. Consequently, an unutilized leave balance may accumulate in an employee’s leave quota by the time of departure or retirement. Upon off-boarding, the company must reimburse the employee for any unutilized paid leave, and this payment is referred to as leave encashment.
Benefits Of Leave Encashment
Leave encashment benefits both employees and employers.
Importance for Employees
Employees get paid for unused leave
It adds to final settlement during exit
It acts as a financial cushion during job transitions
It rewards long-term service
Importance for Employers
Prevents excessive leave accumulation
Ensures policy compliance
Helps in accurate payroll processing
Improves employee satisfaction
Leave encashment rule
The leave encashment rule for non-government employees is exempt up to a certain limit. Initially, this limit was set at 3 lakhs in 2002 due to the relatively low salaries of employees at the time. However, the limit was recently revised to 25 lakhs due to a substantial increase in employee salaries.
Any payment received as encashment at the time of retirement, up to 25 lakhs, is exempt from income tax. However, any amount beyond this is taxable under the salary head of income tax.
Who Is Eligible for Leave Encashment?
Eligibility for encashment depends on company policy and employment type.
Private Sector Employees
Most private companies allow leave encashment at the time of resignation or retirement. Some companies also allow encashment annually or after crossing a leave limit.
Government Employees
Government employees usually receive leave encashment at retirement. The rules are defined by government regulations.
Contractual or Temporary Employees
Eligibility depends entirely on the employment contract. Not all contract workers qualify for leave encashment.
Types of Leave Eligible for Encashment
Here are some common types of leaves eligible for encashment.
1. Earned leave or privilege
An employee can avail of earned leaves with prior notice to the designated authority. These leaves become eligible for encashment after a certain period. This policy varies from organization to organization.
Leaves That Are Usually Not Encashable
1. Casual leave
Casual leaves are available for a short time that usually varies from 7 to 10 days. Employees may avail of these leaves for personal reasons.
2. Medical leaves
Employees generally take medical leave when they are unable to perform their duties due to poor health. The encashment of medical leaves, however, may vary depending on the organization’s policy.
3. Holiday leaves
Holidays may be granted to employees and no salary would be deducted for that. The number of holidays provided may vary from organization to organization.
4. Maternity leaves
Employers provide maternity leaves to pregnant female employees ranging from 12 to 26 weeks. Additionally, an employee can request an extension, but no salary will be provided during that period. However, these leaves are not available for further extension beyond this.
5. Sabbaticals
Employees can take leaves to upskill and expand their knowledge base. During this time, they can enroll in courses to learn new skills, and in some cases, employers may reimburse these leaves.
Taxation on leave encashment
Here are the taxation rules on leave encashment in various situations:
1. Leave encashment received during service
The tax on leave encashment depends on when it is received. If an employee receives encashment during their tenure, it is fully taxable under the salary head of income tax. However, some tax benefits can be claimed under Section 89 of the Income Tax Act. To claim this deduction, you can fill out a specific form designed for this purpose.
2. Encash the leaves at the time of termination
Here are the conditions under which an employee can claim a tax deduction on leave encashment at the time of termination.
Firstly, the extent of the tax deduction usually depends on the sector in which you are working. For instance, state and central government employees enjoy full tax exemption on encashment of leave. On the other hand, non-government employees receive a partly exempt and partly taxable benefit. This exemption is based on Section 10 of the Income Tax Act.
Moreover, in the unfortunate event of an employee’s death, the legal heir who receives the encashment amount is fully exempted from income tax.
Leave Encashment Calculation
The formula for calculating leave encashment exemption of a non-government employee
“Proposed limit of income tax exemption for a non-government employee has been increased from 3 lakh to 25 lakh.
Particulars Amount
1. Leave encashment received (A) …………..
2. (-) Exemption under Section (10AA)- (B) Least …………..
Of the following
(i) Amount notified by the government (2500000) ©
(ii) Actual leave encashment amount (D)
(iii) Average salary of last 10 months (E)
(iv) Salary per day* unutilized leave (considering
Maximum 30 days in a year for completed service)
Leave encashment taxable (A)-(B) …………..
Let’s understand how it is made using a simple illustration.
Conclusion
Leave encashment is an important part of employee compensation and payroll management. It ensures that employees receive the financial value of unused leave while helping employers maintain structured leave policies.
With clear rules and automated systems, leave encashment becomes easy, transparent, and compliant.
For growing organizations, integrating leave encashment into a smart HRMS ensures accuracy, efficiency, and better employee experience.
FAQs (Frequently Asked Questions)
Leave encashment refers to the money that an employee receives for their unutilized leaves in an organization.
You can either encash or clear your leaves at the time of termination or layoff.
The other terms used for leave encashment are holiday pay and vacation days.
